Information Imperfect Markets And Transaction Costs

Transaction costs are a result of imperfect markets. In a world of perfectly competitive markets both transaction and governance costs would be zero because the prices of all products and factors of production together with consumer preference and production functions would all be fully known to decision makers. The assumptions of perfect competition necessary for this conclusion to be reached are presented in Table 14.2. In imperfect markets, transaction costs exist because these assumptions do not hold.

Perfect markets are characterized by the assumption of unbounded rationality; this assumes that decision makers always make optimal transaction decisions because they have full knowledge of all the relevant information and have the ability to sift and process all this information. Consequently, mistakes are never made. Imperfect markets are characterized by bounded rationality; this means that decision makers

CHAPTER 14 ■ THE BOUNDARIES OF THE FIRM 2 89 Table 14.2 Characteristics of perfect and imperfect markets


Perfect markets

Imperfect markets


Unbounded rationality

Perfect Total




Bounded rationality

Imperfect Partial

Asymmetrical Opportunistic behaviour Positive



Transactions costs

Source Author may wish to act rationally but their ability to do so is limited because they have a limited ability to absorb and handle information.

In imperfect markets a decision maker may not be fully informed or may only have available part of the information required to make a decision. Unfortunately, the decision maker will not know the quality of the information he does have nor the importance of the information he does not have. In addition, some information may be difficult to acquire and be known to only a few people, who may be unwilling to sell or impart it to anyone else. All information about future prices or costs will be uncertain. Where information is unequally available to the parties trying to reach an agreement, this is described as a situation of asymmetric information.

Adverse selection

Situations of adverse selection arise where information is both asymmetric and hidden from one party to a potential agreement; this is described as ex ante asymmetric information. Akerlof (1970) illustrated the consequences by examining the market for used motor cars. He sought to explain the wide differences in price between new, and nearly new, or second-hand, cars. The answer he argued lay in the existence of asymmetric information (i.e., the seller knows more about the motor vehicle than the buyer).

Buyers lacking the full detailed history of the car may wonder why the seller wishes to dispose of it. The real answer may be that it is a ''lemon'', a poor quality and unreliable car. All prospective buyers are suspicious about the quality, and the result is that good cars are excluded from the market. The consequences can be illustrated as follows. First, assume that there are two types of used motor cars: good and bad. Second, assume that sellers know the difference but buyers do not. Buyers, therefore, have to decide what value to put on a second-hand car without knowing whether it is a good or bad one. As a result, high-quality cars are driven from the market as buyers are unwilling to pay high prices just in case the one they buy might be a lemon.

Let us assume that the seller of a low-quality motor vehicle is willing to sell for £500 and the seller of a high-quality car is willing to sell for £1,200 and that buyers are willing to pay £700 for a low-quality motor vehicle and £1,500 for a high-quality car. Buyers will have to estimate how much they are willing to offer for a second-hand car, without knowing which car is the good one and which is the bad one. If we assume that the probability of obtaining a high or low-quality car is equal, then the expected value of any car to a buyer is given by the weighted average of the two values multiplied by the probability ratio. Thus, the expected value is equal to (0.5 * 700) + (0.5 * 1, 500), or £1,100. If the buyer is only willing to offer £1,100, then the only sellers willing to sell their cars would be the owners of low-quality cars; this is because the selling price of low-quality cars is less than the buyer is offering, while the selling price of quality cars is greater than the offer price. The seller of the quality car wants £1,500, but the buyer is only willing to offer £1100. As a result, quality cars are withdrawn from the market, only low-quality cars would be offered for sale and buyers would expect to get low-quality cars. Market failure will occur because buyers' perception of the quality of all motor cars is adversely affected through the presence of asymmetric information.

Solutions to the problem involve trying to redress the inequality of information available to both parties. Sellers may try to develop a reputation for selling only high-quality products to give buyers confidence in the product they are buying. In a similar way, sellers may offer guarantees and warranties to signal the quality of the cars for sale. Buyers might try to improve their knowledge or hire experts to advise them.

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