Asymmetric Information

Unit 5 - Lesson 12
Learning outcomes:

● Define all terms in orange bold in section 6.4. (AO1)

● Distinguish between adverse selection and moral hazard. (AO2)
● Evaluate government responses to the problem of asymmetric
information including legislation and regulation, and provision of
information. (AO3)
● Evaluate private responses to asymmetric information including
signalling and screening. (AO3)
Competitive Market Assumptions
In unit 2 we learned that in a competitive market it is assumed that all
firms and producers have perfect information regarding a products
price, resources and methods of production.
Asymmetry of information occurs when buyers and sellers do not
have equal access to information about a product or service.
Sometimes the buyers or sellers have more information than the other
most often resulting in an underallocation of resources to the production
of a good.
Since there tends to be an underallocation of resources to the
production of a good when there exists asymmetry of information the
market is said to be allocatively inefficient.
Explain adverse selection.
Adverse Selection occurs when one party either the consumer or producer has
more information than the other about the quality of the product.

Adverse Selection where seller has more information than the buyer.
● Sellers often have more information than the consumer regarding the
quality of the product.
○ Sellers of used cars usually have more information about the quality of
the used car and sometimes do not reveal various defects to the
consumer.
○ In a free and unregulated market sellers of food could sell food that is
unsafe for consumption to the consumer.
○ Producers of medicine could sell ineffective medications to the consumer.
Explain adverse selection.
In a free unregulated market the likely outcome is to under allocate resources
to the production of the good or service.

Consumers will likely be hesitant to purchase the good or service resulting in

lower demand, sales and production.

However, if the consumer is unaware of the possible harmful effects of the good
or service then it may result in an over allocation of resources to the production
of the good.

An example of this is the Purdue Company and the “supply of drugs ‘without
legitimate medical purpose’”. Read the BBC ARTICLE HERE

Outcome was an over allocation of resources to the production of OxyCotin.

Evaluate government responses to the problem of asymmetric information
including legislation and regulation.

Government Response Regulation

● Governments can pass regulations ensuring that a
certain standard, quality and safety is adhered to
by producers and consumers.
○ Examples include:
■ FDA (Food and Drug Administration) -
oversea the regulatory requirements for
standards set forth by the government of
the USA.
■ Nutritional labelling on foods.
■ In Europe fee structure to ensure
consumers receive a certain amount of
service within a specified price range.
Evaluate government responses to the problem of asymmetric information
including legislation and regulation.

Government Response Regulation - Limitations

● When the government is responsible for the provision of the
information, there exists issues with:
○ Collection and dissemination of the information
○ Accuracy of the information
○ Opportunity costs for providing the information
● When the producer is responsible for disseminating information
questions arise as to the whether all hazards and substances included in
the product are being disclosed accurately.
Evaluate government responses to the problem of asymmetric information
including legislation and regulation.

Government Response Regulation - Limitations

● Sometimes it is not possible to eliminate all information asymmetry through the
use of regulations.
● No matter how extensive the regulations are on the firms there is always a way
for the producer to hide some information from the consumer.
○ The Purdue OxyCotin example shows how even given a regulatory
framework to follow, the Purdue company still was able to withhold
information from the consumer.
● In cases where firms such as doctors, lawyers and bankers often have more
information than their clients. Sometimes this additional information not known
by the client can be used to have the client increase the demand for services.
● “Supplier-induced demand” where the demand for a service is created by the
firm with information not made available to the client.
Evaluate government responses to the problem of asymmetric information
including licensure.

Government Response Licensure

● All countries around the world require licenses for certain activities.
○ Tanzania requires licensing for Doctors.
■ These licenses are only granted if the individual completes a certain
level of education and provide as proof to the government for licensing.
● Also include teachers, lawyers, electricians and plumbers in some
countries.
Some economist view this intervention as detrimental to the marketplace because it
limits the supply of workers in that profession. By restricting the supply of workers in
that profession, prices for services are driven up, increasing the incomes of those
in that profession at the expense of consumers who must pay the higher price.
Evaluate private responses to asymmetric information including
signalling and screening. (AO3)

Private Responses - Screening

● Screening the goods or service before purchasing is a method used by the buyer.
● Consumers will try and obtain information about the good or service through
various means such as the internet or by asking a family member or friend.

Though this may be helpful it will not result in the consumer from attaining symmetry
of information. It will help to reduce the asymmetry, but it will not eliminate it.

