Economics Notes: Rational Choice, Asymmetric Information, Market Failure

Rational Choice Theory

• Decision makers use logic to choose the best option for their self-interest.

• Basis of most economic theories.

Consumer Rationality

• Individuals make sensible choices that offer the best value.

• Driven by self-interest and incentives.

Utility Maximisation

• People choose the option with the highest utility (satisfaction).

• Example: Choosing movies over ice skating for greater satisfaction.

Perfect Information

• Decision makers have easy access to information for well-informed choices.

• Too many choices can be exhausting.

Rational Consumer Choice (AO3)

• People make choices that maximize benefits or utility.

• Firms maximize profit, consumers maximize utility.

• Rational assumptions:

  • Consumers buy more when prices fall.

  • Firms buy from the cheapest supplier.

  • Shareholders seek the greatest return.

  • Investors minimize risk.

  • People prefer a higher standard of living.

  • Government improves citizen well-being.

  • IB students study to pass exams.

What is Asymmetric Information?

• One party has more information than the other.

• Leads to misallocation of resources.

• Markets fail due to informational imbalances.

Adverse Selection

• Occurs before a transaction.

• Party with better information uses it to their advantage.

• Causes market failure:

  • Low-quality participants dominate.

  • High-quality participants leave.

Real-World Examples of Adverse Selection

Loan Applicants Without Credit Histories

• High-risk borrowers take loans, low-risk borrowers opt out.

• Pool of borrowers becomes riskier.

Hiring Without Reference Checks

• Firm hires low-productivity employees.

Job Applicant Hides Employment History

• Employers end up with costly hires.

Moral Hazard

• Occurs after a transaction.

• Party changes behavior after being protected from risk.

• Causes market failure:

  • Increases costs for the uninformed party.

  • Creates inefficient levels of risk-taking.

Real World Examples of Moral Hazard

Driver Becomes Careless After Buying Full Insurance

• Increased claims costs, higher premiums.

Employee Slacks Off After Probation Ends

• Misallocation of firm resources, lower productivity.

Construction Firm Uses Cheaper Materials After Winning Contract

• Results in long-term costs for society.

Signalling

• Informed party reveals information to the less-informed party.

• Reduces adverse selection.

• Examples:

  • Labour Market: University Degrees.

  • Consumer products: Product Warranties.

  • Online Sellers: Verified reviews.

  • Financial Markets: Voluntary Credit Ratings.

The Role of Signaling

• Signals must be credible and costly.

• Helps solve information gaps.

Screening

• Less-informed party extracts hidden information.

• Examples:

  • Employment: probationary work period.

  • Insurance: choice of deductibles.

  • Rental Housing: credit and reference checks.

  • Banking: loan application questions.

The Role of Screening

• Helps identify characteristics of the more informed party.

• Markets fail due to asymmetric information.

• Private solutions may not be enough.

• Governments improve transparency, correct incentives, and protect consumers.

Type of Intervention Description Example Strengths Limitations

• Regulation & Licensing

  • Sets standards.

  • Medical licensing, building codes.

  • Ensures minimum quality.

  • Can raise costs.

• Mandatory Disclosure Laws

  • Provides clear information.

  • Nutrition labels, loan terms.

  • Increases informed choice.

  • May be ignored.

• Third-Party Certification

  • Verifies quality.

  • Food safety inspections.

  • Objective and trusted.

  • Requires oversight.

• Subsidising Information Access

  • Funds consumer education.

  • Government health websites.

  • Improves long-term decisions.

  • Takes time.

• Public Provision or Regulation of Key Services

  • Regulates services.

  • Public healthcare.

  • Avoids inequality.

  • Large cost.

Market for Lemons

Asymmetric information leads to market failure.

The Market for Lemons

The Used Car Example

• Buyers can't observe car quality, so offer average price.

• Sellers of high-quality cars leave the market.

• Only lemons remain.

Adverse Selection

• Asymmetric information causes low-quality products to remain, high-quality products driven out.

Opportunistic Behaviour

• Sellers hide defects, undermining trust.

Solving Asymmetric Information Problems

Signalling

• Informed party reveals information.

• Sellers of good cars may:

  • Offer warranties.

  • Provide service records.

  • Use certified programs.

  • Sell through reputable dealerships.

Screening

• Uninformed party acquires more information.

• Buyers might:

  • Pay for inspections.

  • Use reputation systems.

Government Intervention

• Governments may:

  • Enforce lemon laws.

  • Mandate disclosure laws.

  • License dealers.

Asymmetric Information and Car Insurance

Asymmetric Information Exists

• Drivers know more about their risk than insurers.

• Leads to adverse selection and moral hazard.

Adverse Selection: When the Wrong People Buy Car Insurance

• High-risk individuals buy insurance, low-risk individuals opt out.

• Reduces efficiency, drives up prices.

Moral Hazard: When Insured People Take More Risks

• Insured people take riskier actions.

• Increases claim costs, raises premiums.

How the Private Market Tries to Fix the Problem of Asymmetrical Information

Screening (by insurers)

• Insurers gather more customer info.

• Voluntary excess.

• Telematics and Usage-Based Insurance (UBI).

• Driver Profiles.

• Kilometres Driven Per Year.

• Tiered pricing.

Signalling (by consumers)

• Consumers signal they are low risk.

• Higher Excess.

• Driving History.

• Garage Parking.

• Advanced Driver Training Certificates.

Government Regulation of Insurance Conduct

• ACCC monitors price transparency.

• ASIC ensures clear disclosure.

• Moneysmart.gov.au offers public education.

Telematics and Usage-Based Insurance in Queensland

• Telematics monitors driving behavior.

• Tracks speed, braking, acceleration, and time of driving.

Excesses

• Policyholder pays out-of-pocket when claiming.

• Reduces moral hazard.

Tiered Insurance Policies

• Multiple coverage levels for consumers.

Advantages of Tiered Insurance Policies

• Improves Market Efficiency.

• Encourages Consumer Choice.

• Incentivizes Safer Behaviour.

Disadvantages of Tiered Insurance Policies

• Complexity and Confusion.

• Information Asymmetry Still Exists.

Asymmetric Information Asymmetric Information, Adverse Selection, and Moral Hazard in Health Insurance

• Consumers know more about their health than insurers.

• Adverse selection and moral hazard exist.

Government Incentives to Encourage PHI:

• Lifetime Health Cover (LHC).

• Medicare Levy Surcharge (MLS).

• Private Health Insurance Rebate.

Government Intervention in the Private Health Insurance Market in Australia

Objectives of Government Intervention

• Encourage PHI uptake.

• Correct market failures.

• Screening strategies: Co-payments, Benefit Caps, Waiting Periods.

• Strategy: Wellness Programs.

Market Failure

• Divergence between private and social costs and benefits.

• Examples:

  • Under-provision of merit goods.