market failure - information failure/imperfect information

information failure/imperfect information

• imperfect information: do not have complete or correct information about the costs or benefits ⇒ the market will produce inefficient outcomes

• asymmetric information: one side of the market (buyers or sellers) may have better information than the other

causes of imperfect information → myopic decision-making

1. MPCperceieved < MPCactual

   • in making decisions, consumers may only consider the costs and benefits in the immediate term, and are unaware of the costs or benefits in the long run ⇒ causes them to perceive the MPC to be
     lower than what it actually is

     • e.g.: smokers in deciding how many cigarettes to consume may only consider the private costs and benefits to themselves presently, and are unaware of the long-run detrimental health effects of smoking

   • when economic agents underestimate MPC, MPCperceived is less than MPCactual ⇒ the private optimal quantity Qp (where MPCperceived = MPB) is greater than the socially optimal quantity Qs (where MSC = MSB)

   • there is an overconsumption or overproduction of the good or service ⇒ deadweight loss of area abc because between Qs and Qp units of the good, the total social costs (area QsabQp) is greater than the total social benefits (area QsacQp), resulting in market failure

   • as the actual MPC is not fully taken into account, there is distortion of price signals ⇒ price mechanism fails to bring about a socially optimal allocation of resources

2. MPBperceieved < MPBactual

   • individuals may only take into account the costs and benefits to themselves at that point in time, but are unaware
     of the long-run benefits → causes consumers to perceive the MPB to be lower than what it actually is

   • e.g. health screening

   • when economic agents underestimate marginal private benefits, MPBperceived is less than MPBactual ⇒ the private optimal quantity Qp (where MPCPERCEIVED = MPB) is smaller than the socially optimal quantity Qs (where
     MSC = MSB)

   • there is an underconsumption or underproduction of the good or service ⇒ deadweight loss of area abc because between Qp and Qs units of the good, the total social benefits (area QpabQs) is greater than the total social costs (area QpcbQs), resulting in market failure

   • as the actual MPB is not fully taken into account, there is a distortion of price signals ⇒ price mechanism fails to bring about a socially optimal allocation of resources

causes of imperfect information → addiction

• consumers may be addicted to consuming a good, causing the perceived MPC to be lower than what it actually is

  • e.g. for someone who is addicted to smoking, the smoker perceives the MPC of consuming cigarettes to be lower than the actual MPC, though he may experience a short-term high from smoking, he does not fully recognise the health risks of consuming cigarettes due to his addiction, causing him to underestimate the MPC involved

• because MPCperceived is less than MPCactual, the private optimal quantity is more than the socially optimal quantity,
  resulting in overconsumption of the good and hence deadweight loss of the shaded area ⇒ allocative inefficiency and market failure

causes of imperfect information → product complexity

• when consumers shop for a technical product, they may not be
  familiar with many of the technical terms or functions associated with it → consumers may end up overestimating the MPB and go for higher specifications or additional features even when they do not need them at all

  • e.g. in the purchase of laptops, consumers are faced with technical terms such as “Processor Speed”, “RAM” among many others

• customers may end up overestimating their MPB and go for more expensive procedures than needed

  • e.g. medical services which would involve a lot of technical knowledge, unethical doctors may prescribe services or medicine that may be more than what a patient actually requires

causes of imperfect information → persuasive advertising

• firms may engage in advertising to influence consumers to buy their good or service⇒ perceived MPB is higher than what it actually is (an overestimation of the MPB)

  • e.g. laptop firms and salesmen may go all out to convince consumers that having more features and functions is better or necessary

• when economic agents overestimate MPB, MPBperceived is more than MPBactual → the MPBperceived curve lies above the MPBactual curve

  • the private optimal quantity Qp (where MPCperceived = MPB) is greater than the socially optimal quantity Qs (where MSC = MSB)

  • there is an overconsumption or overproduction of the good or service ⇒ deadweight loss of area abc because between Qs and Qp units of the good, the total social costs (area QscaQp) is greater than the total social benefits (area QscbQp), resulting in market failure

• as the MPB is perceived to be higher than what it actually is, there is a distortion of price signals ⇒ price mechanism fails
  to bring about a socially optimal allocation of resources

government intervention for imperfect info → rules and regulations

• in situations where consumers have incorrect or incomplete information regarding the private costs and/or benefits of consuming a good or service, the government can put in place measures to provide consumers with relevant information

