2.10 Market failure – asymmetric information

What is asymmetric information?

 A type of market failure where buyers and sellers do not have equal access to information, usually resulting in an under allocation of resources to the production of goods and services, as parties to a transaction with less access to information try to protect themselves against the consequences of the information symmetry.

What is adverse information?

One party in the transaction has more information about the quality of the product being sold than the other party. Either party will result in cases in under allocation of resources to the good/ service. when information asymmetry leads to the selection of unfavorable or risky choices. In markets with imperfect information, buyers may be more likely to purchase lower-quality or riskier goods or services because they cannot differentiate between high and low quality.

What happens if the seller has more information (adverse information)?

If the seller has more information, such as when selling a used car, the buyer will reduce demand. Sellers often have info they don't make available to consumers. In a free and regulated market, the result is usually to underallocate to the production of the good/ service. Consumers likely to be aware of possible dangers to themselves, and will be cautious about buying the good or service resulting in lower demand, less production and lower sales.

What are government responses to the seller having more information (adverse information)?

• Regulation/ legislation: Governments can pass laws and regulations that ensure quality standards and safety features that must be maintained by producers and sellers of goods and services. (time-consuming, bureaucratic procedures, large opportunity costs)

• Provision of information: supplying info directly to consumers/ forcing producers to provide information - protecting consumers in their purchasing decisions. (info about quality, hazards,.) (difficulties involving collection and dissemination of all necessary information to consumers, info accuracy, opportunity costs) Impossible to eliminate an information symmetry, always room for seller to hide come information to seller.

• Licensure: Laws to require doctors to be licensed - can only be obtained upon proof of adequate medical competence. Economists criticise licensing, as it may limit the supply of people in a profession, raising the price of their services and increasing their incomes at the expense of those who must may higher prices.

What are private responses to the seller having more information (adverse information)?

• Screening: then the buyer has limited information, they try to get more information about what they are buying  (the product/ the producer/seller.) Buyer may research the seller of product online, or may informally ask friends in order to get information.

• Signalling: Seller has more information they attempt to convince the buyer that the product is of good quality, for example through use of warranties or establishment of brand names to convey sense of reliability. Unlikely to provide full information to buyers and may even provide inaccurate or misleading information by sellers eager to promote and sell their products.

What is an example of the buyer having more information?

If the buyer has more information, such as regarding one's health condition when buying health insurance, the seller will reduce supply.

What are government responses to the buyer having more information? (adverse information)

* Governments may take the form of direct provision of healthcare services at low or zero prices to an entire population, finances by tax revenues, insuring the entire population has health insurance coverage. Or may take form of social health care insurance, which may cover a country's entire population or selectively covers certain vulnerable groups. (potential problem - difficulties in controlling costs of providing healthcare and growing burdens on the government budget)

What are private responses to the buyer having more information (adverse information)?

* Screening = private insurance companies protect themselves by offering range of policies where the lower the cost of insurance, the higher the deductible. Offers people a choice, so that those who believe they have a low risk of getting sick can buy a low-cost policy with higher deductible whereas high-cost policies with lower deductibles chosen by those with high levels of health risk. Choice of high/ low deductible given to buyers of insurance to screen them by indirectly providing information about their state of health to the seller of insurance.

What is moral hazard?

Where one party takes risks but does not face the full costs of these risks because the full costs of the risks are borne by the other party; often arises in connection with insurance and form of asymmetric information, causing market failure.

What are responses to moral hazard?

Done by making buyer of insurance pay for part of the cost of damages through deductibles. Intended to make insurance buyer face the consequences of risky behaviour, thus leading to less risky behaviour.

Through government regulation of financial institutions, intended to oversee and prevent highly risky behaviour.

To limit moral hazard then, the government must charge deposit insurance assessments that vary with the riskiness of the bank (as signaled by the market).

• Build in incentives

• Penalise bad behaviour

• Split up banks so they are not too big to fail

• Performance related pay