Why More Information Can Actually Decrease Welfare

Companies make decisions based on information from a variety of public and private sources. Public information is typically obtained from macroeconomic statistics and central-bank communications, while private information is often derived through independent analysis and the market interactions of economic agents. Public information, which is shared among economic agents, has the added benefit that it can help agents coordinate their decisions, and conventional wisdom suggests that this coordination should increase welfare in the economy. However, a new publication by George-Marios Angeletos (MIT), Luigi Iovino (Department of Economics), and Jennifer La'O (Columbia University) - Real Rigidity, Nominal Rigidity, and the Social Value of Information, in American Economic Review, 106(1): 200-227, DOI: 10.1257/aer.20110865 - has identified limitations in previous research. The authors note how previous conclusions were based upon models that ignored important factors, such as the underlying sources of the business cycle.

Standard macroeconomic models conclude that firms perfectly coordinate production and pricing decisions. This conclusion, however, requires a number of assumptions, which fail to recognize how the available information is rarely complete. In the real world, the presence of informational frictions inhibits coordination and can upset our conventional wisdom that more information is socially valuable.

The paper recognizes that companies make decisions about production and set prices based upon incomplete information. In a baseline model, firms are allowed to change their prices as they wish and information affects only the employment and production decisions (information is thus a form of real rigidity). In this scenario, the authors show that the key variable to understand the overall effects of information on welfare is the nature of the business cycle. More information, no matter whether it comes from a public or private source, will raise welfare in the economy if benign forces, such as technology shocks, are driving the business cycle. Indeed, more information enables firms to make better decisions by reducing real rigidities. In contrast, welfare decreases with more information when the business cycle is driven by shocks that impact the market power of firms, such as markup shocks, or other kinds of distortionary forces.

Things become more complicated when prices are subject to informational frictions (information is thus also a form of nominal rigidity). The authors show, however, that monetary policy can and should neutralize nominal rigidity when benign forces are driving the business cycle. On the contrary, when markup shocks or similar kinds of market distortions are at work, the monetary authority can exploit informational frictions that cause nominal rigidity to achieve better outcomes and offset the markup shock. In this scenario, more information is bad for two reasons: it exacerbates the inefficiency of underlying flexible-price fluctuations, much like it does in the baseline model, and it also reduces the effectiveness of monetary policy.

The main message of the paper is that the overall welfare effect of information is ultimately determined by the source of the business cycle. When the business cycle is driven by non-distortionary forces, such as technology shocks, welfare improves with more information of a private or public nature. But when the business cycle is driven by distortionary forces - such as shocks to monopoly markups - welfare decreases with either type of information.