Asymmetric information in economics and Moral Hazards

 

In the world of economics, there are numerous variables that may affect markets, however, one of the most significant in terms of influencing the allocative efficiency of markets is information asymmetry. The concept is quite simple it supposes that in markets the buyer and the seller have imperfect knowledge of the products which they buy and sell. A well-studied example, is that of used cars, in such a market a seller would know quite well the value  and state of the good he is selling – he would know the service history of the car and be able to estimate the likelihood of a major breakdown –, meanwhile the buyer does not know the true state of the car when valuing it  consequently, market failure can occur. Asymmetric information can also lead to adverse selection in markets and “moral hazard” all of which come down to “information failure”.

As can be seen in the diagram above market failure occurs in a market where consumers or producers do not have perfect knowledge. In this case, due to the fact that consumers are uninformed in this given market, the demand is significantly higher than what it would be if consumers would know the real value of the good. For example, this could be consumers who have been led to believe that a type of tea decreases the likelihood of cancer occurring. This leads to a shift of the demand curve of the tea from that of an informed customer to that of an uninformed one. Consequently, there is dead weight welfare loss in the market, which can be seen in the triangle point A, the socially optimal equilibrium and the market equilibrium. This leads to a socially inefficient distribution of resources in society, which could mean factors of production going into producing tea rather than researching and developing a proper treatment for cancer. Market failure is one of the many effects that information asymmetry could have on a market, others include “Moral Hazard”.

A “Moral Hazard” is a concept in economics which describes individuals or firms that have “incentives to alter their behaviour when their risk or bad-decision making is borne by others.”. Essentially the concept describes a phenomenon in which the party changes their behaviour to one which is riskier knowing that they would not necessarily have to bear the cost of their actions. This concept is based on information asymmetry because one party holds more information than another. For example, a bank begins giving out sub-prime loans which are more likely to default knowing that it will be able to bundle these loans and resell them. In this case, the bank altered its behaviour knowing that it would be able to resell the loans, and thus wouldn’t have to bear the risks of this type of lending. Another example would be phone insurance. If consumers have their smartphones uninsured they will use a case knowing that if it breaks they will have to pay for the full cost of getting it replaced. In such a scenario, the probability that a smartphone breaks is significantly lower than when it is insured, as when insured it will cause a change in the behaviour of costumer’s such as not using a case which consequently leads to an increase in the probability of it breaking. This “Moral hazard” is often combined with the adverse selection bias.

Adverse selection is a process “which occurs when buyers have more accurate information than sellers” this usually distorts market processes. Information asymmetry, in this case, is combined with adverse selection which leads to market failure. This is quite common in healthcare markets, where the sick and those working positions where they might get injured will seek out medical insurance, meanwhile, those who are young and healthy will stay out of the market as it has become too expensive due to adverse selection. In the case of phone insurance, this would mean a person who knows they are likely to break their phone as they have done so multiple times will self-select and buy phone insurance knowing they are more likely to break the phone. Adverse selection occurs because of information asymmetry and the difficulties in selecting and differentiating between consumers customers. However, the effects of adverse selection can be minimised by decreasing the information asymmetry between the seller and the buyer. This is often done through tests that have to be completed by the potentially insured in order to determine the true cost of insuring them.

 

To conclude, information asymmetry can have a significant effect on the markets in our society. It increases the cost of insurance significantly as there is adverse selection in insurance markets. Information asymmetry also changes the behaviour of firms and consumers as they know the cost of increased risks will be covered by another party. However, information asymmetry is most consequential when we look at the allocative inefficiency it creates in society and the consequences of such inefficiencies.

References:

Pettinger, T. (2018). Asymmetric information problem. [online] Economicshelp.org. Available at: https://www.economicshelp.org/blog/glossary/asymmetric-information/ [Accessed 29 Jan. 2018].

Pettinger, T. (2018). Adverse selection explained. [online] Economicshelp.org. Available at: https://www.economicshelp.org/blog/glossary/adverse-selection/ [Accessed 29 Jan. 2018].

Pettinger, T. (2018). Cite a Website – Cite This For Me. [online] Economicshelp.org. Available at: https://www.economicshelp.org/blog/glossary/asymmetric-information/ [Accessed 29 Jan. 2018].

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