Friday, August 12, 2016

Market Efficiency And Asymmetric Information

Warren Buffet has set up a trust fund for his wife that consists entirely of passive stock index funds.  There are two reasons why he did that.  Most importantly, he understands how difficult, and expensive, it is to collect the information needed to make smart investments.  He made lots of mistakes when he started his career because he was poorly informed.  He learned more about investing through experience and he understands that few investors make well informed investments.  Of course, it is also expensive to pay wealth managers a fee so that they may make better informed decisions.  Buffet decided to fund his wife's trust with passively managed index funds because it is less expensive to bet on the entire market than it is to pay wealth managers to make better informed decisions on individual stocks.

This article applies Buffet's lesson to financial markets in general.  It shows that financial markets cannot be efficient because buyers and sellers are not equally informed about the asset being traded.  That is what economists call the problem of asymmetric information.  Financial markets are heavily regulated in order to limit the problem of asymmetric information.  We learned the hard way that the deregulation of financial markets led to the financial crisis.  Sellers of opaque financial derivatives made fortunes selling assets that were sold to poorly informed buyers.  Buyers and sellers of those assets suffered huge losses when the true value of those assets became apparent.

Economists understand that markets cannot be efficient under conditions of asymmetric information.  Unfortunately, that does not have much of an impact on those who assume that markets are efficient, while many of the products that we purchase are poorly understood by consumers.  For example, drug companies are now able to advertise products directly to consumers who are poorly prepared to evaluate the products.  The consumer then puts pressure on medical professionals to write the required prescription.  That must be an effective strategy for the drug companies because they no longer have to pay sales professionals to call directly on busy physicians.  It must be less expensive and more productive to sell drugs directly to poorly informed consumers.  If we look at our household budgets we find that we are spending considerable sums on products that are very difficult to evaluate and price.  How many consumers can effectively determine the product and price differences on offer from cell phone service providers, TV service providers, internet service providers?  Moreover, many of the products and services that we purchase require the consumer to agree to conditions of the sale which would require a lawyer to effectively evaluate.  In many cases the consumer unknowingly agrees to give up the right to sue the seller and accept the decision of an arbitrator to recover damages.  The bottom line is that producers of goods and services have learned how to take better advantage of information poor consumers.  Markets have became less efficient, and market failures have become more common.  It is not surprising that businesses are willing to spend large sums on lobbyists who oppose regulations that would make markets more efficient.

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