Informational imperfections and asymmetries

Another important assumption of the invisible hand theorem is that both consumers and producers have enough information to accurately estimate the characteristics of the goods they are consuming. Chapter 6 explores the importance of this assumption. The basic idea is as follows. Suppose that there is a competitive market for a good which can be produced in two varieties: safe and unsafe. Consumers' incremental marginal willingness to pay for a safe good exceeds the incremental cost of producing a safe good, so it is efficient for the safe good to be produced. Suppose that there is a rule of caveat emptor (buyer beware) in place. Finally, suppose that consumers do not have enough information to accurately estimate the harm that a good can cause. Specifically, suppose that consumers estimate that all goods are harmless. Then, since consumers believe that all goods are safe, and firms are not liable for harm, and since it is less costly to produce unsafe goods, the competitive equilibrium in this market will result in all firms producing an unsafe good, which will have a very low price. The inability of consumers to estimate expected harm in this example - combined with the legal rule - drives the market towards an inefficient outcome.

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