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Use
examples to illustrate your answers.
By Andrew Sweeting
November 1998
Introduction
This essay is concerned with the issue of information in microeconomics, particularly where
information is a factor in the failure of individual markets in an economy. Economic information and its
importance in microeconomics is initially discussed, and continues with defining asymmetric
information, which is a factor that can lead to a market failure.
In the analysis of asymmetric information in markets, ex ante and ex post asymmetries information
are discussed in relation to market transactions. Ex ante asymmetric information can be explained
through Adverse Selection in relation to quality of goods in the product market, and ex post
asymmetric information can be explained through Moral Hazard in insurance markets. Strategies to
correct market failure(s) caused by these information asymmetries is addressed for each example
discussed.
The exposition of these two types of asymmetric information problems leads to the discussion of
principal-agent problems, particularly in relation to efficiency wage theory, which have been
developed to analyse market failures. Labour market failure explained through the efficiency wage
theory has been used to explain involuntary unemployment.
Economics of Information
"Economics is concerned with the efficient use of limited productive resources for the purpose of
attaining the maximum satisfaction of our material wants"(Jackson and McConnell,1985,p.3), which
involves economic agents undertaking transactions that utilize these resources to meet and satisfy
their wants. By way of analysing these market transactions, economist have developed
microeconomic models, such as perfect competition, to explain the interactions in individual markets.
Much of this analysis has been undertaken on the critical assumption of economic agents having full
information about the goods or services being bought or sold, and full information about each other.
These assumptions describe a market where there is perfect information(Stiglitz,1993).
Stigler(1961) states that "information is a valuable resource: knowledge is power"(p.213), and
information can determine actions such as where purchasers buy higher quality goods at lower prices
explanations
involve
examples
relating
to
insurance
markets
and
their
inefficiencies/failures.
Adverse Selection
Adverse selection is a situation where one party in a transaction knows something about its own
characteristic that the other party does not know. Adverse selection is often referred to as a hidden
information problem in a market, where for example sellers may know more about a product than a
customer(Estrin and Laidler,1995).
Information asymmetry and adverse selection was first pioneered by George Akerlof in his article
"The Market for Lemons: Quality Uncertainty and the Market Mechanism", which examined the
markets for used motor vehicles, insurance, credit and employment. Akerlof explores adverse
selection by the use of asymmetric quality information about the purchase of used motor vehicles to
show market failure. The following example looks at adverse selection in the insurance market(Estrin
and Laidler,1995).
Example: Motor Vehicle Market(Quality)
Akerlof(1970) posed a question as to why there is such a large price difference in new motor vehicle
and those that have just left the showroom. Akerlof developed the concept of asymmetric information
about the motor vehicles quality because the sellers knows more about the motor vehicle than the
buyer. Buyers with a lack of knowledge about the motor vehicle would ask the question, why is it for
sale? - is it a "lemon"? Therefore all prospective buyers would be suspicious of the quality of used
motor vehicles and infer quality from pricing policies of sellers(Pindyck and Rubinfeld,1989).
Akerlofs model is developed on the simplified basis that there are two types of used motor vehicles
available, high quality or low quality, with sellers knowing the quality, and buyers cannot distinguish
the quality. A simplified numerical example explains the results of quality differences:
We assume that the seller of a low quality motor vehicle will sell for $500, the seller of a high
quality motor vehicle will sell for $1200, and buyers will be willing to pay $700 for a low quality
motor vehicle and $1500 for a high quality motor vehicle. Buyers will have to estimate how
much a motor vehicle is worth, and we assume the probability of obtaining a high or low
quality motor vehicle is equal. If a buyer will pay the expected value of a motor vehicle, then
they would be willing to pay 0.5*700+0.5*1500=$1100.
The only seller willing to sell would be that of the low quality motor vehicles
($500<$1100<$1200). Therefore only low quality motor vehicles would be offered for sale and
buyers would expect to get a low quality motor vehicle and no high quality motor vehicles
would be sold. Market failure will occur because selling a low quality motor vehicle affects the
buyers perceptions of the quality of all motor vehicles, the price they are willing to pay, and
affects the sale of all good quality motor vehicles(Varian,1990).
Where there is an absence of full information,, or a high cost of obtaining all the information required,
low quality goods will drive high quality goods out of the market, or even collapse the market(Estrin
and Laidler,1995). Solutions that are available to correct market failure in relation to quality
asymmetries are:
o
Reputation - High quality product sellers can build a reputation to differentiate the
High risk individuals are most likely to claim on insurance and will be enthusiastic to
purchase full insurance.
Low risk individuals are unlikely to claim insurance and are therefore willing to
purchase insurance at a discounted rate(Stiglitz,1993).
Insurers in the market offer an insurance contract at a premium set at the average probability of a
claim where it equals the premium income. i.e. a pooled premium, ensuring average losses from
claims are equal to the premiums collected. As premiums rise, low risk individuals will not be willing to
buy insurance so losses will occur to the insurer and hence market failure will occur(Rees,1989).
The adverse selection problem is that the potential insurer buyer has hidden information from the
insurer before a contract is entered into, and the insurer could not afford to offer full insurance to low
risk individuals because it would incur a loss(Rees,1989).
Solutions to adverse selection in the insurance market include:
o
Offer full insurance at a high premium and partial insurance at lower premium to help
identify individuals into their respective risk groups.
Moral Hazard
Moral Hazard are "situations where one side of the market cant observe the actions of the other[,
and] is sometimes [referred to as] a hidden action problem"(Varian,1990,p.589). The results of moral
hazard are an increased probability of undesired outcomes for one party and the market, post
contractual. A basic example of moral hazard is motor vehicle owners driving more recklessly if their
motor vehicle is fully insured(Gibson,1997).
Example: Home & Contents Insurance
When individuals are insured, they will pay less care ensuring that the undesired outcome does not
occur. e.g. a householder may take less care in locking up their house when they have house and
contents insurance. This moral hazard problem can cause market failure, failure to reach market
efficiency in the insurance market, because individuals incentives are altered by not having to worry
about their post contractual actions in regards to the insured event. Insurers may not offer Home &
Contents insurance where moral hazard problems are strong, or specify certain conditions for the
insured. e.g. fit window locks to the house(Stiglitz,1993)(Estrin and Laidler,1995).
Solutions to moral hazard in the insurance market are:
optional), incentive and reward contracts are offered to employees, and that shareholders need to
monitor behaviour of firms managers to ensure return on their capital. These strategies try to alleviate
the effect of adverse selection and moral hazard problems from informational asymmetries, where
costs to capture these information deficiencies are too expensive or impossible.
References
Akerlof, G.A.(1970), The Market for "Lemons": Quality Uncertainty and the Market Mechanism,
Quarterly Journal of Economics, Vol.84, August, pp.488-500.
Estrin, S. and Laidler, D(1995), Introduction to Microeconomics, 4th ed., Prentice Hall/Harvester
Wheatsheaf, Hertfordshire, UK.
Gibson, H.R.(1987), Asymmetric Information in Insurance Markets: A Situation of Moral