4.1.2.2 - Imperfect Information

Imperfect Information =

Inaccurate or incomplete information crucial to making rational decisions.

Information Failure =

When people have inaccurate or incomplete information so make potentially suboptimal decisions.

• Imperfect information causes information failure

Types of Imperfect Information / Causes of Information Failure

• Incomplete or complete lack of information

• Inaccurate/misleading info (e.g. persuasive ads)

• Complexity (e.g. inability to process technical nutritional info)

• Asymmetric info

• Costs involved in acquiring ‘perfect’ info

Asymmetric Information =

When one party involved in a transaction has more or superior information about the good/service than another party

2 Consequences of Asymmetric Information

• Adverse Selection

• Moral Hazard

Adverse Selection =

When asymmetric information leads to an unfavourable outcome.

(e.g. second-hand car market)

Moral Hazard =

When one party chooses to make excessively risky decisions because they know that another party will have to bear the cost.

(e.g. acting recklessly after buying insurance)

Adverse Selection vs Moral Hazard

• Adverse selection occurs before the transaction

• Moral hazard occurs after the transaction

Adverse Selection leading to Market Failure Chain of Analysis (with contextual example)

• Asymmetric information occurs when sellers know more about the true value of the good or service they are selling than the buyers.

• For example, in the market for Second-Hand Cars, sellers know more about the quality of the car than buyers.

• This means sellers may not reveal all information about the car to the buyer, aiming to attract a higher price from them than would be optimal.

• For example, not telling about an engine defect.

• This leads to adverse selection, where the second-hand car buyer might buy a car they wouldn’t have bought if they’d have perfect information about the car, such as knowing about an engine defect.

• Therefore, information failure has caused market failure, which has resulted in a misallocation of resources; thus, allocative inefficiency and a loss of social welfare.

Moral Hazard leading to Market Failure Chain of Analysis (with contextual example)

• Asymmetric information occurs when buyers know more about their risk profile / their behaviour after a transaction than sellers.

• For example, in the market for Car Insurance, once a driver has purchased full insurance cover, the insurer cannot fully observe how carefully the driver behaves on the road.

• The insured driver now bears less of the financial risk of an accident, so they have a reduced incentive to drive carefully

• For example, they may drive faster or leave their car unlocked.

• This is moral hazard - the insured customer chooses to make excessively risky decisions because they know that the insurer will have to bear the cost.

• This leads to too many accidents occuring relative to the social optimum - overconsumption of risky activity

• Therfore, information failure has caused market failure, which has resulted in a misallocation of resources; thus, allocative inefficiency and a loss of social welfare.

Explain why imperfect information can lead to market failure (15 marks)

Demerit Goods

• Imperfect information can lead to overprovision of demerit goods

• Imperfect information arises when consumers attribute goods with benefits that are not true or fail to take account of long-term costs of consumption.

• For example, [application] sugary drinks can lead to obesity, diabetes, cancer.

• As a result, consumers overestimate the private benefits & underestimate the private costs of consuming the demerit good. This often occurs as a result of short-term bias in decision-making.

• This causes consumers' actual demand to be determined by information that is only partial (shown by D (partial)), so the free-market equilibrium occurs at point A at Pm,Qm

• However, with full information about the good the demand would be lower at D (full), which results in the social optimum being at point C at Ps,Qs.

• Therefore, information failure results in consumers overestimating the benefits of consuming the good so causes overconsumption of the good.

• There is over allocation of scarce resources to the good, resulting in deadweight welfare loss shown by area ABC

• Therefore, the free market mechanism has caused allocative inefficiency, resulting in partial market failure.

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Adverse Selection

• Asymmetric information occurs when sellers know more about the true value of the good or service they are selling than the buyers.

• For example, in the market for Second-Hand Cars, sellers know more about the quality of the car than buyers.

• This means sellers may not reveal all information about the car to the buyer, aiming to attract a higher price from them than would be optimal.

• For example, not telling about an engine defect.

• This leads to adverse selection, where the second-hand car buyer might buy a car they wouldn’t have bought if they’d have perfect information about the car, such as knowing about an engine defect.

• Therefore, information failure has caused market failure, which has resulted in a misallocation of resources; thus, allocative inefficiency and a loss of social welfare.

‎

Moral Hazard

• Asymmetric information occurs when buyers know more about their risk profile / their behaviour after a transaction than sellers.

• For example, in the market for Car Insurance, once a driver has purchased full insurance cover, the insurer cannot fully observe how carefully the driver behaves on the road.

• The insured driver now bears less of the financial risk of an accident, so they have a reduced incentive to drive carefully

• For example, they may drive faster or leave their car unlocked.

• This is moral hazard - the insured customer chooses to make excessively risky decisions because they know that the insurer will have to bear the cost.

• This leads to too many accidents occuring relative to the social optimum - overconsumption of risky activity

• Therfore, information failure has caused market failure, which has resulted in a misallocation of resources; thus, allocative inefficiency and a loss of social welfare.