Asymmetric Information

Question 1

What is asymmetric information?

Answer 1

Type of market failure occurring when one party to a transaction has more information than the other party, leading to allocative inefficiency

Question 2

What are the two types of asymmetric information?

Answer 2

Type 1: sellers have more information than buyers

Type 2: buyers have more information than sellers

Question 3

What happens when seller knows more than buyer?

Answer 3

In a free, unregulated market, knowledge asymmetries usually result in an underallocation of resources because buyers try to protect themselves against the risk of purchasing a good or service that is not in their best interests.

However, if consumers are unaware of possible hidden dangers, there could be an overallocation of resources to the production of these goods.

Question 4

What are government responses to avoid information asymmetry where sellers know more than buyers?

Answer 4

1. Regulation
   - pass laws to ensure quality standards and safety features are maintained by producers
   - time consuming and hard to monitor
2. Provision of information to consumers
   - nutritional labels on food, information on health hazards of products, etc.
   - difficult to collect and disseminate all necessary information accurately & huge opportunity cost
   - some special information is impossible to share (legal or medical knowledge) and often individuals selectively reveal information to their client
3. Licensure
   - requirement that professionals have a license
   - can limit supply and thereby increase the price

Question 5

What happens when buyer knows more than seller?

Answer 5

1. Moral hazard

2. Adverse selection

Question 6

What is moral hazard?

Answer 6

Occurs when someone takes more risks because someone else bears the costs of those risks
- example: unemployment insurance may lead some people to be less hesitant about being unemployed

Sellers in an attempt to protect themselves will under-allocate resources to the production of insurance services

Question 7

What is the solution to moral hazard?

Answer 7

Dealt by making the buyer of insurance pay part of the cost of damages

• lower the cost of the insurance, the higher the out-of-pocket payments
• lower income earners can only afford the cheaper policies and thus are incentivised to change behaviour (but high-income people will not be incentivised)

Question 8

What is adverse selection?

Answer 8

Arises when buyers of insurance have more information than sellers of insurance.
- example: someone sick is less likely to admit this to an insurance provider

In an attempt to protect themselves, sellers will under-allocate resources to the production of insurance services. Moreover, insurance companies might not provide elderly people as they are more likely to fall ill.

Question 9

What are the solutions to adverse selection?

Answer 9

1. Low-cost policy with higher out-of-pocket payments for those who believe they have a low risk of getting sick & high-cost policy with lower out-of-pocket payments for those who believe they have higher risk of getting sick
   - regressive as poor people can afford low-cost policy regardless of their health

To counter the regressive effects, government can directly provide free health services from tax funds
- this will be a massive opportunity cost