Discuss the reasons why asymmetric information can be a source of market failure

Discuss the reasons why asymmetric information can be a source of market failure. Use examples to illustrate your answers. By Andrew Sweeting November 1998 Introduction This essay is concerned with the issue of information in microeconomics, particularly where information is a factor in the failure of individual markets in an economy. Economic information and its importance in microeconomics is initially discussed, and continues with defining asymmetric information, which is a factor that can lead to a market failure. In the analysis of asymmetric information in markets, ex ante and ex post asymmetries information are discussed in relation to market transactions. Ex ante asymmetric information can be explained through Adverse Selection in relation to quality of goods in the product market, and ex post asymmetric information can be explained through Moral Hazard in insurance markets. Strategies to correct market failure(s) caused by these information asymmetries is addressed for each example discussed. The exposition of these two types of asymmetric information problems leads to the discussion of principal-agent problems, particularly in relation to efficiency wage theory, which have been developed to analyse market failures. Labour market failure explained through the efficiency wage theory has been used to explain involuntary unemployment. Economics of Information "Economics is concerned with the efficient use of limited productive resources for the purpose of attaining the maximum satisfaction of our material wants"(Jackson and McConnell,1985,p.3), which involves economic agents undertaking transactions that utilize these resources to meet and satisfy their wants. By way of analysing these market transactions, economist have developed microeconomic models, such as perfect competition, to explain the interactions in individual markets. Much of this analysis has been undertaken on the critical assumption of economic agents having full information about the goods or services being bought or sold, and full information about each other. These assumptions describe a market where there is perfect information(Stiglitz,1993). Stigler(1961) states that "information is a valuable resource: knowledge is power"(p.213), and information can determine actions such as where purchasers buy higher quality goods at lower prices in their allocation of scare resources(money), or where Governments regulation of the environment can be more efficient if they have the good scientific information. Therefore information can be seen as a valuable economic factor, especially in the allocation of scare economic resources, and the level of uncertainty that can ultimately determine utility levels(Nicholson,1998). With microeconomic assumptions of perfect information in economic models, economists do not represent real world situations. e.g. households do not know the price of a particular good at every store that sells it, or firms do not know the actual productivity of every job applicant for a vacant position. Therefore there is imperfect information in individual markets, for reasons such as accurate information being too costly, or impossible to obtain, for important decision characteristics. The lack of information in a market transaction may be only one sided, or be evident to both parties(Stiglitz,1993)(Varian,1990). Asymmetric Information Definition Asymmetric information is a situation in which economic agents involved in a transaction have different information, as when the a private motorcycle seller has more detailed information about the its quality than the prospective purchaser, or an employee will know more about their ability than their employer. Information that is distributed asymmetrically between economic agents can be categorized as ex ante, pre-contractual of the transaction, or ex post, post-contractual of the transaction, that will influence economic behaviour and operation of the market(Stiglitz,1993). These two forms of asymmetric information, ex ante -Adverse Selection- and ex post -Moral Hazard- are foundations in the explanation of insurance market theory and therefore much of informational asymmetry explanations involve examples relating to insurance markets and their inefficiencies/failures. Adverse Selection Adverse selection is a situation where one party in a transaction knows something about its own characteristic that the other party does not know. Adverse selection is often referred to as a hidden information problem in a market, where for example sellers may know more about a product than a customer(Estrin and Laidler,1995). Information asymmetry and adverse selection was first pioneered by George Akerlof in his article "The Market for Lemons: Quality Uncertainty and the Market Mechanism", which examined the markets for used motor vehicles, insurance, credit and employment. Akerlof explores adverse selection by the use of asymmetric quality information about the purchase of used motor vehicles to show market failure. The following example looks at adverse selection in the insurance market(Estrin and Laidler,1995). Example: Motor Vehicle Market(Quality) Akerlof(1970) posed a question as to why there is such a large price difference in new motor vehicle and those that have just left the showroom. Akerlof developed the concept of asymmetric information about the motor vehicles quality because the sellers knows more about the motor vehicle than the buyer. Buyers with a lack of knowledge about the motor vehicle would ask the question, why is it for sale? - is it a "lemon"? Therefore all prospective buyers would be suspicious of the quality of used motor vehicles and infer quality from pricing policies of sellers(Pindyck and Rubinfeld,1989). Akerlof’s model is developed on the simplified basis that there are two types of used motor vehicles available, high quality or low quality, with sellers knowing the