Unit 2.10: Asymmetric information (HL)

Asymmetric information is an imbalance of information that exists between buyers and sellers in a market that gives one side an unfair advantage in a transaction. For example, when someone goes to buy a used car the seller of the car will normally know more about the car than the buyer. The seller might know that the engine is unreliable but chooses not to tell the buyer about this.

  • The nature of asymmetric information
  • Adverse selection
  • Moral hazard
  • Asymmetric information as a market failure
  • Market responses to asymmetric information
  • Policy responses to asymmetric information through legislation and regulation

Revision material

The link to the attached pdf is revision material from Unit 2.10: Asymmetric information (HL). The revision material can be downloaded as a student handout.

Unit 2.10: Asymmetric information

What is asymmetric information?

Asymmetric information is an imbalance of information that exists between buyers and sellers in a market that gives one side an unfair advantage in a transaction. For example, when someone goes to buy a used car the seller of the car will normally know more about the car than the buyer. The seller might know that the engine is unreliable but chooses not to tell the buyer about this. As a result, the seller receives a higher price, and the buyer pays a higher price than if this information had been made available to the buyer as well as the seller.

Types of asymmetric information

Adverse selection

Adverse selection is an example of where asymmetric information leads to market failure. Adverse selection is where one party in a transaction has better information than another on which to make their buying or selling decision.

Buyer advantage

When buying insurance, for example, the buyer has more information about their risk to the insurer than the insurance company selling them a policy. A buyer of car insurance might drive at high speeds and use their phone when driving, but the insurance company does not know about this because the buyer hides it from them. As a result, the buyer gets cheaper insurance and the insurance company receives a lower price than would be the case if the company had known about the buyer's risky driving. Other examples include, where an expert antique dealer buys antiques from inexperienced sellers, or a person takes out a loan from a bank and lies about their income.

Seller advantage

Sellers often hold more information about the good or service they are selling than is available to the buyer. In markets for complex products this puts sellers at a significant advantage. For example, a firm that sells anti-virus software knows how much protection their product offers the consumers who buy their software. It is very difficult for a buyer who is unfamiliar with this type of software to value what they are buying except by looking at competing products and assessing how much to pay to stop their computer getting a virus. The product might cost the firm $10 to manufacture but they can sell it for $100 to an uninformed buyer. Other examples include, when people buy complex financial products like pensions or a real estate agent selling a house with structural problems.

Moral Hazard

Moral hazard occurs when there is an incentive for people to change their behaviour because the negative consequences of their decisions are borne by others. For example, if you hire a car and it is covered by comprehensive insurance, it means that any accident you might have is covered by the insurance.  Because of the insurance cover, you might drive the car much more recklessly than if it is not covered by the insurance. The costs of the repairs caused by your reckless driving will add to the insurance cost of the car hire firm and push up the hire price for everyone else.

There was a rise of 13% rise in mortgage fraud in the UK last year. People think it is acceptable to lie when they are filling out their mortgage application form. People are happy to exaggerate their income and understate their existing spending in an attempt to secure a bigger loan. Knowingly giving false information on a mortgage application is against the law. Applicants sometimes use falsified or altered bank statements when they are applying for loans.

This is a big problem for the banking sector who incur significant bad debts as a result of mortgage fraud. Bad debt is a cost to a bank and it reduces their profits. It also affects other customers who pay their debts because they have to pay higher charges to cover the costs of bad debts. There is some evidence than exaggerated incomes on mortgage application forms contributed to the financial crisis in 2008.

Questions

a. Define the term asymmetric information. [2]

Asymmetric information is an imbalance of information that exists between buyers and sellers in a market that gives one side an unfair advantage in a transaction.

b. Explain how mortgage applications are an example of asymmetric information. [4]

When a person applies for a mortgage the lender makes their lending decision based on the information given to them by the borrower. If the person borrowing money from the lender chooses to exaggerate their income and hide previous missed payments then the lender will be make their decision based on false information in this asymmetric situation. The borrower may be given a loan when they should not be or the interest rate they are charged should be higher than the lender offers. 

Do some research into other situations where people might lie on forms to obtain a good or service?

Why is asymmetric information a market failure?

Asymmetric information means buyers and sellers in a market make decisions on information that does not accurately reflect the value they put on the good they are buying or selling.

Seller advantage

An example of seller advantage is where buyers of diesel cars made decisions about buying them based on the private benefits they received from owning a diesel car. Part of this decision may have related to the low emissions associated with diesel cars. The car manufacturers knew that the emissions were higher than those they advertised. This buyer asymmetry means that the marginal social benefit curve of diesels cars is lower than the marginal private benefit curve. As a result of this, the socially efficient output of Q* is below the market output of Q, which is shown in diagram 2.54.

Buyer advantage

When businesses, for example, sell health insurance they set the price for their insurance based on the health risk of the people they insure. If someone is overweight, smokes and does not exercise, then they are more likely to be ill and claim on their insurance. These people should pay a higher price for their insurance, but if these buyers keep their unhealthy lifestyle hidden from the insurance company, they will pay a lower price than the true value of their insurance premium. This means the marginal social cost of providing the insurance is greater than the marginal private cost.

