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Unit 2.10: Asymmetric information (HL only)

Introduction

This page contains a higher level only element of the market market failure section and highlights another example of market failure in an economy.  I find that asymmetric information is a difficult concept to teach.  For the majority of the IB economics course, we build a world where everyone is rational and the market always operates efficiently.  Asymmetric information is a large factor in markets for used goods, insurance, and contracts; all of which a typical economics student will come into contact. 

Enquiry question

Why do economic transactions, when either the buyer or the seller possesses more information than the other, result in market failure.  

Teacher notes

Lesson time: 40 minutes

Lesson objectives:

Explain, using examples, that market failure may occur when one party in an economic transaction (either the buyer or the seller) possesses more information than the other party.

Evaluate possible government responses, including legislation, regulation and provision of information.

Teacher notes:

1. Beginning activity - complete the bag of sweets game which introduces the concept of information failure. (10 minutes). 

2. Opening discussion - what have you learnt about information failure as a result of this exercise? (5 minutes)

3. Processes - technical Vocabulary - your classes can learn the required vocabulary watching the video and studying the activity and class handout which follows.  (15 minutes)

3. Reinforcement activities - attached to the class handout are two activities to test the students skills in this topic.  (10 minutes).

Beginning activity

Watch the following very short video, just 14 seconds, from the American series, The big bang theory.  Then play the broken candy game which is designed to teach the concept of imperfect information.

Broken candy game

To play this class begin by purchasing a variety of pack of chocolate bars and (if necessary) a hammer.  Smash exactly half of the chocolate making them inedible.  Now distribute the sweet so that exactly half the class have ruined chocolate and the other half, perfectly edible.  You will then inform your class that if they wish they can try and trade the chocolate they were given.  Furthermore, that when trading there is one rule:

'You can say whatever you want to the person you are trading with, but you can't show them your candy bar'.

Announce that anyone wanting to trade their candy should come to the front of the room and begin trading.  Allow the willing group of willing participants to trade, if they are able.  Now, ask the students in the front to pull out their candy bars.  In almost all cases, every bar will be smashed.  Occasionally, you might get an undamaged bar.  If this happens then ask the student why?  They will probably say that they hate that type of chocolate anyway or perhaps don't particularly like chocolate anyway - some of your class may be Vegan for instance.

Turning to the class, ask if anyone who has an undamaged candy bar doesn't particularly care for their candy.  Some group of students will raise their hands.  Allow them to trade candy bars while showing the other student that their candy is undamaged. This is the only group of mutually beneficial trades that didn't occur because of the asymmetric information.

Activity 1

Start by watching the following video and then answer question regarding Groucho Marx.

Activity

Why is Groucho Marx's assertion that he would not wish to join any club that allowed him to be a member an example of asymmetric or imperfect information?

Hint

This message was sent by telegram with Groucho Marx arguing that any club accepting him as a member must be either charging a price above the socially optimum level and / or granting membership to too many members, given the imperfect information available to them at the time. 

Adverse selection

Imperfect information exists when either the buyer or seller has less than complete information about the quality of the product they are purchasing, meaning that it will not be possible for the market to reach the allocative efficiency level of output.

For example, diagram 1 illustrates the used car market.  The seller will typically have much greater information about the quality of the car than the potential buyer.  Concerned that the car they are trying to purchase maybe a lemon, the buyer is not prepared to pay above MPB.  The seller, in return, is only prepared to offer a below quality car, given that even a high quality one will fetch a price below the socially optimum price.  The result is that the equilibrium price will be below the socially efficient price and too few second hand cars will be traded - this is illustrated in the diagram to the right, where both price and output are below the socially optimum level.  This also explains why there is a market for second hand car dealerships offering an element of quality / guarantee in exchange for a higher price.

The second diagram, by contrast, illustrates the opposite situation, where the seller is less informed than the purchaser, for example the market for private medical insurance.  In this case the purchaser is more aware of their own health than the supplier of the service.  Concerned that each person they provide cover for may be in worse health than they claim, the seller is only prepared to provide coverage at MPC, rather than the socially optimum level of MSC.  This means that the final selling price ends up higher than the socially optimum price and again few resources are diverted to the production of that good or service.  This is because some potential consumers, classified as risky will not be offered coverage, while some healthy customers, unprepared to pay the high price of premiums will decide not to pay for the service.

Available as a class handout at:  Adverse selection

Activity 1

Describe examples of markets where either the seller or the buyer has more information about the product being sold?

Examples of where the seller has more information and the final selling price will be the below the socially optimum level include:

  • second hand cars where the seller has much greater knowledge of the products quality, durability, and other features
  • used telephone, electronics shops.

Examples of where the buyer has more information and the final selling price will be the above the socially optimum level include:

  • the insurance market where insurers generally possess little information regarding the risks taken by their clients or their likely behaviour and so factor this into the price accordingly.

Activity 2

What actions can a government take to smooth the path of information in such markets?

  • warranty / guarantee certificates
  • behaviour clauses in the case of the insurance market e.g. certain behaviours that are prohibited when a consumer purchases a certain policy
  • consumer protection legislation that allow the purchaser some recourse should the product that they purchased in good faith not be delivered as reported
  • quality / safety certificates.

Activity 3: A focus on the provision of medical coverage in the private sector

Explain how imperfect knowledge impacts on the market for private medical coverage, in nations without universal public provision

The provision of medical coverage is one of the markets where the purchaser has more information (i.e. their own health, family history e.t.c.) than the seller of the programme.  In economies without universal coverage this presents a clear market failure because consumers will seek to maximise their own advantage when obtaining cover.  To cover this eventuality insurance providers will include a significant 'risk premium' in their pricing and may also refuse to cover patients or medical conditions which they consider to be unworthy of the risk, making an efficient allocation of resources in the market impossible.