INFORMATION ASYMMETRY

AND MARKET FAILURE

TEAM MEMBERS:

Abhilasha Yadav
Amritha Satish Kumar
Kriti Kumari
Pooja R
 Introduction to Information Asymmetry

● Importance of Information:

Information flow plays a central role in determining various other

dynamics in the economic system.

● Information Asymmetry:
Pareto optimality assumes perfect information which is against the reality
of the market situation. The reality is a situation of a symmetric
information where one party in an economic transaction has insufficient
information in comparison to the other party involved.
 Result of Information Asymmetry
● The main effect of Information Asymmetry is market failure.
● The market mechanism by which the laws of supply and demand that
determines prices of goods and services is askew.
● Market failure also indicates the inability of the markets to bring about
equilibrium of private and social cost and benefit.
● When the producer has more information Marginal Social Cost > Marginal
Social benefit
● When consumer has more information Marginal Private Cost > Marginal
Private Benefit and therefore Social benefit > Social benefit
Adverse Selection and Moral Hazard
● Adverse Selection:
Adverse selection describes a situation in which one party in a deal has more accurate and different
information than the other party. This asymmetry causes a lack of efficiency in the price and the
number of goods and services provided. Here, there is a lack of symmetric information prior to when the
contract or deal is agreed upon.

● Moral Hazard:
Moral hazard occurs when there is asymmetric information between two parties and a change in
the behaviour of one party occurs after an agreement between the two parties is reached.Often
witnessed in the lending and insurance industries. In a moral hazard situation, one party entering
into the agreement provides misleading information or changes their behaviour after the
agreement has been made because they believe that they won't face any consequences for their
actions. There is always the risk that one party has not entered into a contract in good faith
ADVERSE SELECTION
● Market side can't observe quality of goods (hidden information).
● Lack of information symmetry between buyers and sellers, borrowers and lenders.
● Occurs when one side has limited knowledge of the other side's product or
creditworthiness.
The market for lemons
● Lemon Problem: Asymmetric info in investments/products.
● Lemon = Defective product
● Used car market: Sellers know more about value than buyers.
● Buyers assume equal chance of good/lemon, pay expected average.
● Disadvantages good quality car sellers.
● Market failure due to externality between good and bad car sellers.
● Impacts buyer perceptions of overall car quality.
How to deal with adverse selection problem?
1. Signaling:

Good quality car owners want to signal their car's quality to potential buyers.

Sensible signal: Offering a warranty with the used car.

Warranty signifies the car's good condition and reliability.

2. Screening:

Encourage or require sellers to get independent inspections before listing cars.

Inspection report shared with potential buyers.

Assures buyers of the car's condition, reducing information asymmetry.

How Does The Insurance Market Collapse Due To Adverse
Selection ?
Consider two individuals, A and B. A is healthy and B is unhealthy. Both want health
insurance.
Assumptions:
i.Two individuals are alike in all respects except their health condition
ii.Insurers can’t observe applicants’ health status; this is private information
How will insurance companies decide on the insurance premium?
Suppose the insurer’s price schedule reads, “Charge $10 monthly premium to the healthy
one, and $25 to the unhealthy one”
Natural to charge average premium ($17.50) to each
Because of adverse selection, only the worse risks will participate in the market
Outcomes Due To Adverse Selection

The lower risks are grouped with higher risks and all pay the same premium
Hence, the lower risks face an unfavorable rate and will tend to under-insure
They sustain a welfare loss by not being able to purchase insurance at rates appropriate to their risk
Conversely, higher risks will face a favorable premium and therefore over-insure;
They will insure against risks that they would not otherwise insure against
When the insurance company can’t pool its risks
It loses money on the contracts it sells, eventually withdraw from the market i.e., a market failure
Moral Hazard Problem & Insurance Market

A is a risk-averse person with a utility function given by U(w)= √w , where w = wealth

A wants to take an automobile insurance for her vehicle

However, she can also choose to be either a careful driver or a not-so-careful driver. If she drives with
care, she incurs a cost of $ 3000

Assume A drives a car with a market value of $10,000

The only other asset she owns is $3,000 in her bank account. Thus, she has a total initial wealth of
$13,000

Insurance premium is $2750 for automobile insurance

 Outcomes Due to Moral Hazard

Four outcomes: to drive with or

without care, without insurance
Accident
and with insurance

No accident

When she has an accident, car is a total loss

“loss” and “no loss” probabilities reversed when she decides to drive
without care

E(L) equals $2,500 in case she drives with care and $7,500 in case she
does not
CASE I: The utility distribution for A (Without Insurance)

Care costs $3,000, her initial wealth gets

reduced to $10,000 when driving with
care. Otherwise, it stays at $13,000

Drives with care and has an accident, FW=$13,000−$3,000−$10,000=$0; Utility = 0

Drives with care and no accident, FW= $13000 - $3000 = $10,000; Utility= 100
E(U) of driving with care with no insurance = 0.25×0+0.75×100=75

Drives without care and has accident FW: $13000-10,000=3000 , utility= √3000 =54.77
Drives without care and has no accident FW= $13000 , Utility =√13000 = 114.02
E(U) of driving without care with no insurance=0.75×54.77+0.25×114.02=69.58
Final Action A will take : When no insurance is taken, drive with care
 CASE Ⅱ: The utility distribution for A (With Insurance)

Insurance premium priced at $2750

Wealth after purchase of insurance equals=
$13000 - $2750= $10,250
If A has an accident, the insurance company
indemnifies her with $10,000

Drives with care and has accident FW= $10,250−$3,000−$10,000+$10,000=$7,250 & Utility= √7250= 85.15
Drives with care and has no accident FW= $10,250−$3,000=$7,250 & Utility= √7250= 85.15
E(U) of A = 85.15 when she drives with care with insurance
Drives without care and has accident FW = $10,250−$10,000+$10,000=$10,250 & Utility=√10,250 = 101.24
Drives without care and has no accident FW= $10,250 & Utility=√10,250 = 101.24
E(U) of A = 101.24 when she drives without care with insurance
Final Action A will take : When insurance is taken, drive without care