• provides consumers with more accurate information of the private costs and/or benefits of consuming a good or service ⇒ reduces the extent of over- or under- consumption, and hence the extent of allocative inefficiency

  • e.g. in Singapore, food companies are required to declare a significant amount of basic information (e.g. name and description of food, ingredients, possible
    allergens, country of origin etc) on the labels of pre-packed foods. this enables consumers to more accurately consider the private costs and benefits of consuming a food product. if these regulations are not complied with, offenders may be subjected to a fine and/or imprisonment not exceeding 3 months

  • e.g. in the area of healthcare services, all medical practitioners are required to display medical charges openly and provide itemised receipts of fees charged, so that consumers have more accurate information regarding the services and reduces instances of overestimation of MPB

  • e.g. cigarette companies are also required by law to
    display health warnings on cigarette packets so that consumers can more accurately determine the private costs of consuming cigarettes. this allows consumers to get a better sense of the actual costs of smoking and reduces instances of underestimation of MPC

limitations of rules and regulations

high administrative costs → unsustainability

• there are high administrative costs involved in the enforcement of laws, which include the costs incurred in
  setting up structures and deploying government officials to check whether consumers and producers are complying with the laws

• such high administrative costs could cause the implementation and enforcement of the rules and regulations to be unsustainable and hence ineffective in the long term

unintended consequences of public education

• higher prices/poor quality of goods

  • requiring firms to provide more information to consumers may raise their cost of production

  • firms may pass on these additional costs to the consumers in the form of higher prices, or compromise on the quality of their good or service, thus negating the gain in consumer welfare from having more information

• opportunity cost of implementation

  • to fund the high administrative costs, the government may have to channel public funds from other public projects, thus incurring opportunity costs in terms of the benefits that could have been gained from spending more in the other sectors

  • if the administrative costs of implementing, monitoring and enforcing the laws are substantial, causing it to outweigh the intended welfare gain, government failure will result

government intervention for imperfect info → public education

• aims to provide more information to consumers about the actual
  private costs and benefits of consuming a good to allow them to make informed choices

• reflected by the shifting of the MPCperceived curve upwards to
  coincide with the MPCactual curve and shifting the MPBperceived curve to coincide with the MPBactual curve so that the private optimal quantity is equal to the socially optimal quantity, thereby eliminating the deadweight loss

• some examples include education fairs, education on preventive healthcare, and anti smoking campaigns

  • the Health Promotion Board engages the community in various public campaigns to educate the public on the benefits of regular health check-ups

  • the Screen for Life (SFL) is a national screening programme that encourages members of the public to go for regular health screenings and follow up → educates the public of the private benefits of health screening, increasing their perceived MPB of doing so, and hence their consumption of such screening services ⇒ reduces the deadweight loss that would otherwise arise from under-consumption, achieving allocative efficiency

limitations of public education

• time lag

  • it takes time for education to take effect, so this method does not offer immediate solutions to more pressing, urgent problems

  • the over- or under-consumption of the good continues, causing the market failure to persist

• uncertainty of outcome

  • the outcomes of public education are subjected to the
    receptivity of the public

  • the eventual outcome is uncertain as people may not heed the advice due to stubbornness and ingrained habits that are hard to change

unintended consequences of public education

• opportunity cost of implementation

  • education campaigns are expensive and may require substantial public funds

  • to fund these extra costs, the government may have to channel public funds from other public projects, thus incurring opportunity costs in terms of the benefits that could have been gained from spending more in the other sectors

other arguments for public education

• education is a long-term solution to raise awareness of the actual costs and benefits of consuming certain goods and services

  • by reducing the extent of imperfect information, it directly targets the root cause of the market failure, hence reducing the gap between the private optimal quantity and the socially optimal quantity, as opposed to subsidies which are more expensive in the long run and only make people behave like they are well informed when they are not

• public education may be a more politically favourable policy option for the government compared to rules and regulations as consumer sovereignty is preserved (consumers can still decide their level of consumption)

• success of public education is also dependent on government’s knowledge of consumers’ cognitive biases such as salience bias

salience bias is our tendency to focus on things that are more apparent or obvious