quality, and buyers cannot distinguish the quality. A simplified numerical example explains the results of quality differences: We assume that the seller of a low quality motor vehicle will sell for $500, the seller of a high quality motor vehicle will sell for $1200, and buyers will be willing to pay $700 for a low quality motor vehicle and $1500 for a high quality motor vehicle. Buyers will have to estimate how much a motor vehicle is worth, and we assume the probability of obtaining a high or low quality motor vehicle is equal. If a buyer will pay the expected value of a motor vehicle, then they would be willing to pay 0.5*700+0.5*1500=$1100. The only seller willing to sell would be that of the low quality motor vehicles ($500<$1100<$1200). Therefore only low quality motor vehicles would be offered for sale and buyers would expect to get a low quality motor vehicle and no high quality motor vehicles would be sold. Market failure will occur because selling a low quality motor vehicle affects the buyers perceptions of the quality of all motor vehicles, the price they are willing to pay, and affects the sale of all good quality motor vehicles(Varian,1990). Where there is an absence of full information,, or a high cost of obtaining all the information required, low quality goods will drive high quality goods out of the market, or even collapse the market(Estrin and Laidler,1995). Solutions that are available to correct market failure in relation to quality asymmetries are: Reputation - High quality product sellers can build a reputation to differentiate the high quality products. Standardization - To help with the problem of building a reputation, sellers may standardize the high quality service/good. e.g. McDonalds or KFC around the world. Guarantees and Warranties -Higher quality products can overcome asymmetric information problems by signalling product quality through an extensive warranty or guarantee(Pindyck and Rubinfeld,1989).   Example: Insurance Market(Pooled) With insurance, any potential buyer faces different probabilities of an insurable event occurring, some at least under his control. Therefore an assumption can be made that individuals are either Low Risk or a High Risk of the insured event happening, but they are not individually identifiable by the insurer. General assumptions are: High risk individuals are most likely to claim on insurance and will be enthusiastic to purchase full insurance. Low risk individuals are unlikely to claim insurance and are therefore willing to purchase insurance at a discounted rate(Stiglitz,1993). Insurers in the market offer an insurance contract at a premium set at the average probability of a claim where it equals the premium income. i.e. a pooled premium, ensuring average losses from claims are equal to the premiums collected. As premiums rise, low risk individuals will not be willing to buy insurance so losses will occur to the insurer and hence market failure will occur(Rees,1989). The adverse selection problem is that the potential insurer buyer has hidden information from the insurer before a contract is entered into, and the insurer could not afford to offer full insurance to low risk individuals because it would incur a loss(Rees,1989). Solutions to adverse selection in the insurance market include: Trying to obtain critical information before insurance is provided. e.g. pre-inspection before fire insurance is provided. Offer full insurance at a high premium and partial insurance at lower premium to help identify individuals into their respective risk groups. Moral Hazard Moral Hazard are "situations where one side of the market can’t observe the actions of the other[, and] is sometimes [referred to as] a hidden action problem"(Varian,1990,p.589). The results of moral hazard are an increased probability of undesired outcomes for one party and the market, post contractual. A basic example of moral hazard is motor vehicle owners driving more recklessly if their motor vehicle is fully insured(Gibson,1997). Example: Home & Contents Insurance When individuals are insured, they will pay less care ensuring that the undesired outcome does not occur. e.g. a householder may take less care in locking up their house when they have house and contents insurance. This moral hazard problem can cause market failure, failure to reach market efficiency in the insurance market, because individuals incentives are altered by not having to worry about their post contractual actions in regards to the insured event. Insurers may not offer Home & Contents insurance where moral hazard problems are strong, or specify certain conditions for the insured. e.g. fit window locks to the house(Stiglitz,1993)(Estrin and Laidler,1995). Solutions to moral hazard in the insurance market are: The use of deductibles(excess) and co-payments, depending on whether moral hazard increases the risk or increases the size of the loss. Government intervention through taxation or subsidies to ensure an incentive to reduce the risk or improve the care taken by individuals(Gibson,1997). Example: Government Health Insurance(Medicare) Gibson(1997) introduces the problem of moral hazard to a Governments operation of universal health care such as Medicare. Medicare is compulsory payments("a tax") to fund the public heath system. Moral hazard could lead to individuals taking less care of their health then if they had to pay all costs from their actions. Public health costs will probably then increase under this scenario. To reduce moral hazard and any rising health costs, Governments may introduce taxes or subsidies, such as increasing the tax on cigarettes, or introduce co-payments for the public health system. These two options may reverse the market failure, but if private health insurance exists to cover co-payments, then moral hazard will still contribute to market failure and health budget problems(Gibson,1997). Principle-Agent Problem and Asymmetric Information Principal agent problems