Information, Economics of
Information, Economics of
The primary sources of the tremendous growth of modern economies are technologies (including sociopolitical ones), and these are applications of systems of information. For entrepreneurs, information is a valuable but often costly commodity. Hence for political and business executives and managers, so-called inside information, that is, information that is known to business managers and public policy executives but not to the general public, presents constant temptation for illegal trading.
The absence of information influences markets, especially through the troublesome use of public ignorance, not to mention ignorance of information about technological innovations. The paradigm case for this is Adolf Von Bayer’s discovery of synthetic indigo in 1880, which famously and tragically ruined Indian farmers who grew the indigo plant in ignorance of the innovation. Less drastic but more spectacular was the fall of the price of shares of telephone companies, once deemed gilt-edged, due first to deregulation and then to the advent of Internet telephony; both were made possible by new technologies. The economic value of innovations creates incentives for secrecy regarding them. Patent laws were designed to discourage this secrecy; their success depends on their success as disincentives.
The most important innovation in retail trade was the replacement of haggling with price-fixing, which entails sellers publicizing information about the minimum price they would settle for. Initially motivated by moral considerations, it proved efficient and prevailed in competitive markets. The theoretical basis for it came from Adam Smith (1776), who deemed competition to be the best incentive for efficiency (Smith 1776, bk. 1, chap. 7). He refuted there (Smith 1776, bk. 1, chap. 1) the popular idea of trade as players outguessing one another in a zero-sum game (that is, one player’s gain is another’s loss). Because free exchange rests on expectation of improvement, all parties to it are partners. Trade is not zero-sum game: Specialization raises productivity and imposes trade. Smith’s major recommendation was to cancel protective import duties that protect the inefficient. In contrast, partial equilibrium theory (Marshall 1890), which is the bread and butter of traditional economics, incorporates the assumption that markets are perfectly competitive—that is to say, free of friction. They suffer no constraints, allow free entry, offer perfect knowledge of all relevant information, and incur no transaction costs. As this assumption is obviously false, economic advisers can easily blame friction for the failure of their forecasts. This is an excuse, the right for which is available only to those who begin with informing their clients of it. Lionel Robbins in 1932 stressed that this makes their economic forecasts sheer speculations, unlike the ones based on generalizations about observed regularities. This then resembles the distinction that Frank Knight (1921) and John M. Keynes (1921, chap. 26) made between risk and uncertainty. Unlike uncertainty, risk assessments rest on regularly observed probabilities. What information then can we have on the probabilities that affect markets? This is a vast field, as friction is blamed for so many aspects of the market untreated by the standard models yet given to statistical studies, including changes of tastes, unemployment, market fluctuations, money markets, and even markets for innovations.
The earliest studies of imperfect competition were the models for monopolistic competition (Chamberlain 1933; Robinson 1933). Friction can be viewed as spacetime dependent monopoly (and often also vice versa). Kenneth Arrow and Gerard Debreu (1954) offered an economic-equilibrium model that allowed for friction, including information asymmetry, the asymmetry being in one partner to any given transaction having more relevant information than the other. They ascribed to each transaction space-time coordinates and its own characteristics, thus allowing for a diversity of market situations that permit the study of transitions from one market situation to another, including improved information systems and innovations. Particular commodities, such as secondhand cars and risky investments, invite the misuse of information asymmetry, which is troublesome. By contract, ignorance of prices of fairly standard commodities is far less troublesome. Where asymmetry is harmful, as in real estate deals, prospective customers usually examine matters more carefully. The literature shuns the study of the most blatant information asymmetry, namely that of experts. A partial remedy for this is the use of a second opinion, and this is why insurers support it. There is also the matter of conflict of interest, conspicuous in the cases of accountants who examine the books of their clients and of teachers whose grading of their students is inevitably also grading themselves (Flexner 1910). In medicine, informed consent, though legally required, is seldom practiced. To improve matters it should apply not only in treatment of disease but also in diagnosis and from the very first meeting, so that patients will be able to acquire vital information from their physicians (Laor and Agassi 1990).
