Market failure - asymmetric information (HL)

Screening (private responses to asymmetric information)

-A private response to the problem of asymmetric information in which participants with less information force those with more information to reveal their information. -Screening is most effective in dealing with problems of adverse selection.

Signalling (private responses to asymmetric information)

-A private response to the problem of asymmetric information in which participants with more information communicate this information to the other party. -In which participants have asymmetric information before the transaction, the party with more information can communicate, or signal, which 'type' they belong to -Most efficient with adverse selection

Provision of information (asymmetric information)

-Government can directly provide information to combat asymmetric information. -Examples of information provision by the government include public health campaigns, information about city planning and public projects, public tenders and changes of legislation or regulation. All of these increase the information available to the public, lessening the problem of asymmetric information.

Example of adverse selection

-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. People who think their health is at risk due to a less healthy lifestyle or existing health conditions will be more likely to buy health insurance. They will also be more at risk of illnesses and accidents, which will increase the costs to the insurance company. This means that insurance companies will want to increase the prices of their health insurance, making it unnecessarily expensive for people with healthy lifestyles to purchase insurance. Consequently, there is adverse selection, as people who are less healthy will buy health insurance.

Legislation (asymmetric information)

-Legislation refers to laws enacted by lawmakers of a country. The main goal of legislation that combats information asymmetry is to prevent the incomplete sharing of information. Governments can legislate to force consumers and producers to disclose all relevant information without hiding or forging it. -Most countries will enforce legislation regarding the information supplied by producers about the nature of the goods and services they sell.

The principal-agent problem

-Moral hazard -Refers to the conflict of interest when the objectives of the owners of a firm and objectives of the firm's managers are different. -The owner of a business is interested in growing the size of the business and earning profits from the business. The manager of the business is usually paid with a salary, not with profits from the firm, so their incentives are different from those of the owner. Additionally, the manager will think about their own success in the business, as well as the welfare of other employees. The manager of the business may take more risk than the owner would, because their salary does not depend on future business earnings. One way to solve this problem would be to reward the manager with profits from the firm.

Regulation (asymmetric information)

-Regulation refers to the monitoring of industries by government agencies. It is also possible that industries self-regulate. -Regulation is important to ensure that laws are enforced and legislation is being adhered to. It is costly, as governments will need to spend tax revenues on departments that will undertake the regulation of specific industries. However, it is a good way to hold companies to account and enforce change. -Example, financial innovation since the 1990s has made it even more difficult for participants to fully understand financial market transactions. Countries therefore employ regulation, usually done by specific regulatory authorities, to oversee and monitor financial corporations.

Adverse selection

-Type of asymmetric information -A situation in which one participant has more information before the transaction occurs.

Moral hazard

-Type of information asymmetry (market failure) -A situation in which one participant takes on more risk because they know they will not pay the consequences of that risk. There is asymmetric information after the transaction has taken place.

Asymmetric information

-Type of market failure (allocative inefficiency) -When one party in a transaction has more information than the other party. the market outcome will not be the most efficient one, as the decisions are made based on incomplete information. This means that consumers are not getting the maximum benefits they could and producers are not making maximum profits.

Advantages of signalling (private responses to asymmetric information)

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 of screening (private responses to asymmetric information)

Can still select the wrong participants

Example of moral hazard (insurance)

In insurance. Some customers behave more riskily because they know that they are insured. If drivers are involved in an accident and they have insurance, then they only pay a fraction of the costs resulting from the accident. Because they know this, they might take more risks when driving, compared to if they were uninsured.

The market for lemons (example of adverse selection)

It is about the sale of poor-quality second-hand cars. In the US, 'lemon' is a slang term for a bad car, whereas a 'peach' is a high quality car. Akerlof stated that unknowing buyers will only pay a price that averages out the prices between the 'lemons' and the 'peaches'. This price will be higher than the price should be for 'lemons', and lower than the price should be for 'peaches'. As a result, sellers with 'lemons' are more likely to bring cars to the market than sellers with 'peaches', and the market will only be supplied with 'lemons'. Akerlof concluded that the price mechanism has failed to allocate resources efficiently.

Different government responses to asymmetric information

Legislation: for example, adding health warnings on cigarette packets Regulation: for example, monitoring the quality of service provided by healthcare services Provision of information

Example of moral hazard (financial markets)

One example is that lenders are always able to avoid holding debt by selling it when they need or want to, and they pass on the risk of holding the undesirable assets. It is important to be clear that this behaviour isn't necessarily unethical - a bank can engage in riskier lending or investment practices and still operate within the law. Transactions only become unethical when as sets are sold to participants who are misled.

Pros and cons of provision of information (asymmetric information)

Pros: Cheaper Empowers consumers to make their own decisions about what is best for them Cons: Might not always be as effective as strong intervention Still carries an opportunity cost

Pros and cons of regulation (asymmetric information)

Pros: Often necessary to enforce legislation Effective in holding companies to account Cons: Expensive Investigation into malpractice will take time Subject to political debate Departments can experience internal problems

Pros and cons with legislation (asymmetric information)

Pros: Cost-effective Improves transparency of information Cons: Government can change legislation Can take time to enact Is subject to political debate Needs to be enforced

Private responses to asymmetric information

The government doesn't have to be the only one to intervene. Affected stakeholders, such as firms, can institute changes themselves to improve information asymmetries. There are two main methods: by signalling and by screening.

Advantages of screening (private responses to asymmetric information)

The participant with less information is acting and may be more likely to trust the information. Increases the amount of information available to all participants Improves market efficiency

Disadvantages of signalling (private responses to asymmetric information)

There must be consequences for inaccurate information Takes time for the newly provided information to be taken up