When consumers lack information, free-market system falters

March 29, 2010|By Charles Scott, Fred Derrick and Andrew Samuel

On the face of it, the markets for automotive maintenance, Wall Street, and health care seem unrelated. But they all have a common problem.

Most of us become nervous when a mechanic tells us that a relatively new car that we have brought in for routine maintenance needs parts replaced that (by the way) will cost $750 plus labor. One is left feeling helpless in trying to decide whether the mechanic is telling the truth or ripping us off. Although not every mechanic is a cheat, we all know that there is some truth to this stereotype.

The problem with this situation is that a mechanic is an expert who possesses private information about the true state of your car. Since he can charge by the hour and because of the type of service he provides, he has no incentive to reveal the truth about your car or suggest the most cost-effective way to fix it. And a dishonest mechanic often exploits this private information to his advantage.

Economists refer to such situations as markets with asymmetric information. Unlike buying a piece fruit or a shirt, where customers know exactly what they are purchasing, in markets with asymmetric information buyers do not know whether they are receiving the service or product that is in their best interest. And, more importantly, sellers in these markets do not have any incentive to reveal the truth, because doing so does not serve the seller's interest.

Heart stent surgery at St. Joseph Medical Center is a current local example. When asymmetric information is present, and sellers do not have incentives to reveal the truth, market transactions (such as automobile services and used cars) possess the problem of "moral hazard" - where the seller does not act in your best interest. Just as with the mechanic, sellers of financial services are experts with private information about the true risk of the financial instrument or service they are trying to sell.

For example, in the housing market, purchasers of flexible-rate mortgages were not told the true risks of the financial service they were purchasing. Similarly, investors bundled the "toxic mortgages" into portfolios that they claimed were diverse when, in fact, these portfolio elements had the same risk profile. Worse, incentives were structured so that hedge fund managers made a percentage of any of the gains from the asset but did not share any of the losses. Thus, managers had no incentive to responsibly invest the money of their customers.

It can be argued that the major factor prompting the meltdown was asymmetric information and associated moral hazard. The buyers in each of the transactions leading up to the crash knew less than the sellers. These transactions created unrecognized risk. When banks became "too big to fail," the American public was forced to bear the cost of this unrecognized risk.

The end result was, in effect, a big Ponzi scheme with the inherent risk in the mortgages accumulated and passed on, while at the same time creating incentives (due to the unrecognized risk) for propagation of the secondary mortgage market, leading to a housing bubble. When the rise in housing prices slowed, the unrecognized risk became real and the current holder of the portfolios including the mortgages suffered the consequences.

The current health care system has many similar characteristics. There are asymmetric information and moral hazard issues between the doctor and patient, as well as between the health insurance providers and the patients. There is risk created through the health risks of the patients, for which they do not pay directly. The insurance companies off-load onto the public patients that have "pre-existing conditions" or have incurred expenses above their spending caps, since hospitals are not allowed to reject sick patients.

In addition, we have created the Medicare and Medicaid systems to insure the elderly and the indigent. These systems inherit the riskiest clients, serving as the insurer of last resort. This creates cost for the U.S. taxpayer and for the insured through higher premiums. Both of these populations are growing, as the population ages and medical care (and insurance) becomes more expensive, and as the economy remains weak and citizens lose their jobs (and health insurance).

Free markets work extremely well in situations with symmetric information, such as purchasing a shirt. But as Nobel Prize-winning economists George Akerlof and Joseph Stiglitz have shown, markets with moral hazard are generally inefficient and do not serve the best interests of society.

In such situations, more regulation may actually enhance the ability of markets to provide goods and services in a cost-effective manner to the public. In particular, government regulations must require that providers of financial services clearly reveal the true risks and costs.

Further, regulations can also ensure that fund managers' incentives are realigned so that they bear both the gains and the losses of their investments. Similar regulations for the health care sector and in the home mortgage sector can also help reduce this problem of asymmetric information. That is, given the "pre-existing conditions" in these markets, government intervention is necessary.

Charles Scott and Fred Derrick are professors of economics and Andrew Samuel is an assistant professor of economics at Loyola University Maryland.

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