are "any situation in which one party(the principal) needs to delegate actions to another party(the agent), and thus wishes to provide the agent with incentives to work hard and make decisions about the risk that reflect the interest of the principal"(Stiglitz,1993,p.A12). e.g. the property owner and the real estate agent managing it on the owners behalf. Problems may occur because principals cannot monitor every action that the agent undertakes, agents will therefore have better information, and the collection of this information by the principal may also be costly, if at all possible. As defined at the start of this essay, this principal relationship demonstrates the characteristics of asymmetric information being prevalent(Pindyck and Rubinfeld,1989). The principal-agent problem and asymmetric information can be shown in a number of markets such as the owners(shareholders) and managers of publicly listed companies, or owners(citizens) and managers of publicly owned organizations. Solutions to the problem of the principal-agent problem usually incorporate incentives to the agent of some sort. One of the recent attentions has been the utilization the problem of asymmetric information in the labour market. In particular, one of the major issues in economics, that of unemployment, and the failure of the labour market to clear, has been addresses through efficiency wage theory(Hillier,1997). Efficiency wage theory has several variants, but the common thread is that the quality of workers in a firm is dependent on the wages paid in such a way that reducing the wage would reduce the quality of the workers and the profits of the firm. Therefore the firm will not cut wages even it was possible to do so on the current workers, or hire from unemployed workers. Therefore the wage may not fall to its market clearing level. The reason for this result is because of the asymmetric information available to firms about workers productivity, both in an adverse selection and moral hazard form(Hillier,1997). Adverse selection problems are based on the inability for employers to distinguish between type of workers(as seen previously in relation to quality) and that good quality workers will be less willing to take low paid jobs that bad quality workers. Therefore firms will have an incentive to pay higher wages to attract the good quality workers, but good quality workers may choose to remain unemployed because if a job is low paid it may send a signal about their low quality(Hillier,1997). Moral hazard problems are referred to as the shirking model in the principal-agent theory, where in the simple model, assumptions of a perfectly competitive market, employees are equally productive, and are paid the same wage. Workers can either work and be productive, or be non-productive and ‘shirk’. Because asymmetric information is present, workers may therefore not lose their jobs for shirking(Pindyck and Rubinfeld,1989). Pindyck and Rubinfeld(1989).provide an example of the effect of efficiency wages in the history of Ford Motor Company. By paying an efficiency wage of $5 in 1914, rather than the average market rate of $2 to $3 per day, Henry Ford attracted better workers and gained greater profits. Productivity was estimated at a 51% increase, absenteeism halved and discharges had reduced(signs of shirking). These incentives helped overcome the asymmetric information for the Ford Motor Company with its labour market principal-agent problem. Conclusion Asymmetric information is a problem that economists should always consider in the analysis of markets, as it tends to create market failures in product markets where low quality products drive out good quality products, insurance markets where low risk groups do take out insurance and high risk groups do, and other markets where principals do not receiving productivity/return from agents. Complexity of the items being traded will usually ensure there is asymmetric information in the particular product market. Therefore it is not just the uncertainty economic agents face, but the distribution of the information between agents that can influence their actions in the market. The existence of asymmetric information explains why manufacturers offer warranties(mandatory and optional), incentive and reward contracts are offered to employees, and that shareholders need to monitor behaviour of firms managers to ensure return on their capital. These strategies try to alleviate the effect of adverse selection and moral hazard problems from informational asymmetries, where costs to capture these information deficiencies are too expensive or impossible. References Akerlof, G.A.(1970), ‘The Market for "Lemons": Quality Uncertainty and the Market Mechanism’, Quarterly Journal of Economics, Vol.84, August, pp.488-500. Estrin, S. and Laidler, D(1995), Introduction to Microeconomics, 4^th ed., Prentice Hall/Harvester Wheatsheaf, Hertfordshire, UK. Gibson, H.R.(1987), Asymmetric Information in Insurance Markets: A Situation of Moral Hazard?, [WWW document], URL http//users.hunterlink.net.au/%7Eddhrg/econ/moral_hazard.html Hillier, B.(1997), The Economics of Asymmetric Information, Macmillian Press, Hampshire, UK. Jackson, J. and McConnell,C.R.(1985), Economics, 2^nd Australian ed., McGraw-Hill, Sydney, Australia. Nicholson, W.(1998), Microeconomic Theory: Basic Principles and Extensions, 7^th ed., The Dryden Press, Orlando, Florida, USA. Pindyck, R.S. and Rubinfeld, D.I.(1989), Microeconomics, 2^nd ed., Macmillian Press, USA. Rees, R.(1989), ‘Uncertainty, Information and Insurance’, in Hey, J.D.(eds), Current Issues in Microeconomics, Macmillian, Hampshire, UK. Stigler, G.J.(1961), ‘The Economics of Information’, Journal of Political Economy, Vol.69, June, pp.213-225. Stiglitz, J.E.(1993), Economics, W.W. Norton & Company, New York, USA. Varian, H.R.(1990), Intermediate Microeconomics: A Modern Approach, 2^nd ed., W.W. Norton & Company, New York, USA. © Andrew Sweeting 1998, [e-mail]