Imperfect Information and Externalities

Jon Henke at QandO makes this observation:

It follows from the a priori assumption that, in a free market where all transactions are voluntary, no actor will engage in a transaction that is not to his benefit. Therefore, every exchange will increase the overall wealth and well-being of a society.

Now, that's a reasonable assumption, except for two things:
1: imperfect information.
2: externalities.

These two factors can result in exchanges that reduce the wealth/well-being of a society, even though it was no part of the original intent of the transaction.

* Imperfect information can result in transactions that don't benefit one or both sides of the transaction. (ex: I give you $5000 for a used car, thinking it's worth it to me....but, as it turns out, the car is a lemon. With better information about the state of the car, I could have made a better choice)

* Externalities (def: "...costs or benefits arising from an economic activity that affect somebody other than the people engaged in the economic activity and are not reflected fully in prices.") are perfectly illustrated by pollutants. The pollution given off by a factory is not a factor in the cost of making a product, and--though it has a cost--has no direct reflection in the price of the produced item. In other words, it assigns a cost to people not involved in the transaction

Right. OK, pretty much standard economic theory, nothing to really disagree with from any flavor of economics.

Those are the limitations of the free market. So, what's the solution?

More precisely, those are the limitations of Nature. There is no economic system that can handle those two things perfectly, free markets handle them the best.

Both Mises and Hayek have demonstrated that governments will have even less perfect information, only the individual(s) closely involved can have the best information. If the government tries to have a bureaucrat be closely involved enough to gain the best information, the incentive structures are such that his best interest is to gain and provide mis-information.

Attempts at taxing or otherwise regulating effluents will be heavily influenced by the polluters for their own benefit. The polluters have incentive to participate in and influence the regulatory process, whereas the victims may not have the incentive or will to participate. See my previous post "Subtlety" for information on how and why corporations pervert this type of regulation.

What is not seen or even known is how many companies have been aborted or destroyed because they are locked out of the market by the regulatory and tax structure of the government's policies. Those companies would most likely be smaller more flexible companies that had come up with more efficient and thus cleaner methods of production.

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David, "It follows from the


"It follows from the a priori assumption that, in a free market where all transactions are voluntary, no actor will engage in a transaction that is not to his benefit. Therefore, every exchange will increase the overall wealth and well-being of a society...."

No actor will engage in a transaction that is not EXPECTED to leave him in a subjectively preferred state.

There is no reason to assume that an individual will necessarily be able to accurately predict his post-transaction subjectively ranked scale of values even with perfect pre-transaction information of all kinds.

Regards, Don

'..therefore every

'..therefore every transaction will improve the overall wealth and wellbeing of society.'

You've hit on two of the key assumptions, but I think there's at least one more, the assumption that people, when given free choice, will always choose to engage in activities which benefit themselves.

If, for whatever reason, I buy 2 crates of beer and finish them off in one night, it's easy to take the position that this doesn't benefit society.

The counter-argument, as in your examples, is that efforts by the state to regulate our behaviour for our own good always prove to be worse than useless. Society as a whole works better when individuals are left free to decide how and whether to participate (within certain limits, which we may well disagree on), even if there are some instances in which this is not the case.

Regarding the two cases of

Regarding the two cases of beer, can we consider stupidity to be a subset of "imperfect information", or is it a wholly different category.

Andy, I'll go along with

Andy, I'll go along with stupid being a part of imperfect information. In fact, drinking beer gives us mis-information - but that is why many people drink.

Andy, partly yes and partly

Andy, partly yes and partly no.

A lot of us certainly do stupid things because we don't know any better, but I'd say we also often do stupid things when we do know better.

Any transaction suffers from

Any transaction suffers from three imperfections in information available: only buyers know exactly what they want, only sellers know exactly what they are trying to sell and nobody knows what is going to happen in future.