LOGO

PUBLIC ECONOMICS
CHAPTER 2 (cont.)
ECONOMIC EFFICIENCY AND THE GOVERNMENT’S RE-
ALLOCATIVE FUNCTION
 Day 08

Asymmetric Information and

Chapter 2 Wrap up

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 Lecture Outline

 The nature of asymmetric information

 Seriousness of asymmetric information
 Remedies for asymmetric information: Private solutions
 Remedies for asymmetric information: Government
interventions
 Chapter 2 Wrap-up

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Nature of asymmetric information

 Why farmers are not really willing to produce hygienic

vegetable?
 What is asymmetric information?
 deals with the study of decisions in transactions where one
party has more or better information than the other.
 This creates an imbalance of power in transactions, which
can sometimes cause the transactions to go awry, a kind of
market failure in the worst case.
 Characteristics:
 Asymmetric information can be derived from seller or buyer
 As information failure, it always leads to deadweight loss
 Asymmetric information can cause:
Market failure
Adverse selection
Moral hazard
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Market failure: When the seller is more informed than the
buyer – the Case of Hygienic food

P
S
C

P0 B

D0
P1 A

D1

0 Q1 Q0 Q 5
Market failure: When the buyer is more informed than the
seller – the Case of life insurance

Assumptions:
- Group A: Low risk (occurrence possibility: 2%o)
- Group B: High risk (occurrence possibility: 6%o) Average = 4%o
- Compensation: 100,000 $  PA = 200, PB = 600

P P SB

E
S’ S’
600
B
A
F SA F
400 400
E DB
200
DA
O 5,000 10,000 Q O 10,000 15,000 Q

Group A Group B
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Adverse selection and Moral hazard
Adverse selection
 the ignorant party lacks
information while negotiating an
agreed understanding of or
contract to the transaction
 E.g. when people who are high-
risk are more likely to buy
insurance
 because the insurance company
cannot effectively discriminate against
them,
 usually due to lack of information about
the particular individual's risk but also
sometimes by force of law or other
constraints
 describes a situation where
the type of product is hidden
from one party in a transaction
Moral hazard
 the ignorant party lacks
information about performance
of the agreed-upon transaction
or lacks the ability to retaliate for
a breach of the agreement
 E.g. when people are more likely
to behave recklessly after
becoming insured, either
 because the insurer cannot observe
this behavior or
 cannot effectively retaliate against it, for
example by failing to renew the
insurance.
 describes a situation where
there is a hidden action that
results from the transaction
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Seriousness of asymmetric information

Good classification by seriousness of

asymmetric information
 Search good: a product or service with features and
characteristics easily evaluated before purchase
E.g. furniture, pens, cloths…
 Experience goods: a product or service where product
characteristics, such as quality or price, are difficult to
observe in advance, but these characteristics can be
ascertained upon consumption.
E.g. a meal, a hair cut, a concert …
 Post-experience goods: goods for which it is difficult
for consumers to ascertain the quality even after they
have consumed them, such as vitamin supplements
E.g. medicine, health treatment, …
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Factors affecting information asymmetry

Cost of ascertain
Consistence between price and quality of product
Frequency of purchase

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 Post Very high cost of
experience ascertain

Asymmetric information
Experience High

Search Low

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Remedies for asymmetric information:
Private solutions

For goods:
 Signaling: Brand name and marketing
 Warrantee
For services:
 Conditional offering: Insurance caps, past performance
records
 Base on the third party

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Remedies for asymmetric information (2):
Government interventions

Compulsory insurance
Setting up legal framework: To protect
consumers
Supporting the “third party” in private sector
Acting as the third party
Directly providing information

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CHAPTER 1-2
WRAP UP

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 Key issues

 Public sector/state/government:
 Its role in the economic cycle
 Evolution of the perception on government
 Measuring effectiveness of a government:
 Efficiency: Pareto criteria and marginal conditions
 Equity
 Why is government needed?
 Limitation of the fundamental theorem of welfare economics
• Imperfect competition
• Inequity
• Instability
• Close economy
 Government failures
 Positive vs. Normative analysis

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Role of government in market economy

Perfect competition
Efficiency
Stable
If imperfect
competition? Re-allocation
Market
economy
If instable
economy? Gover Stabilization
nment

How about Re-

equity? distribution

Equity
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 Market failures

Type of market failures Questions addressed

1. Monopoly
Normal monopoly
Natural monopoly
2. Externalities 1. What is it?
Negative externalities 2. What are its characteristics?
Positive externalities 3. Why is it called market failure? (or what
3. Public goods is deadweight loss created by it?)
Pure public goods 4. What are private solutions?
Impure public goods 5. What can be done by the government?
Excludable 6. What are limitations of government
Rivalrous remedies?
4. Asymmetric information
Against sellers
Against buyers

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