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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.
Revision notesWhat 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. This means the buyers and/or sellers make decisions that do not maximise welfare in a market and this lead to market failure.
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 from 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 which 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 that 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 previously missed payments then the lender will be making 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.
c. Explain how asymmetric information in the mortgage market might lead to adverse selection. [4]
Because insurance companies are aware of potential customers making mortgage applications with misleading information they increase the interest rate they charge to all of their borrowers to cover themselves against the risk associated with borrowers who give misleading information. This reduces the supply of mortgages to the mortgage market.
Investigation
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 goods they are buying or selling.
Seller advantage
An example of seller advantage is when buyers of diesel cars make decisions about buying them based on the private benefits they received from owning a diesel car. Part of this decision may have been 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 demand curve for diesel cars D is greater than the demand for diesel cars if the buyers had full information about emissions D1. As a result, the socially efficient output of Q* is below the market output of Q, which is shown in diagram 2.54.
Buyer advantage
There is asymmetric information in the car insurance market because drivers (the buyer) know more about their risk than the insurance company (the seller). This can lead to adverse selection because the insurance company might set a price that is not high enough to cover the driver's risk.
There can also be a moral hazard in the car insurance market when drivers know they are covered by insurance and they might take more risks with their driving because any accidents they might be involved in will be covered by their insurance company.
Insurance companies know there is adverse selection and moral hazard in the market for car insurance and will increase the price of insurance to cover these risks and this will have to be paid by all drivers (buyers) in the market. This means the price of insurance will be higher and output lower when there is asymmetric information which is a market failure.
This is shown in diagram 2.55 where market supply is below the level of supply that would exist with symmetrical information. This means the market output Q is below the socially efficient output Q*
Market responses to asymmetric information
Signalling
Buyers are 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 warranties 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 warranties to attract buyers.
Screening
Buyers in asymmetric information situations can pay an agent or a lawyer who has 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 a good approach before buying antivirus software.
Questions
a. 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. Buyers of anti-virus software are in an adverse selection situation. 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.
b. Explain how buyers of anti-virus software might try to improve the information they have about the product by using screening. [4]
Buyers of anti-virus software could use screening to improve the information they have about the product by seeking advice from an expert in IT or by looking at online reviews on anti-virus software.
Investigation
Research 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 an asymmetric situation both buyers and sellers face regulations and laws that try to correct the asymmetry and the market failure associated with it.
- For 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 the necessary standards.
For sellers, rules and regulations are in place to protect them by requiring buyers to give 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.
The problem with any government regulations to reduce asymmetric information is the cost of designing, administering, and enforcing any laws put in place. The regulations can also increase bureaucracy and business costs in markets which reduces efficiency and leads to higher prices.
Education
By educating potential buyers it is possible for the government to reduce information asymmetry. For example, schools and universities run courses in personal finance for students with allows them to make more informed decisions about their future decisions relating to savings, investments and pensions. Certain states in the US make it compulsory for personal finance to be taught in their schools.
Using education comes with the costs to government in terms of putting such a scheme into place and also assessing how effective education is in reducing information asymmetric information.
Public information and advertising
Governments can run public information and advertising campaigns to help potential buyers become more informed about the goods and services they are buying and reduce information asymmetry. For example, governments in many countries run adverts that inform people about the health consequences of alcohol consumption which reduces asymmetric information in this market.
Similar to education, public information and advertising come with associated costs for the government and it can be difficult to judge the effectiveness of public campaigns.
All 
countries have contract laws that exist between buyers and sellers that protect both parties when goods 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.
Worksheet questions
Questions
a. Explain 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 to 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 a 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.
b. Explain two problems of a government regulating a market to protect consumers and producers when there is asymmetric information. [4]
Two problems of regulating a market when there is asymmetric information might include:
- The cost to the government of setting up and enforcing the regulations.
- Regulations might make business decision-making more complex and force up business costs.
c. Using a real-world example, evaluate the policies a government might use to correct the market failure associated with asymmetric information in an industry. [15]
Answers might include:
Market failure is where marginal social benefits do not equal marginal social cost in a market and the community/social surplus is not maximised.
Asymmetric information is where there is an imbalance of information between buyers and sellers in a market which gives one side an advantage in a transaction.
A policy the UK government could use to correct the market failure associated with asymmetric information would be to regulate the industry to make sure buyers and sellers have to provide accurate information so both parties are confident in their decision when buying or selling a good. This might include:
UK buyers of car insurance being legally required to provide accurate (screening) information related to their insurance so that insurance companies are confident about the risk of insuring a driver. This would mean insurance companies could offer more accurate premiums and reduce the insurance cost to all drivers. This would reduce the price of insurance and increase output to the allocatively efficient output at P*,Q*. This is shown in diagram 2 where the supply curve for car insurance shifts from S to S1.
- UK car second-hand car dealers being legally required to guarantee the quality of the cars they are selling by offering one-year warrantees to buyers. As UK car buyers become more confident about the quality of second-hand cars they are buying demand will increase making output increase to the allocatively efficient output.
- UK food manufacturers being legally required to provide accurate labelling about the contents of the food products they are selling. This means UK food buyers can make more accurate utility-maximising decisions on the food they buy.
The government could also fund education programmes and information campaigns that improve the knowledge of buyers closing the information gap between buyers and sellers. This might include:
- Alcohol information campaigns funded by the UK government so that buyers of alcohol can make an accurate assessment of the risks associated with drinking alcohol.
- UK healthy eating campaigns that provide buyers with information about the nutrition associated with different types of food.
- Personal finance information used in UK schools and universities to help UK citizens make more informed decisions about the financial products they buy such as pensions and savings plans.
Evaluation
UK government regulation, education and information used to improve the asymmetric information problem all require government funds and are associated with an opportunity cost.
When the UK government intervenes in markets to correct the market failure associated with asymmetric information it may mean political decisions that are taken ahead of correcting market failure.
UK government regulation can be bureaucratic and time-consuming for businesses which reduces their efficiency, increasing costs and prices.
Investigation
Research other laws that might protect buyers and sellers in asymmetric situations.
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 healthy 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 healthy 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 knowledge 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 is 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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