Friedrich von Hayek (Nobel 1974) is among the most prominent of those who have made the case that imperfect information strengthens the case for free markets. Samuel Bowles, Alan Kirman, and Rajiv Sethi offer an overview of Hayek's beliefs about information and free markets in "Retrospectives: Friedrich Hayek and the Market Algorithm," in the Summer 2017 issue of the Journal of Economic Perspectives (31:3, pp. 215-230).
In one much-quoted example, Hayek offers a discussion of what happens in the market for some raw material, like tin, when "somewhere in the world a new opportunity for the use" arises, or "one of the sources of supply of tin has been eliminated." Either of these changes (rise in demand, or a fall in supply) will lead to a higher market price. But as Hayek points out, no company that uses tin, nor any consumer who uses products made with tin as an ingredient, needs to know any details about what happened. No commission of government officials needs to meet to discuss how every firm and consumer should be required to react to this change in the price of tin. No government quota system for allocation of tin supplies needs to be established. No special government program for research and development into cheaper substitutes for tin, and no government-subsidized producers for potential-but-still-costly substitutes needs to be created. Instead, the shifts in demand or supply, and the corresponding changes in price, work themselves out with a larger number of small-scale shifts in the market.
A government agency might collect information on who currently produces and uses tin. But that government lacks the granular information about all the different alternatives that might possibly be used for tin, and any sense of when a user of tin would be willing to pay twice as much, or when a user of tin would shift to a substitute if the price rose even a little. Indeed, this granular information about the tin market is not even theoretically available to a government planner or regulator! Many users of tin, or potential suppliers of additional tin, or potential suppliers of substitutes, don't actually know just how they would react to the higher price until after it happens. Their reactions emerge through a process of trial and error.
Hayek's point becomes even more acute if one considers not just existing basic products, like tin, but the potential for innovative new products or services. One can make a guess about whether a certain type of new smartphone, headache remedy, spicy sauce, alternative energy source, or water-in-a-bottle will be popular and desired. But government planners--especially given that they are operating under political constraints--won't have the knowledge to make these decisions. Hayek's point is not only that government economic planners not only that government planners lack perfect information, but that is is not even theoretically possible for them to have perfect information--because much of the information about production, consumption, and prices does not exist. thus, Hayek wrote:
"[The market is] a system of the utilization of knowledge which nobody can possess as a whole, which … leads people to aim at the needs of people whom they do not know, make use of facilities about which they have no direct information; all this condensed in abstract signals … [T]hat our whole modern wealth and production could arise only thanks to this mechanism is, I believe, the basis not only of my economics but also much of my political views ..."As Bowles, Kirman and Sethi point out in the title of their article, Hayek's view of market system can be viewed as an "algorithm" for calling information into existence and then coordinating among the agents in the market.
On the other side, there's also a powerful case that imperfect information can cause markets not to function well. For example, the financial meltdown leading up to the Great Recession can be described as a situation where the available information was highly imperfect about the expected path of housing prices, and more specifically about complex financial securities based on home mortgages (that is, collateralized debt obligations). The information about what could happen to the macroeconomy as a result was imperfect, too. Bowles, Kirman and Sethi point out that there are a variety of economic settings where imperfect information can lead a market, or even an entire economy, into dysfunction and recession.
Joseph Stiglitz (Nobel, 2001) is among the best-known of those who have explained how imperfect information can hinder the functioning of a market, and thus offer a justification for government intervention or regulation. Stiglitz offers a readable overview of his perspective in "The Revolution of Information Economics: The Past and the Future" (September 2017, National Bureau of Economic Research Working Paper 23780). The paper isn't freely available online, although readers may have access through a library subscription, but a set of slides from when he presented a talk on this topic at the World Bank in 2016 are available here. Stiglitz emphasizes two particular aspects of imperfect information: it leads to a lack of competition and especially to problems in the financial sector. He writes:
"The imperfections of competition and the absence of risk markets with which they are marked matter a great deal. ... And in those sectors where information and its imperfections play a particularly important role, there is an even greater presumption of the need for public policy. The financial sector is, above all else, about gathering and processing information, on the basis of which capital resources can be efficiently allocated. Information is central. And that is at least part of the reason that financial sector regulation is so important. Markets where information is imperfect are also typically far from perfectly competitive ... In markets with some, but imperfect competition, firms strive to increase their market power and to increase the extraction of rents from existing market power, giving rise to widespread distortions. In such circumstances, institutions and the rules of the game matter. Public policy is critical in setting the rules of the game."Stiglitz also argues that in a modern economy, concerns over information are likely to become more acute.
"Looking forward, changes in structure of demand (that is, as a country gets richer, the mix of goods purchased changes) and in technology may lead to an increased role of information and increased consequences of information imperfections, decreased competition, and increasing inequality. Many key battles will be about information and knowledge (implicitly or explicitly)—and the governance of information. Already, there are big debates going on about privacy (the rights of individuals to keep their own information) and transparency (requirements that government and corporations, for instance, reveal critical information about what they are doing). In many sectors, most especially, the financial sector, there are ongoing debates about disclosure—obligations on the part of individuals or firms to reveal certain things about their products."Both Hayek and Stiglitz use a similar "straw man" argumentative tactic: that is, set up a weak position as the opposing view, and then set it on fire. Hayek's preferred straw man is government economic planners who seek to dictate every economic decision. He was writing in part with economic systems like the Communist Soviet Union in mind. But arguing that a market is better than wildly intrusive and weirdly over-precise old-time Soviet-style economic planning doesn't make a case against more restrained and better-aimed forms of economic regulation. Indeed, Hayek occasionally expressed support for a universal basic income and for certain kinds of bank regulation.
Stiglitz's straw man is a free market that operates essentially without government intervention or regulation. He likes to emphasize that in the real world of imperfect information, there is no conceptual reason to presume that markets are efficient. But arguing that imperfect information can offer a potential justification for government regulation doesn't make a case that all or most government regulation is justified. especially given that the real-world government regulators labor with their own problems of political constraints and limited information. And indeed, while Stiglitz tends to favor an increase in US economic regulations in a number of specific areas, his vision of the economy always leaves a substantial role for private sector ownership, decision-making, and innovation.
So what's the bottom line here? In my introductory economic textbook (if you are teaching the course, I encourage you to check it out), I seek some resolution between these competing views by quoting the well-known line from F. Scott Fitzgerald: “The true test of a first-rate mind is the ability to hold two contradictory ideas at the same time.” In this case, the contradictory ideas are that markets can often be a substantial improvement on government regulators, and government regulators can often be a substantial improvement on unconstrained market outcomes. One can't presume that unconstrained markets are efficient, one can't presume that government interventions are efficient, either. I finish Chapter 20 of the textbook with this comment:
As the famous British economist, Joan Robinson (1903–1983), wrote some decades ago: “[E]conomic theory, in itself, preaches no doctrines and cannot establish any universally valid laws. It is a method of ordering ideas and formulating questions.” The study of economics is neither politically conservative, nor moderate, nor liberal. There are economists who are Democrats, Republicans, libertarians, socialists, and every other political group you can name. Of course, conservatives may tend to emphasize the virtues of markets and the limitations of government, while liberals may tend to emphasize the shortcomings of markets and the need for government programs. But such differences only illustrate that the language and terminology of economics is not limited to one set of political beliefs, but can be used by all.