The imperfect information model describes an economic framework where economic agents, particularly producers, do not possess complete and accurate information about all relevant market variables, especially the overall price level in the economy. This lack of full information influences their decision-making, leading to specific economic outcomes.
What is the Imperfect Information Model?
The imperfect information model posits that producers are primarily aware of the price of the specific goods and services they produce, but they struggle to discern whether a change in their product's price reflects a genuine shift in relative demand for their product or simply an overall increase in the general price level (inflation). This limited awareness can lead to misinterpretations and, consequently, short-run deviations in economic output.
Core Principles of Imperfect Information
At the heart of this model lies the concept that agents operate with a knowledge deficit, impacting their ability to make perfectly optimal decisions.
Limited Producer Awareness
In this model, producers are considered to be really only aware of the price of the goods and services that they produce. That is, producers are unable to recognize overall increases in the price level because they are focused on their products only. When the price of their specific product rises, they may mistakenly interpret this as an increase in the relative demand for their good, prompting them to increase production. They do not immediately understand if this price increase is part of a broader inflationary trend affecting all prices in the economy.
Relative vs. Absolute Price Changes
- Relative Price Change: This refers to the price of a good or service relative to other goods and services. A producer correctly interprets a rise in their product's price as a relative increase if it outpaces the prices of other goods.
- Absolute Price Change (Inflation): This is a general increase in the overall price level across the entire economy. If a producer's product price rises along with all other prices, its relative price has not changed.
The imperfect information model suggests that producers struggle to distinguish between these two types of price changes in the short run. They observe a nominal price increase and might incorrectly attribute it solely to a relative price change, leading them to adjust supply based on this misperception.
How Imperfect Information Affects Supply
When producers observe an increase in the price of their output, they face a decision: is this a signal of higher demand for their specific product, or is it merely part of a general inflationary surge? Without perfect information, they often lean towards the former interpretation in the short run.
This misinterpretation leads producers to:
- Increase Production: Believing their product's relative price has risen, they increase their supply by hiring more labor and utilizing more capital, even if the real (inflation-adjusted) price has not changed.
- Short-Run Aggregate Supply Expansion: As many producers across the economy make similar misjudgments due to rising overall prices, the aggregate supply of goods and services temporarily expands beyond the economy's natural rate. This forms the basis for the upward-sloping short-run aggregate supply curve.
Over time, as producers gain more information about the general price level—through observing input costs, wages, and other prices—they realize their error. This leads them to adjust their expectations, and the short-run aggregate supply curve shifts back to its long-run, vertical position.
Implications and Economic Significance
The imperfect information model is a cornerstone of New Classical economics, particularly associated with economists like Robert Lucas Jr. It helps explain various macroeconomic phenomena:
- Business Cycles: The model suggests that unexpected changes in the money supply or aggregate demand can lead to short-run fluctuations in output and employment because agents misinterpret price signals. An unexpected monetary expansion, for instance, initially raises prices, which producers misinterpret as relative price increases, leading to higher output.
- Policy Effectiveness: According to this model, only unanticipated policy changes (e.g., unexpected monetary policy shifts) can affect real output in the short run. If policy changes are anticipated, agents can correctly forecast the general price level changes and adjust their behavior accordingly, negating the real effects. This aligns with the concept of rational expectations.
- Phillips Curve: The model provides a theoretical underpinning for the short-run trade-off between inflation and unemployment, as unexpected inflation can temporarily reduce unemployment by tricking producers into increasing output.
Example Scenario
Consider a wheat farmer. Suppose the price of wheat increases from $5 to $6 per bushel.
- Without Perfect Information: The farmer might immediately conclude that demand for wheat has significantly risen relative to other goods. Based on this, they decide to plant more wheat, perhaps by working longer hours or using more fertilizer.
- With Imperfect Information (Model's premise): Unknown to the farmer, all other prices in the economy (e.g., labor wages, tractor prices, consumer goods) have also increased by 20%. So, while the nominal price of wheat rose, its real or relative price remained unchanged ($5/bushel * 1.2 = $6/bushel). The farmer's decision to increase production was based on a misinterpretation of the true economic signals, driven by their focus solely on the price of wheat.
- Long-Run Adjustment: Eventually, the farmer realizes that input costs (like fertilizer) have also risen, or they observe general inflation in other sectors. They then understand that the initial price rise was not a relative increase and adjust their expectations and production back to the long-run natural rate.
