market failure: informational gaps Flashcards
What are the different forms of informational failure and what do they cause?
- Causes either overconsumption or underconsumption of a good
-Imperfect information: when decisions are based on the lack of information and not the optimum decision that would have been made if there was perfect information
Asymmetric information: when one side has more information than the other in an economical transaction which they exploit to their own advantage
IMPERFECT INFO: Merit and Demerit goods
Merit: Products that are underconsumed as consumers do not have the full information about its potential benefits
-The social benefits for consuming a good outweigh private benefits
-Benefits occur both privately and socially
Demerit: People overconsume these goods because they are uninformed about all the potential costs
-The social costs of consumption outweigh the private costs
-Costs occur both privately and socially
ASYMMETRIC INFO: second-hand car market
Example:
-There are varying quality cars
-There is asymmetric info about the varying quality- seller knows, buyer doesn’t
-Buyer decided how much they are willing to pay based on the average quality car in the market- unable to distinguish
-Given the seller’s knowledge of their car, they will only sell if the price they will receive is more or equal to the true value
-The people who actually sell their cars are owners of low quality cars
-The owners of good quality cars will be unwilling to sell and will leave the market
-Leads to adverse selection
Adverse selection
-Asymmetric info causes good quality goods to be pushed out of the market by bad quality things-MARKET FAILURE OCCURS
how can market failure be solved in second-hand car market
-A guarantee/ warranty can act as a signal to the buyer than it is a high quality item
Asymmetric info: Health insurance
-People have varying degrees of risk
-Insurance company does not know true health of individual
-Insurer decided how much they will charge based off of average health
-Individual will only take health insurance if the price is worth the money- incentive to conceal health problems
-Only people buying insurance are unhealthy people- can buy coverage at lower prices that company would charge if aware of actual risk regarding applicant
-Low risk customers will leave the market
The principal agent problem
-When one person (agent) is allowed to make decisions on behalf of another person (principal)
-Agents are incentivised to act in their own best interest even if contrary to the principals - conflict of interest
Example: landlord and tenant
Costs:
-monitoring costs: principal has to spend money on monitoring and providing incentives
-inability to contract: principal is reluctant to agree to contacts as they do not know what they are getting themselves into.
How does the principal agent problem lead to moral hazard?
-An individual takes excessive risk as the cost of their actions is borne by someone else
Example: Investment banker may gain bonus for making high profits - encouraged to take risky investments - if they fail the losses are absorbed by the bank
Solutions:
-incentives should be aligned
-rewards/penalties
