2.10 Market failure - asymmetric information
Asymmetric information
Asymmetric information means one party (either the buyer or seller) in an economic transaction may possess more information than the other party and may use it to his/her advantage at the expense of the less informed side. There are two common types of asymmetric information: adverse selection and moral hazard. As asymmetric information leads to inefficient allocation of resources, it is a type of market failure.
Adverse selection
Adverse selection arises from hidden characteristics before a transaction or contract is agreed. The less-informed party cannot distinguish between different types of buyer or seller, which can discourage mutually beneficial transactions or drive better-quality participants out of the market.
A common example is the market for used cars. Suppose each car is either a good used car or a bad used car. The good car has a value of $50,000 while the bad car is only worth $5,000 as scrap metal.
In a market with perfect information, buyers know whether the car is good or bad, and pay the right price accordingly. However, this is not always the case. In a market with asymmetric information, while used car sellers know the true quality of the cars they sell, the buyers do not.
Suppose the salesman claims all his cars are good, and offers to sell both of them at $50,000. The buyer, knowing that there is a possibility that the car is bad, is unwilling to pay the price of $50,000.
Because the price buyers are willing to accept is lower than the value of the good car, the used car salesman has no reason to put any good cars on the market. Only bad cars remain, and bad products drive out good products, leading to the disappearance of the market for good used cars. This is a form of market failure because the good products cannot be allocated with market mechanisms.
Another common example is the market for health insurance, where buyers have more information about their health than the insurance company. Consider the example of a heavy smoker who buys insurance; if the insurance company charges them the market price, they will end up losing money as they will have to pay out larger amounts when the heavy smoker gets sick. This will result in the insurance company having to charge other people higher prices in order to cover their losses, and may result in fewer people buying health insurance.
Moral hazard
Moral hazard arises when a party changes its behaviour after an agreement because it does not bear the full consequences of its actions. The other party cannot fully observe or control those actions. This may encourage excessive risk-taking or reduced care.
For instance, someone who has car insurance may be less careful about locking his car. The car has a greater risk of getting stolen, but because the insurance company provides compensation for a stolen car, the owner does not bear the full cost. If no remedial actions are available, the insurance company may stop offering car insurance altogether; moral hazard leads to a market where too little or no car insurance is offered.
Responses to asymmetric information
Government responses to asymmetric information
1) Government regulation
The government can enact laws and regulations to ensure the basic safety requirements and quality standards are met by producers. E.g. doctors have to obtain a license to ensure professional standards are met.
The US currently has a three-step examination which prospective doctors have to pass in order to achieve their licence to practice, called the United States Medical Licensing Examination (USMLE). Even after passing their Doctor of Medicine degree, physicians are still required to pass the USMLE before being allowed to practice in the US.
The USMLE is intended to assess a prospective doctor’s ability to apply their knowledge, as well as to determine the standard of their patient-centered skills.
2) Provision of information
The government can also intervene in the market to require producers to reveal critical information, such as mandatory quality labelling.
In July 2010, the Hong Kong government implemented a mandatory nutrition labelling scheme for pre-packaged foods. According to this scheme, producers of pre-packaged foods have to present nutrition information about the content of energy, protein, carbohydrates, total fat, saturated fat, trans fat, sodium, and sugars on their food packaging, therefore allowing consumers to make healthier choices about their food.
Private responses to asymmetric information
1) Signalling
A better-informed party may take actions to signal credible information to the less-informed party. For instance, in the market of used cars, the seller can offer warranties, or construct elaborate showrooms to show their intention of staying in the market (for good used cars).
One common way to ‘signal’ to employers that a prospective employee has a certain level of ability is through education. For example, one might choose to attend university and attain a bachelor’s degree in order to signal to potential employers that they have a certain amount of knowledge in their field of study, as well as being organised and articulate enough to attain a university degree.
Higher levels of education are associated with higher employment rates, but that association alone does not establish signalling. Education may also develop human capital, while people entering education may differ in their prior characteristics. For example, in the US in 2018, the employment rate among those aged 25-34 was highest for those with a bachelor’s degree or higher (86%), followed by those who had completed high school (72%) and those who had not completed high school (59%).
2) Screening
Screening occurs when the less informed party tries to get the more informed party to reveal the relevant information. For example, health insurance companies will try to get information about risk factors by asking questions about buyers’ health, weight, smoking habits, and pre-existing conditions. This allows them to charge different people different prices depending on how likely it is that they will need to use the insurance.
One recent debate regarding screening in the healthcare market is whether or not genetic tests should be used for screening. Genetic tests can reveal whether or not an individual is more likely to have diseases like Huntington's disease and other degenerative diseases, and can also reveal someone’s likelihood to develop cancers. At the same time, genetic testing is becoming cheaper; in 2020, the cost of genetic testing in the US varies from under $100 to around $2,000, depending on the nature of the test.
In response to calls for insurance companies to be allowed to use genetic testing as part of their screening process, the Canadian Coalition for Genetic Fairness (CCGF) argued that such testing would allow insurance companies to discriminate among prospective customers, leading to disadvantage and higher premiums for those who may be genetically predisposed to develop an illness through no fault of their own. In response, the Canadian Life and Health Insurance Association argued that genetic test results allow insurers to accurately assess risk; in this way, they are similar to insurers asking customers if they smoke, and how large their average alcohol intake is.
In 2017, Canada passed a bill which prevents insurance companies from using the results of genetic testing to determine their pricing; in so doing, it became the last member of the G7 to pass such legislation.
Evaluation of responses to asymmetric information
1) Legislation and regulation
Minimum standards and licensing can prevent some low-quality or unsafe goods and services from being supplied. Consumers do not have to assess every aspect of quality themselves, which can increase confidence and participation in the market.
However, the government needs information and resources to enforce the rules. Inspections are costly, and producers may comply with the letter of a rule while concealing other problems. Strict requirements can also raise entry costs and reduce competition. The benefits depend on whether the reduction in harm exceeds these costs.
2) Provision of information
Clear information allows consumers to compare alternatives and make better-informed decisions. Disclosure can reduce the information advantage held by producers while leaving consumers free to choose.
Information must be reliable and understandable. Technical details, lengthy documents or information presented selectively may do little to improve decisions. Disclosure is less effective where consumers lack the time or knowledge to interpret what they are given.
3) Signalling
A signal helps distinguish a high-quality seller or product when it is harder or more costly for a low-quality seller to provide the same signal. A warranty can be credible because a seller expecting frequent failures would face higher repair or replacement costs.
A signal that can be copied cheaply may reveal little about quality. Buyers also need confidence that promises will be honoured. Signalling can therefore depend on enforceable contracts and the seller's continued ability to meet its obligations.
4) Screening
Screening allows the less-informed party to obtain information before agreeing to a transaction. Better assessment of risk can reduce losses and make it possible to offer contracts to customers who would otherwise be difficult to distinguish.
Collecting and checking information is costly. Applicants may conceal information, and screening can raise privacy concerns. It can also identify high-risk customers who are then charged more or excluded, so a more informed allocation is not necessarily a more equitable one.
Policies may need to be combined. Disclosure requirements can support screening, while contract enforcement can make signals more credible. The appropriate response depends on which information is missing and whether the problem concerns hidden characteristics or actions after the agreement.