1.3.4 Information gaps – Edexcel A Level Economics notes

Contents

Definitions

Symmetric information means buyers and sellers have the same amount of information.

Asymmetric information means either buyers or sellers have more information.

Imperfect information means parties involved in a transaction do not have full information.

For theme 1 microeconomics, there are two types of information-related market failures.

• Consumer lack of awareness about long-term personal benefits and harms from consumption.
• Asymmetric information – this includes moral hazard and adverse selection.

Consumers’ lack of awareness

Consumers may lack information or awareness about the long-term private benefits or risks associated with consumption.

Lack of awareness about long-term private benefits

• Consumers may lack information about long-term private benefits of consuming a particular good.
• For example exercising today may reduce risks of illness in the future.
• Other examples include healthcare, education and pensions.
• These are types of “merit goods”: goods that are underconsumed in the free market.
  • [Other goods, such as those with positive externalities can also be considered merit goods].
• So consumers underestimate the benefits of consuming the good.
• So there is lower demand (demand curve at D rather than D1 under full information).
• This leads to a lower quantity (quantity at q rather than q1) than optimal. See the diagram below.

Lack of knowledge about long-term harms for consumers

• Can also reverse. Lack of information about long-term harms for consumers leads to benefits being overestimated.
• For example consumers may not consider the personal harms from consuming cigarettes in terms of increased risk of lung cancer.
• Other examples include unhealthy food and alcohol consumption.
• These are types of “demerit goods”: goods that are overconsumed in the free market.
  • [Other goods, such as those with negative externalities, can also be considered demerit goods].
• This means the demand curve is higher at D than it would be with full information at D1. See the diagram below.
• So there is overconsumption in the free market at q compared to the optimal quantity q1.

Evaluating imperfect information

1) Government lack of information

• The government or regulator may not correctly estimate the extent to which consumers under- or overestimate the benefits from consumption.
• It may be that consumers consume goods knowing their benefits and dangers completely.
• Therefore, the government may not be able to tell whether there is under- or overconsumption of a good.

2) Education and advertising

• Advertising and education may reduce the extent of information gaps.
• For instance, education on the dangers of cigarettes and advertising on cigarette packaging on the health risks from consuming cigarettes may increase the level of information available to consumers.
• This may reduce demand for cigarettes, reducing the extent of market failure.

Asymmetric information

There are two key types of asymmetric information:

Moral hazard

• Moral hazard – being insured against a risk makes someone more likely to engage in riskier behaviour.
• This is also called hidden action. Whether an insured party engages in risky or non-risky behaviour is unknown to the insurer.
• Example:
  • Health insurance markets. Those who buy health insurance may engage in riskier behaviour, such as excess drinking or not eating healthily.
  • Healthcare provided free at the point of use, such as the National Health Service (NHS). Healthcare is provided free when used, but is funded through tax revenues. Knowing they can receive free healthcare if needed may encourage riskier behaviour and less taking care of health.
  • This can also be applied to life insurance, car insurance or to the government bailing out banks during the 2008 global financial crisis.
• If people engage in riskier behaviour, insurance companies will have to pay more out as more people make insurance claims.
• In a health insurance market, this results in higher costs for health insurers. So supply of health insurance shifts left. This raises healthcare prices and results in too few people being insured for healthcare, compared to the optimal outcome.
• Problems also occur if healthcare is provided free at the point of use. Taking risks with health means more operations may be required, increasing the cost to the government of funding healthcare. This comes at an opportunity cost or may require the government to raise taxes.
• However moral hazard can be mitigated.
  • This can occur by monitoring consumer behaviour.
  • Alternatively insurers can request consumers pay part of any insurance claim, so that the consumer has “skin in the game”.

Adverse selection

• Adverse selection – buyers and sellers have different information. This is often about the quality of a good or service or the “type”.
• Examples include used cars, or insurances such as health and car insurance.
• Sellers may know more than buyers about the condition of used cars.
  • For example, sellers may know which parts of the car work and which are faulty.
  • However buyers cannot tell if used cars are in good condition or not.
  • This means demand for used is cars is lower under asymmetric information compared to under full information.
  • See the diagram below.
  • This means that too few high quality used cars are sold, compared to the socially optimal outcome.
• Adverse selection can also apply with buyers knowing more than sellers. A buyer of health insurance may know more about their own state of health than a health insurance company.
• However there are many solutions to adverse selection problems.
  • For example, governments can require by law that sellers disclose any problems with cars.
  • Review systems for the different sellers may also reveal whether sellers are selling high quality or low quality goods. If a product has good reviews, this suggests the product may be of a higher quality.
  • Sellers of high quality goods could also offer warranties or guarantees.
    • These are promises to repair parts of the good or the entire good within a certain time period.
    • Sellers of low quality goods cannot afford to offer warranties as they would have to repair the good too often.
    • So sellers of high quality goods are more likely to offer warranties. Warranties can therefore signal the quality of the good.

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