For the free market to work it is assumed that everyone knows everything, or at least everything they need to know. However the world is full of things we know nothing about. This is the problem of asymmetric information, where one person knows more than the other. This creates many problems which hamper the operation of the free market and prevent it from reaching the perfect equilibrium.
There is one problem every consumer has before buying a product. That is, they pay money without actually trying the product out and knowing anything about its quality. They are in effect, flying blind. Take the cinema for example; you pay your money without knowing whether the movie is any good. As a result you end up going to a lot of rubbish movies (this summer has been particularly bad). This is also a problem when buying electronics, you have no idea how good quality the product is. Sure this television may be cheap, but will it break quickly or is the picture quality terrible?
There is asymmetric information at work at job interviews. The potential employer has no idea how good a worker you are, so they have to guess. This is an inexact science and quite often they end up hiring the wrong person. The potential employee has an incentive to exaggerate their abilities, to the extent that it is almost expected that people tell gross lies in interviews. There is little way for the employer to check to see if you have done all the things you claim to have. As a result, it is incredibly difficult to reach the most efficient outcome.
People try to compensate for their lack of knowledge by using signals. For example a college degree may not teach you anything useful, but it does signal to employers that you are intelligent and capable of learning. Warranties and quality standards can reassure consumers that the product won’t instantly break down. People try to complete meaningless and useless activities just to use it on their CVs and make it look like they are hard-working and helpful. (For example I took part in the “Buddy System” which helped first years adjust to the new school. It was a waste of time because they didn’t need any help, but it’s still on my CV).
Experience is another signal. Looking for work, I know that the one thing everyone is looking for is experience. Employers look for this not only because they have to train you up less (every new job requires some training up) but because it is a signal. It’s a way of telling employers that you were good enough for someone else to hire you, so you must have something going for you. It shows you are capable of doing a job, any job, and all that comes with that (showing up on time, following orders, completing tasks). Simply not getting fired is a signal to employers that although they know little or nothing about you, you might be able to do their job.
A brand is a signal. For example when buying electronics (an area most people have no clue about) people generally rely on brand names. They reason that as they have no way of testing the quality they can rely on a brand that has a good reputation for quality. Of course, brand has as much to do with advertising as actual quality, so the best brands aren’t always the best products. In this way consumers can purchase inferior products and the market won’t reach the most efficient equilibrium.
People also rely on less efficient and more shallow signals. For example people are judged based on how they look or sound. Beautiful people are more likely to get a job and better pay. People are often judged based on their accent (I find myself doing this subconsciously). Someone with a country accent is presumed to be stupid, someone with a North Dublin or a working class accent is presumed to be a gurrier or a troublemaker, while someone with a South Dublin or a posh accent is presumed to be arrogant.
People try to close the information gap by relying on reviews and the opinions of experts. This is the case with restaurants, movies and electronic goods. The problem is that the opinions of experts are quite different from those of ordinary people. I have given up reading film reviews because they recommend terrible movies while slating some quite good ones. Film reviewers tend to have a far more artsy taste than the average consumer. Likewise, the people who write in electronic magazines are usually technology junkies who can easily understand the complex areas and would use it in much different ways to the average consumer. A person who can programme code would not be the best advisor to someone who has difficulty saving a Word file.
People often turn to their networks. So I don’t know what the best phone is, but a lot of people I know bought a Samsung and liked it so I bought one. People value the opinion of their friends who have experienced the product and can warn us of bad ones. On the down side this can lead to a herd mentality and people buying goods just because everyone else is, rather than because it is the best product. This also takes place in hiring, where employers hire friends and relatives of theirs and their staff. The logic being, well at least I know my friends and I know if they are good people or not. Unfortunately good friends don’t always make the best workers.
It is interesting to view how asymmetric information affects racism. If I grow up in a segregated area and only know white people, I won’t be able to judge how good a worker a black person would be. As a result I may not hire him out of uncertainty and ignorance. Likewise, if I hire friends and relatives of current staff, then the dominant ethnic group will stay dominant and the outsiders will remain outsiders. This is the case in Northern Ireland where the dominance of Protestants has been self-perpetuating as much due to asymmetric information as through discrimination.
Asymmetric information can lead to perverse incentives (lack of knowledge can lead to the wrong things happening). Take doctors and lawyers. You don’t know how good they are until after you hire them. Even still, this is heavily dependent on the specifics of your trial or illness, as well as simple luck. So people try to guess skill and quality based on how much a doctor or lawyer charges, presuming that the person who charges the most is the best and the person who charges the least is the worst. This means that the more a lawyer or doctor charges the better people think they are, so the more money they make. This is part of the reason why trials are so expensive and lawyers are some of the richest people in the country.
It is because of asymmetric information that we have government regulation. If people don’t know about a product then regulation on quality can reassure people that at least it won’t kill them. I am reassured about going into a restaurant knowing that even though I cannot see the kitchen, it isn’t necessary for me to personally test my food for disease. If all pilots have to undergo a government exam in order to fly a plane, then the fact I know nothing about a pilots’ skill doesn’t prevent me from getting on a plane. Regulation ensures that if you put your money in a bank, someone doesn’t simply take the money and run (I’m presuming proper and sufficient regulation).
This is also the case in the workplace. Before accepting a job I have little or no idea of the working conditions. However regulations ensure that I won’t be joining a sweatshop hell-hole run by a slave driver. There are so many ways you can be injured on the job (more people are killed at work than in war) that it is impossible for an individual to calculate the risk and decide if it is worth taking (presuming they’re not a maths genius or someone with enough money they can credibly threat to quit their job). How could any individual know of the threat and risk of asbestos? No person could calculate the risk of working with chemicals, so government regulation ensures proper safety precautions are made.
For the perfect competition dream of free marketers to work it is necessary for everyone to have perfect information. However in the real world, what people don’t know can be a serious impediment towards reaching the most efficient equilibrium. When people have to make decisions about things they don’t fully understand (in other words most decisions) the free market can fail. That’s why we have regulations.