2.10 (Asymmetric Information)

Question 1

What is asymmetric information?

Answer 1

Refers to a situation where buyers and sellers do not have equal access to information, and usually results in a misallocation of resources to the production of goods or services.

Question 2

What is competitive market mechanism?

Answer 2

• Presupposes that all firms and consumers have complete information regarding products, prices, resources and methods of production.
• However in the real world this condition is hardly ever met.

Question 3

What is adverse selection?

Answer 3

Situations where one party in a transaction has more information about the quality of the product being sold than the other party.

Question 4

Gives examples of adverse selection where information is available to sellers but not buyers (4).

Answer 4

• Used cars: Sellers have information about car’s quality that they are unlikely to reveal if the car has a defect.
• Food: Sellers of food could sell products that are unsafe for human consumption possibly leading to illness and even death.
• Medicines: Sellers of food could sell unsafe medications that could be ineffective or dangerous.
• Medical services: Individuals claiming to be doctors, with little or no training, could practice medicine/surgery, resulting in huge costs in terms of human health and safety.

Question 5

Evaluate possible government responses where the seller knows more than the buyer.

Answer 5

Regulations: Passing laws to ensure quality standards and safety features that must be maintained by producers and sellers of goods and services.
Limitations
* Time consuming, bureaucratic procedures, which sometimes work to slow down economic activities.
* Regulatory and quality control activities have very large opportunity costs.

Provision of information: Directly supplying information to consumers or by forcing producers to provide information, thus protecting their consumers in their purchasing decisions.
Limitations
* Difficulties involved in:
- collection and dissemination of all the necessary information
- the accuracy of the information
- opportunity costs in providing the information
* Usually still room for the seller to hide some information from the buyers.

Licensure: Licensing for many professions in many countries.
Limitations
* May work to limit the supply of people in a profession, raising the price of their services and increasing their incomes at the expense of consumers who must pay higher prices.

Question 6

Evaluate possible private responses where the seller knows more than the buyer.

Answer 6

Screening: The buyer may try to get more information about what they are buying.
Limitations
* Consumers may still not attain all of the information required to match that of the seller.

Signalling: The party that has more information aims to convince the buyers that the product being sold is of good quality.
Limitations
* Signalling unlikely to provide full information to buyers; information signalled may be inaccurate or misrepresentative in order to secure a sale.

Question 7

Gives examples of adverse selection where information is available to buyers but not sellers.

Answer 7

Insurance services
Buyers of health insurance know more about the state of their health than sellers of insurance.
Those with health problems are unlikely to tell the full truth to the insurance company.

Hence…
In a free unregulated market, adverse selection results in the underallocation of resources to health insurance services

Why?
Insurance companies are likely to reduces the supply of insurance to protect itself against having to provide insurance coverage to people who are more likely to become ill.

Impact on insurance premiums?
Adverse selection leads to higher insurance costs (premiums) for health insurance customers.

Question 8

Evaluate possible government responses where the buyer knows more than the seller.

Answer 8

• Direct provision of health care services at low or zero prices to an entire population funded by tax revenue.
• Social health insurance either covering entire population or selective vulnerable groups.

Limitations:
Controlling cost of health care provision and associated burden on government/social health inurance budget.

Question 9

Evaluate possible private responses where the buyer knows more than the seller.

Answer 9

Insurance companies protect themselves by offering a range of policies:

• Varied prices linked to different deductibles/excess levels.
• Screening is therefore indirectly taking place where those customers less likely to claim would choose higher deductible/lower premium options and vice versa.

Limitations:
- In practice, low-income earners choose low-cost policies with high out-of-pocket payments because theses are more affordable, regardless of the state of their health.

Equity and fairness implications:

• Low income customers are more likely to pay higher deductibles.
• Insurance companies usually refuse to insure customers above a certain age.
• i.e. the poor or those more likely to require health care have little ot no coverage.

Question 10

What is moral hazard? Give examples and possible responses by insurers.

Answer 10

• Situations where one party takes risks, but does not face the full costs of these risks.
• E.g. buyers of car theft insurance may be less careful about protecting their car against theft, because they will be reimbursed if someone steals their car.
• E.g. buyers of medical malpractice insurance (doctors) may be less careful about avoiding malpractice, because of the knowledge that malpractice costs will be covered by the insurer.

Responses:
Making the buyer of insurance pay for part of the cost of damages (these payments are known as ‘out-of-pocket payments’ or ‘gap payment’ or ‘excess’).