This is shown in diagram 2.55 where the market output is at Q, but the socially efficient output is Q*. There is an over-allocation of resources and the yellow shaded area is the associated welfare loss.

Market responses to asymmetric information

Signalling

Buyers are obviously wary of purchasing goods and services in markets where there is asymmetric information and they are at a knowledge disadvantage. Sellers know this and try to sell their goods in a way that makes buyers feel more confident about the goods they are purchasing. One way of doing this is to offer warrantees or guarantees that offer buyers the chance to get a replacement or their money back on faulty goods. The second-hand car market has many offers of warrantees to attract buyers.

Screening

Buyers in asymmetric information situations can pay an agent or a lawyer who have good knowledge of a market to advise them on buying decisions. Most people use an estate agent and a lawyer when they are buying a house to advise them on such a significant purchase.  Buyers can also do their own research to screen the sellers they are buying from. The growth of online independent reviews of hotels and restaurants is an example of this.

As an average consumer you are desperate to keep your expensive PC away from malware.  Like so many people you decide to pay $80 for the latest version of Norton 365 or McAfee. But is this new software worth it? How do you know if it is protecting your computer? Indeed, putting third-party anti-virus software on your PC might actually damage it. Many of the antivirus packages available do offer tools to defend your PC, but chances are you can get good protection for your PC for free. Microsoft Windows machines offer Windows Defender for free.

This is a classic asymmetric situation and you need to do your homework to deal with it. Seeking third party advice from a computer expert or using reputable online computer advice would be good approach before buying antivirus software.

Question

Using a diagram explain why anti-virus software is an example of asymmetric information. [4]

The firms that manufacture anti-virus software such as Norton and McAfee have better information about the product they sell than consumers who normally have little knowledge of the software. This means sellers of the software can charge a higher price for it because the buyer cannot make an accurate valuation and are willing to pay a higher price than the true cost of the software. This is shown in the diagram where the socially efficient price and output are below the market price and output.

Investigation

Investigate other IT products that might also lead to asymmetric buying situations.

Policies for asymmetric information  

Legislation and regulation

When goods are being bought and sold in asymmetric situation both buyers and sellers face regulations and laws that try to correct the asymmetry and the market failure associated with it. 

Buyers

For the buyers there is a considerable amount of consumer legislation that protects people in asymmetric situations when they buy goods and services. Governments set out rules that businesses legally need to follow such as: ‘goods of a satisfactory quality’, ‘fit for the purpose they are used for’ and ‘meet the seller’s description’. Laws will also state that buyers have a right to a refund or a replacement for goods if they do not meet necessary standards.

Sellers

When goods are being bought buyers also have to follow rules and regulations to give the seller complete information before they decided on a sale. For example, when you buy car insurance you need to give the insurance company accurate information about yourself so the company can make a judgement on the risk of insuring you. They will then set an insurance premium based on this. It is illegal to lie to an insurance company when you are applying for insurance.

All countries have contract laws that exists between buyers and sellers that protect both parties when good and services are being traded. In the UK, the Consumer Rights Act states that goods sold must satisfy three conditions:

  • When a buyer receives a good it must be of ‘satisfactory quality’ and not faulty or damaged.
  • Goods sold should be ‘fit for purpose’, which means the good can be used for the purpose the buyer purchased it for.
  • Goods supplied must be ‘as described’ which means they match the description given to the buyer when they decided to buy them.

Outline one policy a government could use to protect consumers and one policy to protect producers in asymmetric information situations. [4]

A policy to protect consumers would be make it a legal requirement for sellers to give full refunds on goods and services sold if the buyer has been misled by the producer about good or service. This could be used in the market for second hand cars.

A policy to protect producers would be for a government to make it a legal requirement for buyers to give accurate information about themselves when they are buying a product. This could be used in the market for car insurance.

Research other laws that might protect buyers and sellers in asymmetric situations.

Thinking about a key concept - Economic well being

When businesses have more information about the negative health consequences of consuming the goods and services they produce than consumers it can have serious consequences for the economic well being of the buyers of these goods and services. Most consumers are very aware of the negative consequences of smoking cigarettes or drinking alcohol but have less knowledge of, for example, drinking too much fruit juice. This is a product that is marketed as a health food by its manufacturers. There is, however, as much sugar and calories in orange juice as there is lemonade, but the 'sugary drink', lemonade would not be marketed as a health product. 

Research into another good that markets itself as a health food, but is not as healthy as consumers would expect. 

Which of the following is the best definition of asymmetric information?

 

 

 

Which of the following is an example of adverse selection where the seller has an information advantage?

The hotel know about the noisy building work and the buyer may not so the hotel has the information advantage.

 

Which of the following is an example of adverse selection where the buyer has an information advantage?

The reckless driver that rents a car has a knowlege advantage over the car hire firm because the car hire firm is unaware of the driver's reckless driving.

 

Which of the following is the best definition of moral hazard?

 

 

 

Which of the following would not protect consumers in an asymmetric buying situation?

 

Making it illegal for a person buying health insurance to lie about smoking protects the seller in an asymmetric situation.

 

When the buyer has the advantage in an asymmetric transaction, which of the following least likely to be true?

When the buyer has the advantage in an asymmetric transaction the MSC is greater than the MPC.

 

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