Market failure may also occur because consumers do not possess perfect knowl- edge. Perfect knowledge includes knowledge by consumers about product prices and qualities, including the hazards associated with a product. Like all other ac- tivities we have studied, search for information is carried out to the point where the marginal benefit of more information equals the marginal cost of gathering it. Consumers choose the optimal level of search based on their individual valua- tions of benefit and their individual search costs. It is a rare consumer who finds it optimal to be perfectly informed. Even when consumers are optimally (but not perfectly) informed about product prices and qualities, market failure due to im- perfect knowledge remains problematic. In this section, we will describe how lack of perfect knowledge may lead to prices greater than marginal cost and possibly too few or too many resources devoted to the production of some goods.
Imperfect Information about Prices
As we just mentioned, consumers will not gather every piece of information about prices and product characteristics as long as information is costly to obtain. We know already from a number of discussions in different contexts that the optimal amount of information for consumers occurs when the marginal benefit of its use is just equal to its marginal cost of collection. As long as marginal benefit is greater than marginal cost, more information will be gathered, but because marginal cost is positive, consumers will never collect information until marginal benefit is zero.
This means that they will be unaware of higher-quality products or the lower prices some sellers charge for exactly the same product. Furthermore, the optimal level of information will not be the same across consumers. For some consumers the marginal cost of collecting information will be relatively high. Age, a handi- cap, high transportation costs, and the opportunity cost of a person’s time all have an effect on the marginal cost of getting information. Marginal benefit will also be different across buyers.
The fact that consumers do not know everything about prices and product at- tributes creates an opportunity for product prices to vary from seller to seller.
Recall that in the model of perfect competition with perfectly informed consum- ers, every seller charges the same price, because every seller’s product is identical to every other seller’s and consumers know this. In reality, as we are now arguing, consumers do not know the price that every seller is charging, even for homo- geneous products. Consider even a particular product—like a 150-count box of white Kleenex tissue. Prices will vary from seller to seller, because all buyers will not go to the seller with the lowest price. The marginal cost of gathering infor- mation about the prices all sellers charge is simply too high relative to marginal benefit. Some sellers will, therefore, survive in the market charging relatively high prices, and consumers will not all be paying the same prices for the same goods.
4Portions of this discussion are adapted from S. C. Maurice and Owen R. Phillips, Economic Analysis: Theory and Application, 5th ed. (Homewood, IL: Richard D. Irwin, 1986).
In addition, firms will not be charging prices equal to marginal cost, because they know information is costly. As long as their prices are not outrageously high, customers will not find it optimal to continue searching for a lower-priced seller. The lack of information gives firms some degree of market power. As we demonstrated earlier in this chapter, market power creates market failure and deadweight loss. In this instance of imperfect information, market power arises not because of product differentiation, or even a lack of perfect substitutes. Market power emerges in competitive markets because imperfectly informed consumers do not possess knowledge of all producers and prices. Even though consumers are optimally informed, they are also (optimally) ignorant about the availability of substitutes. Their ignorance of substitutes creates market power for sellers of homogenous goods, something that did not happen in the model of perfect competition. Thus, imperfect information about sellers and prices can cause market failure in competitive markets.
Imperfect Information about Product Quality
Even when consumers have information, they may not be able to evaluate it cor- rectly. Evaluating information about sellers and prices is not as challenging for consumers as successfully utilizing product quality information. Buyers are fre- quently unaware of undesirable side effects of chemicals in hair spray or new car- pet. Foods may contain harmful substances that are listed on the label, yet the information means nothing to the shopper. And automobiles may have faulty de- signs that only an engineer can evaluate. We also know that producers sometimes provide false or misleading information to make consumers believe a product is better for the buyer than it actually is. Thus, possessing information does not guar- antee that consumers will benefit from the information.
To illustrate the problem, suppose consumers of a product that is competitively supplied misjudge the quality of the product, either because the industry misin- forms them or because they all mistakenly evaluate the quality information they possess. In Figure 16.9, market demand curve D is the demand when consumers evaluate product quality to be higher than the true level of product quality. Market equilibrium occurs at point C. Because the true quality is lower than the perceived quality, the marginal social benefit curve, MSB, lies below demand. The alloca- tively efficient level of consumption and production is found at point E where sup- ply intersects MSB. Because the market price, PC, does not equal marginal social benefit, a deadweight loss due to allocative inefficiency reduces social surplus by the area of the shaded triangle. Of course, if consumers underestimate the quality of a product, demand lies below MSB, and too little of the good is consumed.
The deadweight loss due to imperfect information about product prices and qualities opens the door for profit-seeking entrepreneurs to supply information services. Unfortunately, information is very much like a pure public good, so gov- ernment provision of information about prices and product quality may be war- ranted if government agencies can provide information services at a lower cost than the deadweight loss consumers bear with their own individual search efforts.
