Market Failure on Asymmetric Information

Asymmetric information = transaction in which one party has BETTER information than the other.

Two main consequences:

Adverse selection — occurs BEFORE the transaction. The party with WORSE expected outcomes is MORE LIKELY to engage in the transaction, driving good types out.

Akerlof's "Market for Lemons" (1970) — classic example. In a used car market:

• Buyers can't tell good cars from "lemons" (bad cars).
• Sellers of good cars know they're good; would want fair price.
• Sellers of lemons happily sell at the average price.
• Buyers, expecting some lemons in the pool, only offer the average-quality price.
• Good-car sellers withdraw; only lemons remain.
• Market UNRAVELS — good cars don't trade.

Insurance adverse selection. Healthcare plans face this:

• People who know they have health problems are MORE likely to buy comprehensive coverage.
• Healthy people opt out.
• Insurer's pool becomes high-risk → premiums rise → more healthy people opt out.
• Death spiral if uncorrected.

Moral hazard — occurs AFTER the transaction. The insured party takes MORE risk than they would without insurance because the cost is borne by the insurer.

Examples:

• Car insurance: drivers drive less carefully if fully insured.
• Health insurance: patients seek more treatment than necessary if all costs covered.
• Banking: banks take more risks if they expect bailout ("too big to fail").
• Mortgage market: securitisation in 2000s reduced banks' incentive to vet borrowers carefully → 2008 crisis.

Private solutions:

Signalling. Party with better info CREDIBLY transmits it to the other side.

• Warranties signal product quality.
• Educational degrees signal worker ability (Spence's model — labour market).
• Audited financial statements signal firm health.

For signalling to work, the signal must be COSTLIER for "bad types" to fake.

Screening. Party with WORSE info extracts info from the other.

• Insurance companies offer MULTIPLE plans — high-coverage with low deductible vs low-coverage with high deductible. High-risk customers choose comprehensive; low-risk choose minimal.
• Job interviews and tests reveal ability.
• Credit checks before lending.

Government interventions:

• Compulsory insurance (car, health) — forces all into pool, prevents adverse selection.
• Disclosure regulations — accounting standards, food labelling, financial product disclosure.
• Licensing — quality assurance (doctors, lawyers, hairdressers).
• Consumer protection — Lemon Laws, refund rights.
• Anti-fraud regulation — securities law, advertising standards.

HL application. Asymmetric information is fundamental to modern microeconomics. Examiners may ask: How does asymmetric information lead to market failure? Why are some markets thin or non-existent? How can insurance markets avoid adverse selection?

Real-world example: Affordable Care Act (USA, 2010). Forced healthy people into insurance pool via individual mandate → reduced adverse selection. Mandate later weakened, demonstrating policy fragility.