Market failure: asymmetric information

• Define asymmetric information and explain why it stops a market reaching the efficient outcome.
• Explain adverse selection step by step in a market for used goods and in an insurance market.
• Explain moral hazard and separate it from adverse selection by its timing.
• Evaluate legislation and regulation, and the provision of information, as government responses.
• Evaluate signalling and screening as private responses, identifying which party acts in each.

Asymmetric information exists when one party to a transaction knows more than the other about the quality of the good, the risk involved or its own future behaviour. The seller of a used car knows its faults and the buyer does not. A person buying health insurance knows more about their own health than the insurer does.

The competitive market model assumes that buyers and sellers are equally well informed, so the price a buyer pays reflects the true value of what is bought. When one side is uninformed, the price is wrong for the true quality or the true risk, and the quantity traded is not the efficient one. Trades that would benefit both sides do not take place, or behaviour that costs more than it is worth does. Resources are misallocated, which makes asymmetric information a Market failure.

It causes two distinct problems, separated by timing. Adverse selection arises before the transaction: one side has hidden information about quality or risk, and this changes who is willing to trade. Moral hazard arises after the transaction: one side takes hidden action, behaving differently because the other side now bears part of the cost.

Adverse selection occurs when the uninformed party cannot tell high quality from low, or low risk from high, and so offers the same terms to everyone. Those terms suit the worst of the informed side and not the best, so the best leave. The informed party can be the seller or the buyer.

The seller knows more: used cars. An owner knows whether the car is reliable. A buyer cannot tell by looking.

1. Buyers cannot tell reliable cars from faulty ones, so they will pay only a price that reflects average quality.
2. Owners of reliable cars find that price too low and withdraw their cars from sale.
3. The average quality of the cars still on the market falls.
4. Buyers learn this and lower the price they are willing to pay, which drives out the best of the remaining cars.
5. In the limit only faulty cars are traded, and the market for reliable cars disappears.

With full information both kinds of car would be sold, because each is worth more to a buyer than to its owner. Without it, a buyer who cannot tell the cars apart will pay at most the average value: ($10,000 + $4,000) ÷ 2 = $7,000. That is less than the $8,000 owners of reliable cars will accept, so no reliable car is offered. Buyers then know that every car on sale is faulty and will pay at most $4,000. Faulty cars sell for between $3,000 and $4,000. Each reliable car is worth $2,000 more to a buyer than to its owner, so a sale would benefit both, but it never happens.

The buyer knows more: insurance. Each person knows their own health, or how carefully they drive, better than an insurer does.

1. The insurer cannot see each applicant's risk, so it sets one premium based on the average expected claim.
2. Low-risk people find that premium poor value and do not buy.
3. The people who remain insured are riskier on average, so claims per customer rise.
4. The insurer raises the premium to cover its costs, and the lowest-risk of the remaining customers leave.
5. Cover becomes very expensive or is withdrawn, and low-risk people go without insurance they would have bought at a premium that matched their own risk.

An illustration with invented figures: expected claims are $200 a year for a low-risk person and $1,000 a year for a high-risk person, and there are equal numbers of each. A premium set at the average, $600, loses the low-risk customers, who value cover at about $300. With only high-risk customers left, the premium has to rise to $1,000. Low-risk people would pay $300 for cover that costs the insurer $200 to provide, yet they end up uninsured.

The result is the same in both cases. The market is too small, or missing altogether, and it is the better-quality sellers and the lower-risk buyers who are driven out. Mutually beneficial trades are lost, so resources are not allocated efficiently.

Moral hazard occurs when, after an agreement has been made, one party changes its behaviour in a way the other cannot observe, because the other now bears part of the cost. The person who decides how much risk to take no longer pays the full cost of that risk, so more risk is taken.

• Insurance: a driver or homeowner with full cover bears little of the cost of an accident or a theft, so takes less care. Claims rise, and premiums rise for every customer.
• Banking: a bank that expects the government to rescue it if it fails keeps the gains from risky lending and passes the losses to others, so it takes larger risks than it would with only its own money at stake.
• Health care: a patient whose insurer pays the whole bill has no reason to refuse treatment of little value, and a doctor paid for each treatment has a reason to provide more than is needed.

In each case there is more of the risky or costly activity than is efficient. The party that cannot observe the behaviour, such as the insurer or the taxpayer, pays higher costs. Insurers respond by raising premiums or limiting the cover they offer, so careful customers pay more or cannot buy the cover they want. Resources are again misallocated.