• e.g.: as obesity is a more visible problem compared to other health issues, the public education campaigns aimed at encouraging an active lifestyle are likely to be more successful if they were to focus on how regular exercises can help with immediate weight loss rather than the long term benefits of exercising

asymmetric information

• a specific case of imperfect information and can be thought
  of as a subset of it

• occurs when one party has more information than the other party in an economic transaction ⇒ there is a difference in information available to buyers and sellers of a good (either the buyer or the seller can be the party withholding the information)

• two main issues that can arise from asymmetric information → important to identify when information asymmetry happens (before or after)

  1. adverse selection → happens before the transaction has been completed

  2. moral hazard → happens after the transaction has been completed

• the presence of adverse selection and moral hazard can lead to the eventual collapse of markets → no production and consumption takes place

  • however, with intervention from the government, and/or measures adopted by consumers and firms, asymmetric information can be mitigated, and the markets can continue to function

adverse selection

adverse selection: the process by which "undesirable" members of a population of buyers or sellers are more likely to participate in a voluntary exchange

• arises from information asymmetry between the buyer and seller before the transaction has been completed ⇒ there are hidden characteristics of the good or service before the transaction takes place

adverse selection in the second-hand car market

• used car dealers often have more information regarding the condition of the used cars being sold than potential buyers

  • e.g. dealers would probably have knowledge of the true mileage of the car, whether the car has met with any road
    accidents (and if so, how many and to what extent), as well as whether the car has any defects that are unnoticeable by the naked eye

• in order to profit from the sale of used cars and to fetch the highest possible selling price for their cars, used car dealers might have the incentive to hide some of the information that they have about the condition of their used cars from potential
  buyers

• when used car buyers do not know whether the cars they are buying is of high or low quality, the tendency is for the market to be dominated by low quality cars that need frequent repairs, also known as the ‘lemons’

  • facing lack of information as to whether a car is a ‘cherry’ (high quality) or a ‘lemon’ (low quality), a buyer treats all cars to be of medium quality and will only be willing to pay the average price for a car of medium quality

  • hence, the sellers willing to sell the higher quality cars at higher prices will exit the market, which reduces the average quality of used cars in the market

• over time, the increased presence of low-quality cars in the market will further lower the prices that consumers are willing to pay

  • the decrease in price will further decrease the number of high-quality cars supplied.

• asymmetric information results in a market where some high-quality cars are sold, but fewer than what would be sold in a market with perfect information ⇒ welfare loss

• in the most extreme case, the downward spiral in prices may continue, causing the number of high-quality cars supplied to drop to zero, resulting in no possible trade of high-quality used cars ⇒ missing market – ‘cherries’ are pushed out of the
  market, leaving only ‘lemons’

  • the market fails and is allocative inefficient as welfare
    loss arises when mutually beneficial trade of high-quality used cars cannot take place

  • the sellers and buyers cannot overcome the information gap to trade at the prices that satisfy both their willingness to pay and sell

• adverse selection occurs as the uninformed buyers end up having to choose from an undesirable or adverse selection of goods, which is not socially optimal

adverse selection in the health insurance market

• buyers of health insurance have greater information over sellers (insurance companies), and consumers of health insurance
  might not have the incentive to divulge sufficient and accurate information about their health conditions (e.g. how long they have been smoking, or if they have any persisting ailments) to insurance companies, as that would mean that they are likely
  to have to pay higher premiums on their insurance

• consumers with higher risks are more likely to buy health insurance and choose higher levels of coverage ⇒ insurance companies risk providing insurance coverage to those with higher health risks

• facing a lack of information as to whether a consumer of health insurance is healthy, the insurance company treats all consumers to be of average health and will only be willing to charge an average price for health insurance

  • the healthy consumers who are only willing to buy a cheaper plan will exit the market, which reduces the average health quality of consumers in the market

• over time, the increased presence of less healthy consumers in the market will further increase the prices that the insurance company charges, to cover the potentially higher costs of insuring these people

  • the increase in price will further decrease the number
    of relatively healthier consumers, as they drop out of the market

• as the process continues, eventually, the remaining consumers left dominating the health insurance market will be the unhealthy ones ⇒ leads to adverse selection, where the unhealthy people are the only ones buying health insurance