Information on probabilities helps determine insurance rates. Competition should force the insurance to render premiums fair. Yet all projections are imperfect. Catastrophic deviations from estimates force those who rely on these estimates into bankruptcy. The network of insurance systems that safeguards any subsystem from collapse raises the likelihood of collapse of the whole system, however. For as the saying goes, there is no insurance against epidemics. And the epidemics may be due to some information, misinformation, or even disinformation.
The most valuable information concerns the outcome of tests of theories on valuable matters. Before daring to apply a theory, one must test it to prevent causing too much harm. Information leading to tests of theories is harder to come by in the human sciences than in the natural sciences. It is hard to test even educational theories in experimental classes because conducting tests in classes may be dangerous for the pupils. The same holds true for medical information, and this is why its procurement requires certain precautions guided by the Helsinki Accord and similar constraints. There is nothing to inform the seekers of information regarding education, even though its importance for global politics is all too obvious. Milton Friedman estimated that returns from investment in education are highest and explained the reluctance of entrepreneurs to invest in education as a lack of information (Friedman and Kuznets 1945).
The absence of elementary information forces social researchers to resort to complex theoretical and testing techniques, including systems dynamics. This technique employs systems theory, which is the beneficial suggestion that it is often possible to simplify assumptions about complex systems in diverse ways and obtain different sets of test models. In systems dynamics study is centered on inflow and outflow of certain inventory items in system with feedback loops. These studies are simply too complex to study empirically and often even mathematically. Efforts to apply this to markets are still too hard to evaluate.
In the meantime, entrepreneurs insure themselves as best they can against being pushed out of the market by surprising new technologies. Even marginal investments in small laboratories that function as conduits of new information—habitually useless—have often saved firms from collapse.
This brings a new aspect of information to the fore: How does it flow? This question is basic for the information-transfer technologies that now are growing rapidly. Claude E. Shannon (1949) developed information theory to deal with technical questions, such as how much distortion can a telephone cause without the loss of the ability to identify the voice of a speaker? To be applicable to all sorts of information conduction, Shannon examined signal transfer over channels and distortions as the difference between the message in the source and in the target and asked in the abstract, what characterizes the information that is essential? Unusual information is clearly rare, and Shannon equated information with improbability. (Newer studies improve upon this assumption.) Shannon noted that redundant information helps restore a distorted message. Assuming that no message transfer is perfect, he suggested that with no redundancy a message will be lost with the slightest distortion. Hence the often cited advice to be brief must be qualified. The simplest redundancy is repetition; it helps avoid some distortion. All this holds for signals, not for information proper. Information theory deals with the former and is unable to deal with the latter. The treatment of information as signals was a bold step, and it is central to all computerized systems, including the information highway. Thus a computer spell-checker program spots a rare combination of letters and suggests that it is possibly a misspelled word; if misspelling transforms a word to a common word, then the spell-checker program can only spot it by examining not the word but the sentence. This gets increasingly complicated, and no spell-checker program is perfect.
The rise of information technology is the outcome of a few developments, beginning with the wish to increase mathematical rigor in response to George Berkeley’s criticism of the calculus (Wisdom 1953), the wish to develop logic as a formal system, and the wish to combine logic and mathematics. All this informed the transition from calculators to computers. Information theory was the peak of this process. The hope to see the brain as a computer must fail, as computers are blind to meanings, but much insight developed this way, leading to exciting developments in brain science, computer science, and even perception theory, all of which have breathtaking applications. The greatest boon to the economy, however, is the rise of the Internet, as is manifest from the tremendous new knowledge industries and the enormous markets for them.
SEE ALSO Arrow, Kenneth J.; Competition; Debreu, Gerard; Drucker, Peter; General Equilibrium; Information, Asymmetric; Keynes, John Maynard; Microsoft; Partial Equilibrium; Robinson, Joan; Smith, Adam; Tâtonnement
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Flexner, Abraham. 1910. Medical Education in the United States and Canada: A Report to the Carnegie Foundation for the Advancement of Teaching. New York: Carnegie Foundation for the Advancement of Teaching.
Keynes, John Maynard. 1921. A Treatise on Probability. London: Macmillan.
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Smith, Adam. 1776. An Inquiry into the Nature and Causes of the Wealth of Nations. London: Strahan and Cadell.
Wisdom, John O. 1953. Berkeley’s Criticism of the Infinitesimal. British Journal for the Philosophy of Science 4: 22–25.