Asymmetric Information and Market Failure

1. ECON 453 Asymmetric Information and Market Failure E. Nketiah-Amponsah Department of Economics Room W.18 enamponsah@ug.edu.gh

2. Learning Outcomes • Explain how asymmetric information leads to market failure • Market for used/second hand cars (George Akerlof) • Explain Adverse Selection • Show how information asymmetry leads to adverse selection • Explain Moral Hazard • Explain how information asymmetry leads to Moral Hazard • Explain the principal-agent problem • Identify ways of solving the information asymmetry problem.

3. Information Asymmetry-Theory • Traditional models/standard economic theory of demand assume that individuals have complete information about prices and other relevant market information. • In purely competitive markets, all agents are fully informed about traded commodities (perfect agency). • However in practice, information is often highly imperfect and this can result in decision-making that is socially inefficient. • One aspect of this problem is that different parties in an economic transaction/relationship may have different amounts of information. • Focus of this lecture will be on the ‘consumer’ (demand side); how the amount of information available to a given consumer could alter transaction and market outcomes.

4. Information Asymmetry-What is it? • Asymmetric information occurs if one side of the market is better informed than the other • A situation in which one party in a transaction has more or superior information compared to another. • Asymmetric information exists when either the buyer or seller in a market exchange has some information that the other does not • Information Asymmetry refers to a situation where the buyer and the seller of a commodity or service may have different amounts of information about that commodity’s or service’s attributes. • Implies the existing market price is not determined on full information • one or other party is making an uneducated assessment of opportunity cost or perceived welfare benefits

5. Information Asymmetry-What is it? • AI is potentially a harmful situation because one party can take advantage of the other party’s lack of knowledge. • Asymmetric Information can cause the buyer or seller to lower the demand or supply of the good in question. • AI engenders market failure. In extreme situation. this may lead to market failure where no exchange can take place. • Justification/Rationale for policy intervention, e.g. compulsory car insurance and offering a menu of insurance contracts.

6. Search vs Experience Goods and Asymmetric Information • Search goods: consumers can determine its characteristics with certainty prior to purchase • Experience goods: consumers can determine its characteristics only after purchase • Asymmetric information is more prevalent with/under experience goods

7. Examples of Markets (Selected) Characterized by Asymmetric Information • Medical services (Healthcare): A doctor/health provider knows more about medical services than does the patient/client. • Insurance (Health) : An insurance buyer knows more about his riskiness than does the insurance company. • Used cars (Second Hand Cars): The owner of a used car knows more about it (quality) than does a potential buyer. • Labour Market: Workers know their ability or reliability but firms (employers) might not. • Market for loanable funds (Bank lending) • Education • Pensions • ‘Drug Users’

8. Akerlof’s Lemons Principle • George Akerlof (1970), a Nobel laureate, developed a model of imperfect information to explain what happens in the used car market. • It was the first economic model to have incorporated asymmetric information using 2nd hand cars (lemons) • Has since been applied extensively beyond the used car market, e.g., bank lending and insurance markets; education etc • Some background on Akerlof’s model

9. Akerlof’s Lemons Principle • If potential buyers know only the average quality of used cars, then market prices will tend to be lower than the true value of the top-quality cars. Owners of the top-quality cars will tend to withhold their cars from sale. • In a sense, the good cars are driven out of the market by the lemons. Under what has become known as the Lemons Principle, the bad drives out the good until no market is left.

10. Market for Used Cars (Lemons) • In Ghana, one market characterized by asymmetric information is the market for used cars (also sale of used refrigerators and other electronic gadgets). • The greater the information asymmetry between sellers and buyers of used cars, the greater the scope for deception and fraud. • Example: Market of Lemons (used cars) • Assume there are two types of used cars in the market: Good cars and Bad cars • Every seller knows theexact type of his/her car • However, buyers only knows distribution of each type

11. An Illustration • In particular, buyers know that • 50% of the cars for sale are good • 50% are lemons • Assume, Good cars worth 30,000 and Bad cars worth 16,000 • In this situation, what should a buyer offer for a car of unknown type? • A risk neutral buyer will offer expected value of the car • Expected value here is the probability weighted average value: (1/2)*(30,000) + (1/2)*(16,000) = 23,000 • Thus if quality cannot be assessed, the buyer is willing to pay at most a price that reflects the average quality. However, sellers of good quality cars will not want to sells at the price for the average quality • What will happen in the market for cars?

12. Market for Lemons • At this offer price, which type of cars do you think would be bought and sold in the market place? • Yes, only the lemons (bad cars) • All good car sellers will pull out of the market characterized by asymmetric information • This is an example of market failure for good cars

13. Market for Lemons • What are some of the potential remedies for asymmetric information? How do we restore the market? • 3 months warranty of power-train or buy back policy (lemon laws) • Independent inspection by a mechanic • Third party insurance for repairs • Disclosure laws requiring sellers to disclose all known defects

14. Asymmetric Information in a Product Market Initially, the seller has some information that the buyer does not have; there is asymmetric information. As a result, D1 represents the demand for the good and Q1 is the equilibrium quantity. Then, the buyer acquires the information that she did not have earlier and there is symmetric information. The information causes the buyer to lower her demand for the good so that now D2 is the relevant demand curve and Q2 is the equilibrium quantity. Conclusion: Fewer units of the good are bought and sold when there is symmetric information than when there is asymmetric information.

