Capitalism is a wondrous human institution for the mutual betterment for all in society. Yet, critics often insist that market systems enable sellers to take advantage of buyers, because those on the demand-side often lack the specialized knowledge that suppliers possess, thus, enabling a misrepresentation of what is for sale. However, market competition generates the incentives and opportunities to earn profits precisely by not misinforming or cheating the buyer.
A number of economists, among the most notable being the 2001 co-recipient of the Nobel Prize, Joseph Stiglitz, a professor of economics at Columbia University, have argued that market economies suffer from an inherent inefficiency and potential injustice due to the existence of “asymmetric information.” A core element in his theory is that individuals in the marketplace do not all possess the same type or degree of knowledge concerning the goods and services being bought and sold.
Some people know things that others do not. This “privileged” information can enable some to “exploit” others. For instance, the producer and marketer is likely to know far more about a product’s qualities, features, and characteristics that he is offering on the market than most of the buyers possibly interested in purchasing it.
Coordinating Imperfect Knowledge
By withholding information from the potential buyer about all of the qualities of his good, the seller may succeed in creating a false impression that makes consumer demand greater and raises their willingness to pay a higher price than would otherwise be the case if that consumer knew as much about the good as the seller knows.
This argument is a partially reasonable response to the unrealistic assumptions of the “perfect competition” model of the typical mainstream economics textbook. One assumption is that each seller is too small of a supplier to a particular market to be able to influence the price at which he sells, and, thus takes that market’s price as “given,” and merely adjusts his output to the point at which his marginal costs are equal to his marginal revenues.
Another assumption is that every market participant in each market possesses a “perfect” or sufficient knowledge to never pay more or accept less than objective market conditions dictate. This also assures that all markets, all the time, are rapidly converging to a perfect long-run equilibrium with neither profits earned nor losses suffered. (See my article, “Capitalism and the Misunderstanding of Monopoly”.)
There is no doubt that in a system of division of labor there is an accompanying division of knowledge and, therefore, an asymmetry of information about things bought and sold by those on the demand- and supply-sides of the market. This is a theme in theories of the market process long ago explained by economists in the Austrian tradition, most especially by Friedrich A. Hayek (1899-1992), who also received a Nobel Prize in Economics in 1974.
The Austrians have long emphasized that competition is a “discovery procedure” through which individuals find out things never imagined before. The peaceful rivalry of the marketplace creates the incentives for entrepreneurs to be unceasingly alert to profit opportunities and to see possibilities that others either have missed or not thought of before. The unknown or barely perceived become seen and understood, and then taken advantage of in the form of better and less expensive products offered to the consuming public.
The purpose of competitive markets and price systems is precisely to provide a way to coordinate the dispersed and decentralized knowledge in any complex society. This same competitive market has also found ways to reduce the asymmetry of consumer versus seller knowledge and thereby to reduce the possibility of exploitation.
Search Goods, Experience Goods, and Market Safeguards
In explaining how markets do this, economists sometimes distinguish between two types of market goods: search goods and experience goods. Search goods are those that can be examined by the potential buyer before a purchase is made. For instance, suppose that a supermarket advertises that perfectly ripened bananas are available and on sale in their store. A consumer can enter the supermarket and reasonably judge whether the quality of the good matches what has been promised before buying it.
If examination shows that the bananas are either inedible green or over-ripened brown, the consumer can walk away without spending a penny. By falsely advertising or even unreasonably exaggerating in its advertising, the business runs the risk of not only losing that sale but the loss of its brand name reputation, with that consumer never returning to that establishment again. Plus, that person can tell others, potentially leading to further loss of consumer trust.
This creates a self-interested incentive on the part of such sellers to practice “truth in advertising,” or suffer the loss of customers whose repeat business drives long-term profitability.
Experience goods are those goods whose qualities cannot be fully known without using the product in question for a period of time. Think of an automobile; you can go for a test drive, but your own best judgment of its safety, reliability, and handling cannot be really known without driving the car in various weather and traffic conditions over a period of time. Or think of a bed mattress; you sit down and bounce on it, or stretch out and lay down on it in the furniture showroom, but you cannot really know if it will provide a comfortable and restful sleep every night until you’ve gone to bed on it for a period of time. The same applies to many goods, such as household appliances, for instance.
The competitive market’s response to this imperfect knowledge on the part of potential buyers has been a system of product warranties that enables a buyer to return the product for his or her money back, or a replacement at no extra cost to the buyer.
It is in the seller’s self-interest to make sure that the product matches what has been promised and is reliable. Otherwise, the manufacturer runs the risk of losing their brand name reputation concerning quality and trustworthiness. Plus, if a warranty has to be fulfilled, it is the manufacturer or seller who is forced to eat the cost of replacing the unit, thus cutting into their own profit margin.
Market Uncertainty and Franchise Businesses
But what about those situations in which reputation and repeat business do not seem as relevant? For instance, suppose you are traveling on business or vacation and are passing through some town you are highly unlikely ever to see again.
You’re hungry for a meal or a place to stay for the night. How can you know about the quality of the meal in the local “Joe’s Greasy Spoon,” or the promised bedbug-free mattress in any of the rooms in the local “Bates Motel?”
