February 21, 2005

incomplete information as labour market failure

I thought of a small point in the great 'is the labour market a special market, and should the government therefore set special rules for it" debate today. Generally speaking, employers know more about wages and conditions for a labour market than employees do. This means employers will tend to have more information to base their employment contract decisions on than their employees, and will do better out of the deal over time. This idea is based on my current understanding of the market failure of incomplete information*, the idea that poor information leads to poor decisions. Why is this a market failure? Because market theory is based on the assumption that all parties in the market have perfect information (how much all the alternatives cost, any hidden flaws in the product, whether or not they will still like green in 2 year's time).

I may well be wrong in my assumption that employers have more information about employment than employees. I'm basing my assertion entirely on the fact that I don't tend to ask people about how much they get paid unless they are a friend of mine, so pretty much all my info is from ads in the paper. Specifically I don't know what gets paid in my company, so I feel at a distinct disadvantage thinking about what I should ask to be paid.

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* Incomplete information.

The market failure of incomplete information (as I remember it from 1st year varsity) is where people don't know important things when they make a decision to purchase something. This may mean they undervalue something (and therefore the market doesn't provide enough of it) or they may overvalue something (in which case the market will provide and distribute too much of it). And yes, the definition of how much is the correct amount is defined as the market clearing price#.

A simple example is purchasing a lemon when you thought you were purchasing a car. The amount you would have paid for the lemon if you knew it was a lemon is usually substantially less than the amount you actually handed over.

This idea can be extended to girlfriends who turn out to be incapable of remembering your birthday or the dress which looks awful when you get it home.

The thing I find most interesting about incomplete information is that it affects all market transactions to a greater or lesser degree, and yet is largely ignored by economists. Given the huge scope for not knowing the important stuff (particularly about things like jobs and house purchases) it seems a miracle to me that markets work at all.

Posted by carla at February 21, 2005 09:03 PM
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