2.10 market failure - asymmetrical information (HL) Flashcards
perfect information
Where all stakeholders in an economic
transaction have access to the same
information.
asymmetric information
A type of market failure where one party in an
economic transaction has access to more or
better information than the other party.
two types of asymmetries (in information)
- adverse selection
- moral hazard
adverse selection
A type of market failure involving asymmetric
information, where the party with the
incomplete information is induced to withdraw
from the market.
moral hazard
A type of market failure involving asymmetric
information where a party takes risks but does
not face their full costs by changing behaviour
after a transaction has taken place. It is very
common in insurance markets.
examples of underallocation of resources caused by consumers heaving more information than producers
- Consumers may be able to take advantage of producers. If consumers know more about the quality or value of a product than producers, they may be able to negotiate a lower price or demand a higher quality product. This can lead to producers making less profit or even going out of business.
- Producers may be less likely to innovate. If producers know that consumers have more information about their products, they may be less likely to invest in research and development. This can lead to a slower pace of innovation and fewer new products being developed
examples of adverse selection (2)
insurance
if insurance companies do not ask probing questions about people’s lifestyles to ascertain whether people live healthily or not, then health insurance prices will be the same for people living healthy lifestyles as for people who have less healthy lifestyles or underlying health conditions.
1. people who think their health is at risk = more likely to buy insurance
2. insurance company increase insurance price as they think that -> becomes unnecessarily expensive for people who lead healthy lifestyles
=adverse selection as less healthy will buy insurance
lemons
Buyers hesitate to buy a 2nd hand car without knowing quality
Buyers are only willing to pay a price that averages the prices between the lemons and peaches(high quality car). = Price too higher they should be for lemons but cheaper than it should be fro peaches = sellers more likely to bring out lemons
Moral hazard example
Insurance:
Help people handle the significant costs of repairs etc. -> drivers take up more risk
financial markets:
Lenders avoid holding debt by selling it to pass on risk of holding onto undesirable assets.
Unethical when assets are sold to misled participants
Principal-agent problem
Refers to the conflict of interest when the objectives of the owners of a firm and the objectives of the firm’s managers are different
=occurs when a person can make decisions on behalf of another person
- owner of business is interested in growing size of business and earning profits
vs - manager of business usually paid w salary, not w profits -> inventive different from those of owner
- manager care more abt their own success in business+welfare of other employees = manager take more risk bc salary does not depend on business earnings
Govt response to assymmetric information (3)
- Legislation - prevent incomplete information sharing -> e.g. adding health warnings/making it illegal to give fraudulent information.
- Regulation - monitoring of industries and agencies. It is also possible that insustries self regulate -> e.g. prevent utilities companies from burdening consumers with unreasonably high prices and complicated bills, govt of most countries will have regulators in place to oversee these industries
- Provision of information - for the govt to directly provide information to consumers -> easy for industries that is regulates such as energy or telecoms -> ministers or state agencies disseminate information
Regulation (def + 2 advantages +4 disadvantages)
Regulation refers to the monitoring of industries by government agencies. It is also possible that industries self-regulate
advantages:
- often necessary to enforce legislation
- Effective in holding companies to account
disadvantages:
- expensive
- investigation into malpractice will take time
- subject to political debate
- departments can experience internal problems
Legislations
Legislations refers to laws enacted by lawmakers of a country.
advantages:
- cost-effective
- improves transparency of information
disadvantages:
- Government can change legislation
- Can take time to enact
- Is subject to political debate
- Needs to be enforced
Provision of information (def+advantages+disadvantages)
Directly provide information to consumers.
E.g. health campaigns, public projects
advantages:
- cheaper
- empowers consumers to meet their own decisions about what is best for them
disadvantages:
- might not always be as effective as strong intervention
- still carries an opportunity cost
Private responses to asymmetric information (2)
Signalling -> participants w more information communicate info to party with less info
Screening -> party with less info force party w more info to reveal information
Signalling (def + example +3advantages+2disadvantages)
In asymmetric information, the participant with
more information sending a signal revealing
relevant information about a transaction to
the participant with less information, to reduce
adverse selection
Example: firms want to hire capable employees w particular skill sets -> prospective employees can signal themselves by highlighting their particular skillsets and qualifications in their CVs
Advantages:
- Can be cost-effective if providing the signal doesn’t require any further action
- Increases the amount of information available to all participants
- Improves market efficiency
Disadvantages:
- There must be consequences for inaccurate information
- Takes time for the newly provided information to be taken up
