Information Gaps Lower 6 th Micro Market Failures

Information Gaps Lower 6 th Micro Market Failures

Intro to Information Gaps Mr O’Grady

Intro to Information Gaps Symmetric Information: Where both consumers and producers have perfect and equal market information on a good or service No information gap This leads to an efficient allocation of resources because with accurate information: Consumers make efficient choices and decisions about what to buy, in what quantities and how much they should pay Producers make efficient choices and decisions about what to supply, in what quantities and how much they should charge Asymmetric Information: Where there is imperfect and unequal market knowledge, with either the buyer or seller having more information than the other An information gap This distorts people’s incentives to buy and sell goods at the right price A misallocation of resources results, a market failure Markets where sellers having more information: Second-hand cars, private healthcare, pension schemes, labour markets Markets where buyers having more information: Insurance, insider trading

Causes of imperfect/unequal information: Long-term consequences: when one party isn’t fully considerate of long-term benefits or costs of consuming a product (consumer myopia) E. g. consumption of legal highs, education or smoking Complexity: when a product is highly complex, one party might not fully understand the true benefits and costs of a transaction E. g. understanding the best pension product to buy (if at all!), the probability of sickness for medical insurance, computer specifications Inaccurate, partial or misleading information: When one party is unable to quickly/cheaply find sufficient information on the best value from different transactions. Persuasive advertising may ‘oversell’ the benefits of a product E. g. Cigarettes marketed as ‘cool’ by Camel Cigarettes

Information Gaps & Merit goods Information Gaps Mr O’Grady

Information gaps & Merit Goods Merit Good: A good that is under-traded in a free market Info-gaps & Merit Goods: consumers underestimate the private benefits of consumption MPB partial info (perceived) < MPB full info (actual) Sub-optimal social welfare due to under-consumption Example: education Price N. B. Info-gaps often overlap with positive externalities E. g. Vaccines are under consumed as consumers don’t consider the reduced likelihood of infecting others (externality) or are put off by ‘fake news’ such as micro chips (info gap) S = MPC PSO PFM MPB (full information) Diagram: Market demand would be higher if consumers had better information Consumers undervalue and under-consume the good Higher consumption increases welfare (green triangle) MPB (partial information) QFM QSO Quantity

Information Gaps & Demerit goods Information Gaps Mr O’Grady

Information gaps & Demerit Goods Demerit Good: A good that is over-traded in a free market Info-gaps & Demerit Goods: consumers may overestimate the private benefits of consumption MPB partial info (perceived) > MPB full info (actual) Sub-optimal social welfare due to over-consumption Example: Fast Food Price N. B. info-gaps often overlap with negative externalities E. g. Cigarettes are over-consumed as consumers don’t consider the impacts of second-hand smoking on others (Externality) or don’t fully consider the heightened risk to themselves of diseases such as cancer (info gap) S = MPC PFM PSO MPB (partial information) MPB (full information) Diagram: Market demand would be lower if consumers had better information Consumers overvalue and over-consume the good Lower consumption improves welfare (red triangle) QSO QFM Quantity

Adverse Selection: Akerlof’s Market for Lemons Information Gaps Mr O’Grady

Adverse Selection Definition: A market situation where buyers and sellers have different information, so that the more knowledgeable participant can participate selectively in trades which benefit them the most, at the expense of the other party. This can lead to market failure as total welfare is not maximised as some consumers/producers are removed from the market George Akerlof: American economist, who was jointly awarded the Nobel Economics Prize (along with Spence and Stiglitz) in 2001 for his life’s work in information economics He is perhaps best known for his 1970 article "The Market for Lemons: Quality Uncertainty and the Market Mechanism” examining the effects of adverse selection in the second-hand car market The Market for Lemons: Poor quality second-hand car Peach: High quality second-hand car Problem: Potential buyers can’t tell which is which!

Information Asymmetry: Whilst the buyer doesn’t know the car’s quality, the seller knows a lot about the how good their car is How much will someone sell a car for? Peach sellers want as high a price as possible but would accept a high ‘peach price’ Lemon sellers also want as high a price as possible but would accept a low ‘lemon price’ But since they know buyers are uncertain, they will initially offer their lemon at ‘peach price’! How much would someone pay for a car? As buyers are uncertain of any specific car’s quality, they assume an ‘average quality’ for the market Hence, they only offer an ‘average’ price for the good, in between the ‘lemon price’ and ‘peach price’ Impacts on lemons: Lemons will be increasingly sold in the market as their sellers realise they can get a higher price than they are truly worth The ‘average price’ is higher than the ‘lemon price’ Impact on Peaches: Sellers of peaches wouldn’t accept this average price So, peaches will start to leave the market In the market: Each time a peach stops being offered the average quality falls The average price offered by buyers hence falls too This means even more peaches will leave the market, further lowering the average quality and price, further removing peaches! Extreme result: No-trade equilibrium - i. e. no market for peaches exists Complete market failure “The bad drives out the good”.

Moral Hazard & the Principal. Agent Problem Information Gaps Mr O’Grady

Moral Hazard & the Principal-Agent Problem Moral hazard: A situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly Example 1: Comprehensive insurance decreases the incentive to care for one’s possessions Example 2: Governments bailing out loss-making banks can encourage more risk taking Principal-Agent Problem: An example of moral hazard, when one person, the "agent", takes actions on behalf of, or that impact, another person, the "principal" This dilemma exists in circumstances where agents are motivated to act in their own best interests, which are contrary to those of their principals Key example: Divorce between Ownership and control The owners of a company (shareholders) want to maximise the company’s profits, but management simply want to maximise their pay and perks of work They want to reduce their effort, increase their wages and enjoy perks like a company car These are costly for the firm and therefore reduce the profits for shareholders Solution: Mechanisms to align the interests of the agent with those of the principal Employers (principal) may use piece rates/commissions, profit sharing, efficiency wages, threats of termination etc. to align worker (agent) interests with their own

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