In the previous sections it has been argued that the relationship between government and industry is best described as a complex process of bargaining. The actions of the many interested parties will be influenced by their various objectives, the instruments at their disposal (e.g. voting, lobbying, changing prices, output levels, or production techniques, etc.) and the information available to them. Information is associated with important bargaining problems because it is not complete, and because different people will usually have access to different information.
That people do not have access to complete and accurate information is an obvious point that would not be worth emphasizing were it not for the fact that its importance is often overlooked or seriously underrated. Systems of centralized planning, for example, all depend on the idea that planners can somehow become acquainted, if not with perfect information, at least with the information which is ‘most important’ to their purposes. The fate of such centrally planned systems in Eastern Europe reflects in part the emptiness of this hope. For the purposes of this Course, however, it is the effect of different access to information by different people which is more significant. The information available to business may not be available to government and vice versa, while the incentive for one party truthfully to inform the other may not exist, or may be difficult to contrive.
Where the information available to one party to an agreement is different from that available to the other, the information is said to be asymmetrically distributed. Asymmetric information is associated with two problems that will be encountered at various points throughout the rest of the Course. These problems are called respectively moral hazard and adverse selection.
Where the behaviour of one party to an agreement cannot be observed by the other, the problem of moral hazard arises. It is sometimes classified as a problem of ‘hidden action’ although ‘hidden inaction’ may also be a form of moral hazard. Classic examples of moral hazard include the tendency of people who are insured against some loss, to act (unobserved by insurance companies) in ways which increase the probability of the loss occurring. People may guard their property less attentively, drive less carefully, live less healthily and so forth. Although insurance contracts provide the classic examples, any situation in which there is a conflict of interest and in which the actions of one party (the agent) are unobservable by the other (the principal) gives rise to the moral hazard problem. The debate about the control of public enterprises (Module 8) or of bureaucracies (Module 7), for example, concerns the effectiveness of various mechanisms for coping with moral hazard.
The adverse selection problem arises when contractors differ from one another in various relevant respects. If information were perfect, agreements would be expected to vary according to the type of contractor involved. For example, managers and workers might possess different levels of skill, or firms might produce goods and services of differing levels of quality. These differences in quality would normally be reflected in prices, but a problem arises if the buyer cannot at low cost determine whether a supplier is of high or low quality. All suppliers will then have an incentive to exaggerate their quality, and suppliers of truly better quality goods or services may find the prevailing prices unattractive and decide to retire from the market altogether – hence the term ‘adverse’ selection. Adverse selection arises as a result of ‘hidden information’. Information concerning the characteristics of one of the parties to an agreement is hidden from the other. Government and industry relationships will confront this problem directly where negotiations with suppliers are involved. Examples include the contracting out of public services (Modules 3 and 9) or the purchasing of goods by the government from the private sector (Module 5).