The two problems are easy to confuse because both appear in insurance. Adverse selection concerns who buys the policy: mainly people who know they are high risk. Moral hazard concerns how any policyholder behaves once covered: less carefully than before.

Governments respond in two ways: with legislation and regulation, and by providing information. Legislation and regulation are rules backed by law that require or forbid certain behaviour, a form of Command-and-control regulation. They work in different ways on the two problems.

• Compulsory disclosure: sellers must reveal what they know, such as ingredients and nutrition content, the terms of a financial product, or whether a used vehicle carries a warranty. This narrows the information gap that causes adverse selection.
• Minimum standards and licensing: products must meet safety standards, and professionals such as doctors and lawyers must be qualified to practise. Buyers who cannot judge quality are protected from the worst of it.
• Legal rights to a refund or repair: the seller bears the cost of a faulty product, so selling one is less profitable.
• Compulsory insurance, or penalties for joining late: low-risk people stay in the insurance pool, which removes adverse selection at its source.
• Limits on risk-taking: rules on how much risk a bank may take address moral hazard directly, by restricting the hidden action.

Regulation has two strengths. It applies to every firm, so a careful firm is not undercut by a careless one. It also protects consumers who could not have judged quality themselves, which matters most where a mistake is severe or cannot be reversed, as with medicines.

• Limit, enforcement: a rule changes behaviour only if firms expect to be inspected and penalised, and inspection uses resources.
• Limit, the regulator's information: the regulator also knows less than the firms it regulates, so standards may be too strict, too lenient or out of date.
• Limit, compliance costs: meeting the rules raises firms' costs and prices. Licensing in particular restricts entry, so it can protect existing suppliers from lower-cost competitors.
• Limit, formal compliance: a firm can meet the letter of a disclosure rule while making the information hard to find or to use.

The second response is the provision of information: the government collects and publishes information itself. Examples are hygiene inspection scores for restaurants, school inspection reports, public health information and price comparison tools. Its strengths are that it lowers the cost to consumers of finding out about quality and leaves them free to choose. Its limits are that people may not find, read or understand what is published (Bounded rationality, topic 2.4), that collecting and updating the information is costly, and that some qualities cannot be reduced to a simple score.

Buyers and sellers lose from a market that shrinks, so they have an incentive to close the information gap themselves. The two private responses differ in which party acts. In Signalling the informed party acts to reveal its quality. In Screening the uninformed party acts to uncover it.

Examples of signals are warranties and guarantees, independent inspection certificates, a brand reputation built over many years, and educational qualifications shown to employers. A signal is believable only if a low-quality seller would find it too costly to copy. A long warranty on a reliable car costs its seller little, because few repairs will be claimed. The same warranty on a faulty car would cost more than the sale is worth. Buyers can therefore read the warranty as evidence of quality, and reliable cars sell for more than faulty ones, which keeps them on the market.

• Limit of signalling, cost: resources are spent on the signal itself, and it adds nothing to the product.
• Limit of signalling, weak signals: a signal that is cheap to fake, or that every seller has, tells buyers nothing.
• Limit of signalling, entry: an established firm with a known brand signals more cheaply than a new entrant, which makes entry harder.

Examples of screening are an insurer's questionnaires, medical checks and driving records, a lender's credit scores, and an employer's interviews and trial periods. The uninformed party can also offer a choice of contracts, so that people reveal their type by what they choose. An insurer that offers a low premium with a high excess (the part of each claim the customer pays) attracts people who expect to make few claims, and those who expect many claims choose the higher premium with a low excess.

The insurer uses similar tools against moral hazard. An excess, a co-payment (a share of each bill paid by the customer) and a no-claims discount all leave the customer bearing part of any loss, which restores the incentive to take care. Monitoring, such as a device that records how a car is driven, makes the hidden action visible.

• Limit of screening, cost: tests, checks and inspections use resources, and an individual consumer often lacks the expertise to carry them out.
• Limit of screening, privacy: it requires people to hand over personal information.
• Limit of screening, equity: people identified as high risk may be refused cover or charged a premium they cannot afford, even though their risk is not their choice.

• Asymmetric information: one party knows more than the other about quality, risk or its own behaviour.
• Adverse selection: hidden information before the transaction. The uninformed side offers average terms, the best of the informed side leave, and the market shrinks or disappears.
• Moral hazard: hidden action after the transaction. A party takes more risk because another bears part of the cost.
• Government responses: legislation and regulation; provision of information.
• Private responses: signalling by the informed party; screening by the uninformed party.