• private insurance companies find it unprofitable to provide insurance, as nearly all the people who want to buy insurance are unhealthy to a certain extent

  • could lead to a missing market where no insurance companies are willing to sell insurance

• as transactions that could potentially increase society’s welfare are not realised, there is a deadweight loss, leading to market failure

moral hazard

moral hazard: a situation where economic agents take greater risks than they normally would, because the costs that would result would not be borne by the economic agents themselves

• arises due to the presence of hidden actions taken by
  economic agents after the transaction has been completed

moral hazard in the health insurance market

• after purchasing health insurance, an individual might have the incentive to pursue an unhealthy lifestyle of excessive smoking and alcohol consumption since his medical bills will be covered by insurance payouts

• there is no way for the insurance company to monitor the buyer’s behaviour after the policy is purchased

• may result in excessive insurance payouts as the insured is likely to take on greater risks and engage in undesirable behaviour, which increases the probability that claims are made

• as it would be too unprofitable to provide insurance in this case, no insurance companies would be willing to do so, thus leading to a missing market

  • results in allocative inefficiency and hence market failure, as mutually beneficial transactions between the insurance company and the potential customers do not take place,
    leading to deadweight loss

government intervention for asymmetric information → rules and regulations

laws can be put in place to make it a legal requirement to facilitate the flow of information between economic agents (consumers and producers), reducing information asymmetry

laws to reduce adverse selection

• the government can enact laws to regulate the quality of goods and services produced by firms

1. for second-hand car markets: the government may make it compulsory for used car dealers to send their cars for inspection and certification

   • by allowing the buyer of the car to have similar information to that possessed by the seller of the car, this helps alleviate the asymmetric information problem when buying a used car

   • better cars can be sold at higher prices, and ‘lemons’ can be sold at lower prices, thus allowing mutually beneficial transactions to take place in the market ⇒ eliminates the deadweight loss that would otherwise arise from a missing
     market

2. the government can also set in place laws to protect consumers from ‘lemons’ even after the transaction is completed ⇒ effect is to increase in output of high-quality goods closer to the allocative efficient level

   • in Singapore, there is the Consumer Protection (Fair Trading) Act, also known as the Lemon Law → protects consumers against goods that do not conform to contract or are not of satisfactory quality or performance standards at the time of delivery

     • a consumer is able to make a claim for a defective product (known as a ‘lemon’) sold to him/her within 6 months of purchase

     • under the Lemon Law, it is compulsory for the seller of the defective good to either repair, replace, refund or reduce the price of the defective good, subject to certain conditions

     • if the seller does not comply, the issue can be raised to the Consumers Association of Singapore (CASE), whose aim is to protect the interest and welfare of
       consumers

   • the penalties of the Lemon Law will incentivise the sellers of the defective products to disclose information about the products such that consumers have full information about the costs and benefits of purchasing the good at the point of transaction

     • as consumers can determine the quality of goods prior to the transaction, sellers of high-quality goods have the incentive to supply their goods at a higher price

laws to reduce moral hazard

• the government can regulate insurance plans to ensure that moral hazard is reduced and there is no unnecessary wastage of resources

• e.g. in 2019, the Singapore government passed a law that removed full riders on new insurance policies

  • previously, people could purchase insurance policies with full riders, which effectively allows people to pay nothing for hospital bills ⇒ present a moral hazard problem as it diluted responsibility for personal health, since the insurance would foot the full bill for medical treatment (for example, certain individuals may not be that careful with their sugar intake since they know that they can claim healthcare treatments from their insurance plans anyway).