Also, the reliability of the information received from a third party such as the internet,
family or friends can be biased and therefore not provide the consumer with accurate
information.
Evaluate private responses to asymmetric information including
signalling and signalling. (AO3)

Private Responses - Signalling

● Method used by the person with more information, the seller in this case,
to try and convince the buyer that the product is of good quality.
● Methods include:
○ Warranties
○ Branding
○ Providing service receipts for used cars
Problem with signalling is that it will not provide the buyer with all
information. It will presented it with some information.
Also, there is chance that the information that is provided by the seller may
be incorrect for reasons of self-interest in selling the product.
Explain adverse selection.
Adverse Selection where buyer has more information than the seller
● The buyer of a good has more information than the seller often occurs
in the cases of insurance - health and life.
● In the case of health insurance, the buyer has more information about
the specific underlying health conditions than the seller of the health
insurance.
● The buyer is unlikely to tell ALL information about their health to the
seller.
This result in an under allocation of resources to the production of
the good as the seller may be reluctant to sell the product causing
less insurance to be provided to the market than socially optimal
and at a higher price.
Evaluate private responses to asymmetric information including
signalling and signalling. (AO3)

Private Responses - Signalling

● Screening is a method undertaken by the party with limited information. In
this case the seller.
● Private insurance companies conduct screening in the following manner:
○ Health insurance companies offer policies with:
■ Low premiums (cost of insurance) with high deductibles (buyers
out of pocket expense when they receive medical care)
■ High premiums (cost to purchase the insurance) with low or no
deductibles (buyers out of pocket expense when they receive
medical care)
The choice the buyer makes is intended to indirectly to provide (screen) the
seller with additional information about the buyers health.
Evaluate private responses to asymmetric information including
signalling and signalling. (AO3)

Private Responses - Signalling

● However, this is not always the case. Low income individuals most often
choose the policy with low cost and high deductible regardless of their health.
○ From the view of equity and fairness, this is undesirable as it discriminates
against low income individuals.
● Often to protect themselves from high risks, insurance companies can exclude
certain individuals because of age or occupation.
● The result is that those who need the insurance the most are left out of the
private market because they cannot afford it or do not qualify.
○ Raises the question of equity and fairness.
Evaluate government responses to asymmetric information. (AO3)

Government Responses
● Direct Government Provision - for example healthcare in the Nordic
countries.
● Government funds the healthcare for its citizens through the
allocation of tax revenues collected to healthcare as it is deemed a
positive externality.
● There are varying degrees of direct government provision:
○ The National Health Service in the United Kingdom where
healthcare is provided directly to the citizens by the government.
○ Social Health Insurance that may cover an entire countries
population.
○ Selective Social Health Insurance intended to cover vulnerable
groups such as low income and the elderly.
Evaluate government responses to asymmetric information. (AO3)

Government Responses
Advantages:
● Countries that offer health insurance coverage to it entire population ensure
that no one in the country goes without medical care.
Drawbacks:
● Difficulty of the government in controlling costs and making sure they do not
rise rapidly.
● The rising healthcare costs puts a burden on government and social
insurance budgets.
○ See attached increase in government expenditure for the NHS in the UK
since 1948.
■ ARTICLE
Explaining Moral Hazard.
Moral Hazard
● Where one party takes risks that are not fully compensated for by that party. The
risk is transferred to the other party.
● This often occurs in the case of insurance.
○ Moral hazard occurs when the buyer of car insurance changes their behaviour
after they purchase the car insurance.
■ Drive faster, park in unsafe areas or fail to lock or secure their vehicle.
■ Previous to purchasing the insurance the buyer would normally not engage
in the above activities as they would be deemed too risky.
■ Once the insurance is purchased and the buyer now knows that any
accident or damage will be paid for by the seller (insurance company).
■ The additional risk the buyer undertakes is not paid for by them but
transferred to the insurance company.
Explaining Moral Hazard.
In the car insurance case and with moral hazard, the buyer has more
information about their future changes to behaviour than the seller of the
insurance.
This results in an underallocation of resources to the production of the
good as the insurance company makes decisions with the intention of
protecting themselves from high risk users.
Therefore there is less insurance in the market than socially desirable
resulting in increased costs to the buyers.
Other example of moral hazard is the 2008 financial crisis.
Evaluate responses to asymmetric information. (AO3)

Moral Hazard is normally handled by the seller or provider of the service.

● In the case of health and car insurance this occurs when the seller of the
insurance includes deductibles (additional cost the buyer must contribute when
utilizing a service offered by the insurance) in the insurance policy.
● Intention is to make the buyer aware of the additional cost with the aim of
choosing less risky behaviour.
Similar to adverse selection, the question of equity and fairness arises.
● Low premium and high deductible policies are often purchased by low income
individuals.
● High premium and low deductible policies are often purchased by higher
income individuals.
● This suggests high income earners will engage in riskier activities than low
income individuals.