The market has provided consumer information about such products and services to overcome this imperfect knowledge in the form of chain stores and franchises. You may never eat or sleep again in that particular town, but you will likely eat and sleep away from home some time again in the future.
The sight of McDonald’s golden arches or the sign for an IHOP (International House of Pancakes) tells you the quality and variety of foods that you can have in any of their establishments, regardless of where its located in the United States or even the world. The same applies to seeing the sign for a Motel 6, or a Holiday Inn Express or an Embassy Suites, or a Hilton-family hotel. You may never again go to that particular MacDonald’s or Holiday Inn, but if you travel you may very well eat or spend the night at some other chain franchise of that company.
Another instance of this is Midas Mufflers. An automobile driver can stop in any Midas store in the country, and know that if there is a problem with the muffler or its installation, it can be returned to any Midas outlet for a replacement or reinstallation under the warranty. (And each Midas retail store has an incentive to get the installation “right,” because if another store has to correct their mistakes, the second store sends the bill to the first store for the cost of doing so, under the terms of the franchise.)
Getting it right the first time and making sure that every franchise member meets the franchise requirements is important to the “mother company” to assure the repeat business and brand name reputation upon which its revenues are dependent. Thus, each chain store and franchise is required to meet standards of quality and variety that enables the consumer to have a high degree of confidence and reduced knowledge uncertainty of what he or she is getting when they enter any of these establishments, regardless of where it may be located.
What makes this market practice consistent and successfully relied upon? Market competition and the self-interested profit motive.
Free Markets Constrain Con Men
Are there con men, hucksters, and cheats? Of course, there are. They existed in ancient Athens just as they exist today. There are always people who will try to dishonestly get what others have when doing it that way seems easier and less costly than through honest production and trade.
The question is not whether human nature can be transformed to eliminate this aspect of human conduct. The question is, are there market institutions and incentives that can systemically reduce this type of behavior and, instead, generate more honest and properly informed human interactions?
And the answer is, yes. In fact, most of these positive incentive mechanisms have emerged and evolved out of the competitive market process itself. These market solutions to the social problem of asymmetric information were discovered by market participants themselves to be profitable ways of gaining consumer trust and business, without any government command or imposition. Plus, their discovery and their practiced institutional forms could never have been fully anticipated or imagined in their full detail before and separate from the competitive market processes that have generated them.
Government Failure and Asymmetric Information
Of course, what is rarely pointed out or emphasized by those who worry about the problem of asymmetric information in society is its far more likely danger and abuse in the arena of government intervention.
In the marketplace, a disgruntled consumer who finds that a seller has been less than truthful about a product can immediately stop doing business with that supplier. This is not so in the political arena.
If a voter finds that a politician or bureaucrat has failed to meet their promises or has seemingly deceived him after an election, he must continue to fund their activities in the form of the taxes that that voter is forced to pay, as well as to obey the rules and regulations they have imposed on him or others with whom he may desire to do business.
In the marketplace, the consumer may turn to other competing providers if a particular seller has appeared to deceive him with false, incomplete, or exaggerated information. He does not have this option in the political arena.
The government often monopolizes or narrows the availability of alternative providers. The frustrated voter cannot supply “negative feedback” in the same way he can by withdrawing his business and shifting to another supplier in a more freely competitive market. Indeed, he may have to continue to use the misrepresented or faulty government-supplied or regulated product rather than face doing without it.
In the marketplace, it is usually clear who the seller is who has misrepresented their product and aroused the ire of the buyer. The consumer can, more or less, easily pinpoint the seller who is responsible for the deceit. But with the government, layers of bureaucracy and indirect chains of responsibility in the labyrinth of the political structure enable those in political power to more easily hide those upon whom the charge of lies and fraud should fully fall.
And, finally, in the marketplace, the individual disappointed with presumed misrepresentation or less than sufficient information from a seller can inform others about his experience He does not need the approval or agreement of others to change his own pattern of buying things. He just stops doing business with the seller with whom he is dissatisfied and finds a more attractive trading partner.
But in the political arena, to change those holding political office and determining the government policies considered by that individual to be deceitful and undesirable requires him to persuade enough other voters in the society so that a change may be made in who holds political office and what policies may be implemented when, and only when, the next elector cycle comes around.
But in the political arena, an unsatisfied consumer must persuade enough other voters to make a change in who holds political office and what policies may be implemented when, and only when, the next elector cycle comes around.
It is capitalism and the competitive market process that generates solutions to the knowledge problems of the society, including the “informational asymmetry” that naturally follows from any developed social system of division of labor. All that is basically required, as has been known since the time of Adam Smith in the 1770s, is recognized and respected individual rights to life, liberty, and honestly-acquired property, enforcement of all voluntary contractual agreements, impartial and biased rule of law, and constitutionally limited government.
Richard M. Ebeling is BB&T Distinguished Professor of Ethics and Free Enterprise Leadership at The Citadel in Charleston, South Carolina. He was president of the Foundation for Economic Education (FEE) from 2003 to 2008.
This article was originally published on FEE.org. Read the original article.