  • as the demand for healthcare services is artificially increased with the presence of full riders, this could
    lead to a wastage of resources as more resources are put into the healthcare sector than needed, leading to allocative inefficient outcomes

  • with this law in place, all insurance policies are no longer allowed to offer full riders and will require patients to pay 5% of their hospital bills (co-payment) before the insurance covers the rest

  • from 1 April 2026, this co-payment cap is raised from $3000
    to $6000 per policy year, excluding deductibles

• this would reduce moral hazard as paying part of their own hospital bills (co-payment) would incentivise people to take better care of their health + promote greater personal responsibility and reduce the strain on the healthcare system in the long run

limitations of rules and regulations

• increased government expenditure → unsustainability

  • with a mandatory health insurance scheme, it is necessary to build up a reserve to manage the volatility of claims made by the high-risk insured

  • as a result, the premium rates of the low-risk individuals will increase

  • furthermore, with the growth in aging population in Singapore, medical insurance claims will rise ⇒ puts an upward pressure on MediShield Life premiums and increase government spending on subsidies in order to keep premiums affordable

  • such increase in government spending could be unsustainable, making the policy ineffective in the long term

• information gap

  • the government may not have sufficient information to
    determine the level of co-payment that is sufficiently high to incentivise the insured consumers to take responsibility of their own health, and yet not too high such that consumers end up bearing a large part of the costs

unintended consequences of rules and regulations

• opportunity cost of implementation

  • to fund the high government expenditure, the government may have to channel public funds from other public projects, thus incurring opportunity costs in terms of the benefits that could have been gained from spending more in the other sectors

  • if the costs are substantial, causing it to outweigh the intended welfare gain, government failure will result

application of adverse selection and moral hazard to medishield life

• MediShield Life is a basic and compulsory health insurance plan for all Singaporean Citizens and Permanent Residents, with the aim of lowering healthcare costs at both the individual and state level

  • with MediShield Life, the private insurance companies will help to foot a part of the bill when an individual incurs large hospital bills or have to go for selected costly outpatient treatments, such as chemotherapy for cancer

1. To tackle the problem of adverse selection, the government has made it mandatory for everyone to purchase MediShield Life

   • through the enforcement of such a mandatory insurance for the population, a win-win situation can be created where
     insurers can spread the risk of insurance among both risky and less risky consumers (risk-pooling)

   • consumers who are more susceptible to ailments have access to insurance at a cheaper price, and the government can save on expensive healthcare subsidies

2. to reduce the moral hazard problem, MediShield Life makes use of deductible and co-payment to incentivise people to take better care of their health

   • with a deductible and co-payment clause, the buyer of the insurance is required to pay a portion of any claim made

   • reduces moral hazard on the part of the insurance buyer, as the buyer will now bear part of the costs of his risky behaviour, and hence think twice about taking excessive risks after the insurance is bought

private solutions to reduce asymmetric information

• in the presence of asymmetric information, buyers and/or sellers have the incentive to facilitate the flow of information between parties so that mutually beneficial transactions may take place

• the existence of asymmetric information does not necessarily mean that the government needs to intervene directly to solve
  the market failure

  • private sector solutions often reduce the problems of adverse selection and moral hazard to some extent as private agents are highly incentivised to do so

private solutions to reduce adverse selection

1. signalling

signalling refers to the more informed party’s attempt to convey information about the product quality to the less informed party

• as sellers of high-quality goods would like to charge high prices, they have the incentive to convince buyers that their quality is indeed high

• sellers may signal to buyers that their products are of high quality through various ways

  • e.g. guarantees and warranties may be a way for sellers to signal that their product is of high quality as the sellers are liable to repair or replace a defective product

• with the additional information obtained through signalling, buyers are assured that the product is of good quality and would be willing to pay a higher price for it

• prevents adverse selection and enables mutually beneficial transactions to take place, achieving an allocative efficient outcome

2. screening

screening refers to an action taken by the less informed party to make it mandatory for the more informed party to provide him with information, before the transaction takes place

• by providing the less informed party with the necessary information, screening prevents adverse selection and enables mutually beneficial transactions to take place between buyers and sellers

• e.g. health insurance firms can gather information such as medical history or make it mandatory for customers to go for health check-ups, to determine the risk level of a potential customer before selling the insurance. having ascertained which customers are of high risk, the firm may then charge them a higher premium to compensate for the higher risk

private solutions to reduce moral hazard

• insurance companies can make the insured bear a portion of the claims made through co-payments and deductibles in insurance plans → creates a monetary incentive for the insured to make a more responsible decision and not to engage in risky behaviour

• insurers could also include terms in the insurance contracts to reduce moral hazard

  • e.g. a fire insurance company may insist that a firm install a sprinkler system in a warehouse to offset any increased carelessness once the insurance policy is in place