Failures of Information

Question 1

How does information failure occur?

Answer 1

1. Information exists when some, or all, the participants in an economic exchange do not have perfect knowledge.
2. Information failures exists when one participants in an economic exchange knows more than the other, a situation referred to as the problem of asymmetric information.

In both cases, there is likely to be misallocation of scarce resources, with consumers paying too much or too little, and firms producing too much or too little. Information is common and appears to exist in numerous market exchanges.

Question 2

Information Asymmetries

Answer 2

It can be argued that markets work best when knowledge is perfect and is evenly shared by all the parties in a transaction. Hence, asymmetric knowledge is an economic problem because one party can exploit their greater knowledge.

Question 3

Examples of Information Asymmetries

Answer 3

1. The job applicant, who fails to reveal at a job interview that they do not have a particular skill for the job.
2. The estate agent, who exploits the fact that a potential buyer has very little knowledge about the property, and any possible problems.
3. The cigarette manufacturer, who does not inform smokers of the true health risk of smoking.
4. The buyer of financial product, who is unaware of the true level of risk.

Question 4

Anchoring and Framing in Decision Making Bias

Answer 4

Anchoring is the subconscious use of irrelevant information as a fixed reference point (anchor) for making subsequent decisions about that security. It is an irrational bias towards an arbitrary benchmark figure.

How a choice, or how a new piece of information is ‘framed’ is likely to affect the choice, even when two options have identical outcomes. This is framing.

Question 5

The Lemons Problem

Answer 5

When parties to a transaction are ignorant of certain aspects of the transaction, such as the quality of the product they are buying, they are forced to make assumptions, based on the price (eg. if price is low, quality is poor and vice versa).

In some markets, only low quality products will be sold - the so-called Lemons problem

Question 6

Principal-Agent Problem

Answer 6

In an increasingly complex world, individual decisions making often relies on the advice given by experts, and a potential principal-agent problem can occur whenever decision makers rely on advice from others with more knowledge than they have.

For example, the shareholders of firms, the principals, usually delegate responsibility for day-to-day decision making to appointed managers, the agents. This creates a situation of asymmetric knowledge, with managers knowing much more than the shareholders. This raises the possibility of inefficiencies, especially when shareholders and managers have different objectives.

Question 7

Moral Hazard

Answer 7

Moral hazard is any situation in which one party to an agreement engages in risky behaviour or fails to act in good faith because it knows the other party bears the consequences of that behaviour.

It occurs when people’s behaviour is less careful than it should be because:

1. They believe that their carelessness will not be found out
2. They are encouraged to behave carelessly

This because there is ‘insurance’ protecting them from the adverse effects of their careless decision. A pupil at school can idle because they believe their parents will provide insurance against their idling, or State will give them income if they can’t get a job.

Question 8

Examples of Moral Hazards

Answer 8

1. Consumers may under-estimate the net private and external benefit of merit goods.
2. Consumers may over-estimate the net private and external cost of demerit goods.
3. Fishermen may not know the size of fish stocks, and as a result, over-fishing current stocks.

Question 9

Remedies - Increasing the Supply of Information

Answer 9

Government may force producers to provide accurate information about products through accurate labelling. Public broadcasts to improve knowledge may be made, such as informing smokers and drinkers. Government can subsidise public service TV and radio. Laws may also be passed to force public limited companies to more transparent, and publish their financial accounts, as well as have them audited to ensure accuracy. Government may also regulate advertising standards to make advertising more information, and less persuasive.

Question 10

Remedies - Increasing the supply of information

Answer 10

Employers may be forced to request job applicants to disclose information about themselves, such as whether they have a criminal record. Government can establish organisation to act as regulators and watchdogs.

Question 11

Remedies - Increasing the demand for information

Answer 11

Market theory suggests that demand for knowledge will increase if it is provided freely, or at low cost, hence consumers should not have to pay for information. However, consumers may also become overwhelmed with information and fail to take it into account.

Government may also promote the formation of pressure groups such as anti-smoking groups. Promoting literary, numeracy and IT skills may help increase the demand for information. Having the skills to acquire knowledge can create an increase in demand for knowledge, and a greater appreciation of the value of information in making rational choices.