Information as a Public Good
Recall from our previous discussion that pure public goods are both nondepletable and nonexcludable. When one buyer consumes information about product quality, by reading an article in Consumer Reports, for example, that information remains fully available to other buyers in society. After the information is produced once, the marginal cost of providing additional consumers with product pricing and quality information is very close to zero. In the current digital age, it can be difficult for information suppliers to prevent nonpayers from receiving the information for free. It is certainly not impossible, however. Most city newspapers provide many of their news articles, sports scores, and weather forecasts online at no charge. By placing advertisements on their web pages, the newspapers can generate revenues from their Internet provision of information. A great deal of information now flows over the Internet, so the free-rider problem is apparently manageable.
In some cases, specific governmental bodies such as the Food and Drug Administration (FDA) and the Consumer Product Safety Commission (CPSC) may be necessary for the provision of information that is much costlier to produce than weather reports and sport scores. For instance, the CPSC annually inspects children’s toys and alerts consumers to potentially dangerous features. In some cases, it may even set standards that eliminate the danger. Usually, the danger involved is reduced, but the cost is a more expensive product to consumers. For example, the Commission once determined that baby cribs were unsafe because infants could slip through the crib bars. It then set a maximum legal distance between the bars of cribs. Manufacturers as a group had to place bars closer together; this took more bars and cribs became more expensive.
F I G U R E 16.9
Imperfect Information on Product Quality
Price and marginal social benefit (dollars)
QE Quantity
QC PE
PC
DWL C
S
D
MSB E
I L L U S T R AT I O N 1 6 . 2 Comparison Pricing in Health Care Off to a
Slow Start
Consumers benefit from having better information about both prices and qualities because such infor- mation improves their ability to find the lowest price for the desired level of quality. However, as we ex- plained in this chapter, obtaining information is costly and buyers will not usually find it optimal to gain complete knowledge about all prices and quali- ties. As a consequence of being imperfectly informed, consumers will make purchasing “mistakes,” that is, with more and better information they would have made a different consumption decision. While it is usually too costly to eliminate all “mistakes,”
consumers should be willing to adopt new tools or methods for gathering information and comparing prices or qualities (or both)—especially when the new search tools can be employed for free or at a very low cost. Health care shoppers, however, have been slow to start using the many new search tools recently launched in the United States.
For the first time, consumers shopping for health care services are now gaining access to doctor and hospital prices for medical procedures, as well as software that makes comparison shopping across doctors and hospitals much easier. A number of major health care insurers—Aetna, Cigna, Humana, and UnitedHealth Group—are developing and ex- panding their online price search services to reveal rates negotiated with local physicians for various medical procedures and prices paid to local hospi- tals for health services. Several state governments are also getting into the information business by providing web-based services listing hospital fees.
The primary purpose of these efforts to dissemi- nate pricing information about health care services is to stimulate consumer search and competition among providers, thereby lowering costs to health insurers and state governments. Unfortunately, pa- tients don’t seem to be using these new information services. In a recent Wall Street Journal article
reporting on Aetna’s experience with a new online pricing information program, almost all of the doc- tors in a survey done by Aetna said “their patients hadn’t asked questions about their rates after the program was launched. . . . There really hasn’t been any discussion (of prices).”
For all the effort and expense undertaken to cre- ate more transparent health care pricing, the use- fulness of current pricing data still suffers from serious limitations. Currently, these web services cover a relatively small number of procedures—no more than 75 common medical services at any one website. And, in many instances, the price search software provides a range of prices, rather than specific prices, for each doctor or hospital. This cre- ates uncertainty about the actual price patients will end up paying. None of the online price programs provides any information about service quality, so patients might worry that low price signals low service quality.
Perhaps the most important reason for the lackluster demand for pricing information can be attributed to the low insurance deductibles that many consumers still enjoy. Since they pay only a small fraction of the total doctor or hospital bill, patients don’t have as much incentive to shop for low prices as they do when they are buying a new refrigerator for which they pay the entire price. Ac- cording to Aetna, “as more consumers have plans with high deductibles, prices will become more im- portant to them.” We suspect Aetna is correct. How- ever, until health care shoppers can access accurate information about a wide range of medical services by most of the suppliers in their local areas, market failure due to imperfect information will continue to keep health care prices higher than the competitive level.
Source: Adapted from Sarah Rubenstein, “Patients Get New Tools to Price Health Care,” The Wall Street Journal, June 13, 2006, p. D1.
Such a change in product quality involves a trade-off to consumers. While stan- dards usually relieve buyers of evaluating the hazards of products, they also make manufacturers conform to designs that restrict product variety or make products more expensive—and sometimes both of these things result. In the specific case of baby cribs, safety standards prevented consumers from buying less expen- sive cribs that were undoubtedly not as safe as those that conformed to the CPSC guidelines, but the choice was eliminated and the less expensive models may have suited some consumers’ purposes and budgets.
Whether information problems justify government intervention is a controver- sial topic. Many economists argue that market failure stemming from information problems requires only additional information, not regulation. On the other hand, more is involved than simply acquiring a publication or reading a more informa- tive description of a product. Once information is acquired, it must be studied, and if it is complicated or technically sophisticated, the costs associated with digesting the information can be high. Under these circumstances, many economists argue that safety and quality regulation are beneficial functions of government.
Now try T echnical Problems 11–12.