Information failure

Asymmetric information
The principle agent problem
Moral hazard
 INFORMATION FAILURE IS
A MARKET FAILURE
• Explain why information failure is a market failure.

• Definition
• Examples
• Explanation
There are 2 types of Information
failure – make notes
• When the parties involved do not know
• When one of the parties involved knows
more than the other
• The key issue is whether the information
failure is trivial or whether it has a big
effect on individuals, their families and
society as a whole. (Evaluation)
 Market failure due to lack of
knowledge – make notes
• Lack of education/awareness. Merit and demerit goods
have degrees of information failure with consumers
unaware of the true personal cost/benefit. For example,
if we take tobacco, there was a time when many people
were not aware of the ill-effects of tobacco on health.
Recently, there has been increasing concern about the
health costs of sugar consumption. Many consumers are
unaware of
• the amount of sugar in processed food
• The harmful effects of sugar on health.
 Asymmetric Information

• When one of the parties involved knows

more it is called Asymmetric Information
• A typical example is the second hand car
market or private health insurance
• 2 consequences of Asymmetric
information can be Adverse Selection and
the Principal-agent problem
 Adverse selection
Akerlof- the second-hand car market
• For example, in terms of second hand cars, buyers may be
suspicious of the motives of seller, and wonder whether the car is a
‘lemon’. If an individual buys a new car for £30,000 and tries to
sell on the second-hand market shortly after, they may be forced to
accept a much lower price, given that buyers will be suspicious of
the seller's motive. Not having all the facts, potential buyers are
likely to assume the worst and expect the car to have a problem - in
other words, it is a ‘lemon’. Therefore, given that second hand cars
will generally attract a low price, only those sellers who actually
have poor quality cars will use this market. After a short period, it
can be predicted that all cars sold on the second hand car market
will be lemons.
 Adverse selection

Health insurance: The most likely to purchase

health insurance are those who are most likely to use
it, smokers, drinkers, those with chronic heart
conditions.
The health company knows this and raises the
average price of insurance cover
This may price some healthy low-risk consumers out
of the market. Higher risk individuals gain
insurance – market failure.
 The principle-agent problem
• Asymmetric information is also associated with the principal-
agent problem. In an increasingly complex world, individual
decision making often relies on the advice given by experts, and a
potential principal-agent problem can occur whenever decision
makers rely on advice from others with more knowledge than they
have. For example, the shareholders of firms, the principals,
usually delegate responsibility for day-to-day decision making to
appointed managers, the agents. This creates a situation of
asymmetric knowledge, with managers knowing much more than
the shareholders, and raises the possibility of inefficiencies,
especially when shareholders and managers have different
objectives.
 The principle-agent problem

• Extra costs
• From a firm’s perspective, the principal-agent
problem can increase costs, and make the firm less
efficient than it could be. These inefficiencies
include the costs associated with monitoring the
performance of the managers and having to pay a
premium to attract the ‘best’ managers.
 Moral Hazard

• Moral hazard occurs when people’s behaviour is less

careful than it could be, either because they believe that
their carelessness will not be found out, or because they
are encouraged to behave carelessly. This occurs
because there is insurance protecting them from the
adverse effects of their careless decision. For example, a
pupil at school can ‘idle’ along because they believe,
either that their parents will provide insurance against
their idling, or that the State will provide them with an
income if they fail to get a job.
 Moral Hazard

• Fishermen may not know the size of fish stocks and, as a

result, over-fishing current stocks.
• Firms may provide misleading information about
products, such as producers of cosmetics claiming to
make people beautiful, holiday brochures making resorts
appear more attractive, and car drivers not knowing how
much pollution they are creating.
• See video;
http://www.economicsonline.co.uk/Market_failures/Infor
mation_failure.html
 PEOPLE ARE
INCONSISTENT OVER TIME
1. Would you prefer (A) to spend 50 minutes doing the task
immediately or (B) to spend 60 minutes doing the task tomorrow?
2. Would you prefer (A) to spend 50 minutes doing the task in 90
days or (B) to spend 60 minutes doing the task in 91 days?
3. People choose B to question 1 and A to question 2.
4. Some economists believe that the consumption-saving decision is
an important instance where people exhibit this consistency over
time.
5. Eat the chocolate bar now and go on a diet later?
6. A smoker who breaks his promise?
 What are the solutions?
• Advertising campaigns – costly, they need to lead to a change in
behaviour social norms (if not, government failure)
• Education – It takes time to take effect. The message can get
lost amongst the 1000’s of other messages given to students
• Legislation > regulation>prosecution or fines example company
pensions. However, costly to implement, size of the fine must
be large enough to be a deterrent but not too big that it leads to
the company’s demise.
• Behavioural economics – nudges and choice architecture
 BACK TO SUGAR…

• Evaluate the appropriateness and efficiency of the

various policies the government could use to
reduce the consumption of sugar.
• Use key words to show evaluation.
 Questions
• Explain how imperfect information may result in the failure
of markets for merit and demerit goods. 15 marks
• This question does not require any evaluation.
• Focus on assessment objectives 1,2 and 3.
• Your first paragraph should explain what information failure is
• Second paragraph, using a diagram, explain how imperfect
information impacts the market for merit goods
• Third paragraph, using a diagram, explain how imperfect
information impacts the market for DEmerit goods
 Information failure Matrix

• Information failure matrix.docx

 Student note making sheet

• ..\Revision\Information failure.docx