Real Prices and Ideal Prices - Price Discovery and Information Asymmetry

Price Discovery and Information Asymmetry

Commenting on the information problems associated with prices, Randall S. Kroszner, a Governor of the Federal Reserve Bank of the United States, theorizes:

"When a product’s track record is not well established, there should be a strong market demand for information in order to facilitate price discovery. Price discovery is the process by which buyers’ and sellers’ preferences, as well as any other available market information, result in the “discovery” of a price that will balance supply and demand, and provide signals to market participants about how most efficiently to allocate resources. This market-determined price will, of course, be subject to change as new information becomes available, as preferences evolve, as expectations are revised, and as costs of production change. In order for this process to work most effectively, market participants must utilize information relevant to value that product. Of course, searching out and using relevant sources of information - as well as determining what information is relevant -has its own costs. To underscore the last point, with new instruments, it may not even be clear exactly what information is needed for price discovery - that is, some market participants may not know what they do not know and they may therefore terminate the information-gathering stage prematurely, unwittingly bearing the risks and costs of incomplete information."

In addition to the discrepancies between real prices and ideal prices, it may in fact be impossible at any one time to know what the "correct" price of something ought to be, even although it is being traded anyway, for an actual price. The "correct" price level is only an ideal price, namely a price at which supply and demand would tend towards balance. But because of inadequate information, that price may never be reached; supply and demand may only haphazardly adjust to each other using inadequate information. The reassurance of a self-balancing market does not matter much when people are making money, but when they do not, they become very concerned with market imbalances (mismatch of supply and demand).

When the information needed to calculate prices is inadequate for any reason, it becomes susceptible to swindles, confidence tricks and fraud which may be difficult to detect or combat, insofar as the trading parties have to make assumptions in interpreting price information where any "misunderstanding" is their own responsibility. The risks and risk-bearers may not be fully specifiable. In this context, the Stanford Encyclopedia of Philosophy states:

"When there is a risk, there must be something that is unknown or that has an unknown outcome. Therefore, knowledge about risk is knowledge about lack of knowledge. This combination of knowledge and lack thereof contributes to making issues of risk complicated from an epistemological point of view."

This problem is compounded if various extrapolated ideal prices used to guide economic actors rely on observed trends in real prices which fluctuate a great deal in ways that are difficult to predict, and if the predictions made themselves influence price levels. It plays an important role in the theory of information asymmetry to which Joseph Stiglitz has made important contributions.

Price information is likely to be reliable,

• if market actors have a self-interest in providing true information,
• if it is technically possible to obtain true and accurate information, and
• if there are comprehensive legal sanctions (penalties) for false price information.

But additionally, any market cannot function unless participants show trust and cooperation, and are motivated to do so.