Economics of Information...

The Economics of Information: Communicating/Signaling

Usually in economic models like perfect competition or utility modeling we assume that perfect knowledge exists but this isn’t usually the case, there is uncertainty caused by information asymmetry and this is what this mini booklet or post will explore.

What do we call communication in Economics?

In economics when information is conveyed we call this signaling and signals must fulfill two characteristics if they are to happen between rivals or adversaries (we can already see how important this notion is especially in terms of game theory etc):

1. The signal must be costly to fake. Essentially this characteristic is what it says it is, that it is extremely difficult to fake because it can easily be caught out or financially cost a firm. An example of this is Product Quality Assurance.
2. If the signal conveys information which is favorable for the firm then this automatically reveals information about the other firm even if it is not favorable information. This characteristic linked to the full-disclosure principle which states that firms are often forced to reveal unfavorable information about themselves because their silence can be taken to mean much worse. I guess this characteristic is more conditional on the content of the signal.

A bit of background...

The economics of information is arguably a new genre of economic study which has become popular largely due to the creation of the world wide web in 1973. The market for lemons was a piece written by the Nobel laureate in Economics, George Akerlof who talks about the market of used cars (lemons) and how the existence of inferior goods destroys the market for quality goods , this is caused by information asymmetry. Ultimately, it is up to the plum (good quality car) owner to signal to buyers using things like warranties to the consumers why their car is better. This signalling forces lemon owners to reveal information about themselves which is not favorable, bringing the full-disclosure principle into action.

I guess this example by Akerlof demonstrates why the study of information economics is so important, because ultimately such a situation can lead to unfavorable outcomes. The main two unfavorable outcomes most commonly discussed are:

1. Adverse Selection - this is what can be seen in the market for lemons that the buyer risks trading with the less desirable trade partners as those are the ones who volunteer to exchange.
2. Moral Hazard - Incentives such as insurance that lead people to file fake claims or be negligent in their care of goods.