15. Asymmetric Information in a Factor Market Initially, the buyer (of the factor labor), or the firm, has some information that the seller (of the factor) does not have; there is asymmetric information. Consequently, S1 is the relevant supply curve. W1 is the equilibrium wage, and Q1 is the equilibrium quantity of labor. Then, sellers acquire the information that they did not have earlier, and there is symmetric information. The information causes the sellers to reduce their supply of the factor so that now S2 is the relevant supply curve, W2 is the equilibrium wage, and Q2 is the equilibrium quantity of labor. Conclusion: Fewer factor units are bought and sold and wages are higher when there is symmetric information than when there is asymmetric information

16. Is There Market Failure? • Asymmetric information seemingly resulted in “too much” or “too many” of something – either too much of a good being consumed or too many workers working for a particular firm. • The point is whether or not the asymmetric information fundamentally changes the outcome from what it would be if there were symmetric information. • The presence of asymmetric information does not guarantee that the market fails. What matters is whether the asymmetric information brings about a different outcome than the outcome that would exist if there were symmetric information. If this occurs, the case for market failure can be made.

17. Information Asymmetry and Moral Hazards • The existence of asymmetric information leads to the problem of moral hazards • What then is Moral hazards? • Moral Hazard occurs when one party in an economic relationship seeks to gain from a situation which is not prevented in the relationship. • Normally refers to the disincentives created by insurance for individuals to take measures that would reduce the amount of care demanded. • In the healthcare literature, it particularly refers to the additional quantity of health care demanded, resulting from a decrease in the net price of care attributable to insurance. • It is said to refer to immoral behavior that takes advantage of asymmetric information after a transaction. Dr. E. Nketiah-Amponsah

18. Information Asymmetry and Moral Hazards • The implication of the last example is that insurance companies will increase their premiums • Since insurance policyholders taking unnecessary risks make more claims, the insurance companies will be forced to raise their premiums, and all policyholders, including those careful people that look after their property, will have to pay more.

19. Information Asymmetry and Adverse Selection • Asymmetric information lead to adverse selection. • Adverse Selection occurs before the transaction • Moral hazard arises after the transaction • So what is adverse selection? • Adverse selection occurs when as a result of information asymmetry a party to an economic relationship wrongly chooses another party.

20. Information Asymmetry and Adverse Selection • It is said to refer to the immoral behavior that takes advantage of asymmetric information before a transaction. • For instance poor information on the part of insurance companies can result in higher-risk consumers (patients) being more likely to buy insurance. • The insurance company ends up with an adverse mix of customers.

21. Agency • Asymmetric information lies at the heart of the principal-agent problem. • The market ‘solution’ to imperfect information is the agency relationship • ‘Principal’ (patient) appoints ‘agent’ (health provider) to advise them in making decision • The goal of the principal (those standing to gain or lose from a decision ) are different from those of the agents making the decision on behalf of the principals (e.g. Shareholders vs managers) • Principal combines information with preferences to make decision as if were perfectly informed • More usually agent combines information with principal’s (expressed) preferences to make decision (doctors make decisions for patients)

22. The Principal-Agent problem • This is frequently the basis upon which agents are employed. • However given the asymmetry of information, it will be very difficult for the principal to judge in whose interest the agent is operating. • For instance a second-hand car dealer may "neglect" to tell you about the rust on the underside of the car, or that it has a history of unreliability/over-heating.

23. Supplier induced demand in the Health Care Market • SID is The change in demand associated with the discretionary influence of providers, especially physicians, over their patients (clients). Demand that is provided for the self-interests of providers rather than solely for patient interest. • The ‘gap’ between perfect and imperfect agency • First observed for hospitals – “A bed built is a bed filled” (‘Roemer’s Law’, 1961) • More generally, observation that when faced with shock to equilibrium (increase supply), health providers respond by ‘inducing demand’ (shifting the demand curve) for their services

24. S1 D2 S2 SID Affects the Relation between Physician Supply and Price D1 p3p1p2 q1q2 q3 In a physician services market where physicians can set prices, initial equilibrium is p1, q1. An (exogenous) increase in the number of physicians would have been expected to lower prices to p2 and increase quantities to q2. By increasing demand to D2, however, physicians can not only increase quantity, but push price even beyond p1.

25. Potential Solutions to The Problems that Arise from Information Asymm. • The obvious solution is to obtain better information. • Consumers might talk to other people who have purchased a product or used a particular supplier to ascertain whether the supplier’s product is good. • Another solution is to employ an agent to find out the right information • Product liability laws • Restrict opportunistic behaviour