Information Failures

1. Information Failures Mr. Henry AP Economics

2. Review • Two types of market failures that we have discussed: • Public Goods • Externalities “Free Rider” “Negative Externalities” What are examples of each of these market failures?

3. Information Failures • Firstly, information failure exists when some, or all, of the participants in an economic exchange do not have perfect knowledge. • Secondly, information failure exists when one participant in an economic exchange knows more than the other, a situation referred to as the problem of asymmetric, or unbalanced, information • In both cases there is likely to be a misallocation of scarce resources, with consumers paying too much or too little, and firms producing too much or too little. Information failure is common and appears to exist in numerous market exchanges.

4. It can be argued that markets work best, that is they are at their most efficient, when knowledge is perfect and is evenly shared by all the parties in a transaction. Hence, asymmetric knowledge is an economic problem because one party can exploit their greater knowledge. What are examples of when information problems have prohibited efficient production?

5. There are many examples of information failure associated with economic transactions, including the following cases: 1. The job applicant, who fails to reveal at a job interview that they do not have a particular skill for the job (college football coach who lied about resume) 2. The estate agent, who exploits the fact that a potential buyer of a property has very little knowledge about the property, and any possible problems. 3. The cigarette manufacturer, who does not inform smokers of the true health risk of smoking. 4. The buyer of a financial product, who is unaware of the true level of risk, as in the case of derivative products. 5. The seller of a pension, who misleads purchasers about the financial value of the pension. Indeed, widespread pension 'miss-selling' by large UK insurance companies, occurred at the end of the 1990s.

6. Inadequate Buyer Information About Sellers:The Lemons Problem • When parties to a transaction are ignorant of certain aspects of the transaction, such as the quality of the product they are buying, they are forced to make assumptions, often based on price. For example, a buyer may assume that goods are of poor quality if their price is low and that goods are of high quality if their price is high. • In some markets, only low quality products will be sold - the so-called lemons problem. The lemons problem was first analyzed by American economist George Akerlof in 1970. Akerlof explored the problem associated with pricing second hand cars in the USA, which he called a lemons market – a ‘lemon’ is a derogatory term for a poor quality second-hand car. However, the lemon's problem has many wider implications in terms of understanding information failure in general. • For example, in terms of second hand cars, buyers may be suspicious of the motives of seller, and wonder whether the car is a ‘lemon’. If an individual buys a new car for $32,000 and tries to sell on the second-hand market shortly after, they may be forced to accept a much lower price, given that buyers will be suspicious of the seller's motive. Not having all the facts, potential buyers are likely to assume the worst and expect the car to have a problem - in other words, it is a ‘lemon’. Therefore, given that second hand cars will generally attract a low price, only those sellers who actually have poor quality cars will use this market. After a short period, it can be predicted that all cars sold on the second hand car market will be lemons. • When applying this concept to other markets it can be suggested that, whenever there is information failure, there is the possibility that markets will become lemons markets. If so, the supply of good quality products will fall and the supply of poor quality will products rise.

7. Inadequate Seller Information about Buyers:Moral Hazard Problem Moral hazard occurs when people’s behavior is less careful than it could be, either because they believe that their carelessness will not be found out, or because they are encouraged to behave carelessly. This occurs because there is insurance protecting them from the adverse effects of their careless decision. For example, a pupil at school can ‘idle’ along because they believe, either that their parents will provide insurance against their idling, or that the State will provide them with an income if they fail to get a job. There are many other examples of information failure, including the following situations: 1. Consumers may under-estimate the net private and external benefit of merit goods. 2. Consumers may over-estimate the net private and external cost of demerit goods. 3. Fishermen may not know the size of fish stocks and, as a result, over-fishing current stocks. 4. Firms may provide misleading information about products, such as producers of cosmetics claiming to make people beautiful, holiday brochures making resorts appear more attractive, and car drivers not knowing how much pollution they are creating.

8. Adverse Selection Problem • A problem arising when information known to one party to a contract or agreement is not known to the other party, causing the latter to incur major costs. • ie individuals who have the poorest health are most likely to buy health insurance • Can you think of other similar examples of the adverse selection problem?

9. Remedies for Information Failure: Clearly, government has a considerable role in trying to ensure that some of these information failures are reduced or eliminated. The two basic strategies are to increase both the supply of, and demand for, information. Increasing the supply of information. Options to increase the supply of knowledge include: 1. Government may force producers to provide accurate information about products through accurate labeling. For example, requiring that the alcoholic content of drinks is printed on alcoholic drinks. 2. Public broadcasts to improve knowledge may also be made, such as informing smokers and drinkers of the true cost of their habit. To help inform the public, a government can subsidize public service TV and radio broadcasting. 3. Laws may be passed to force public limited companies to be more transparent, and publish their financial accounts, as well as have them audited to ensure accuracy. 4. Government may also regulate advertising standards to make advertising more informative, and less persuasive. 5. Employers may be forced to request that job applicants disclose information about themselves, such as whether they have a criminal record (ie teacher / public employee background checks & clearances) 6. Government may force car owners to have their vehicles regularly checked for emissions/inspection, which provides some basic information to potential buyers. Online history such as Car Fax gives some assurance to potential buyers that the car is road worthy. 7. In addition to direct intervention, government may establish organizations to act as regulators and watchdogs, such as the FDA and FCC.

10. Remedies for Information Failure: Increasing the demand for information. Options to increase the demand for information include: 1. Market theory suggests that demand for knowledge will increase if it is provided freely, or at low cost, hence consumers should not have to pay for information. However, consumers may become overwhelmed with information and fail to take it into account. 2. Government may also promote the formation of pressure groups such as anti-smoking groups, which campaign for more knowledge to be made available by producers. Can you think of any other “pressure groups?” 3. In addition, promoting literacy, numeracy, and IT skills may help increase the demand for information. Having the skills to acquire knowledge can create an increase in demand for knowledge, and a greater appreciation of the value of information in making rational choices.

11. HW: Income Inequality 409-414