DP Economics HL 2.10 Market Failure: Asymmetric Information

DP Economics HL 2.10 Market Failure: Asymmetric Information - Full notes

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DP Economics HL | 2.10 Market Failure: Asymmetric Information

DP ECONOMICS · UNIT 2: MICROECONOMICS

2.10

Market Failure: Asymmetric Information

Full notes for HL · IB-style

Contents

1	Information and market failure
2	Adverse selection
3	Moral hazard
4	Private responses: signalling and screening
5	Government responses
6	Asymmetric information in practice: health, finance and insurance
7	What is asymmetric information?
8	Adverse selection
9	The market for lemons
10	Moral hazard
11	Principal–agent problem
12	Signalling
13	Screening
14	Government responses
15	Information in healthcare
16	Information and online markets
17	Diagram: underconsumption from information failure
18	Mixed review: worked problems
19	Additional exam-style practice
20	Asymmetric information in labour markets
21	Financial markets and information
22	Behavioural links
23	Evaluating signalling and screening
24	Common misconceptions and links
25	Exam-style question with markscheme
26	Check your understanding
27	Summary and topic map

These are full teaching notes. Read each section in order, try the Think about it question before you read on, and do every Quick check before moving to the next section.

Before you start

Rate yourself on each statement now, and again after you've worked through the notes. Shade R (not yet), A (getting there) or G (confident).

I can…	R	A	G
explain asymmetric information and why it causes market failure
explain adverse selection, using the market for lemons and insurance
explain moral hazard with examples from insurance and banking
explain how signalling and screening reduce information problems
evaluate government responses: regulation, licensing, information provision and compulsory insurance
apply the analysis to health care, finance and insurance

2.10 is entirely Additional Higher Level content. It is not part of the SL course.

Guiding questions

Why does a car lose value the moment you drive it away? Why do insurers ask so many questions? Why might a bank take bigger risks if it expects the government to rescue it?

How this topic is examined

Asymmetric information is examined in HL Paper 1 essays on market failure and in Paper 2 texts about insurance, health care, used goods or financial markets. You must be able to distinguish adverse selection from moral hazard and give a precise example of each.

Evaluation answers weigh private solutions (warranties, reputation, screening) against government intervention (regulation, licensing), and consider the costs of each.

Command term	What the examiner wants
Define	the precise meaning, ideally in the IB wording, in one or two sentences
Draw / Sketch	a fully labelled diagram with every axis, curve, equilibrium and change labelled
Explain	a causal chain linked to economic theory, usually supported by a diagram
Analyse	break a situation into its parts and trace the effects of each
Evaluate / Discuss	weigh up arguments, question assumptions and reach a justified conclusion using real-world examples

How to use these notes

Each section teaches one part of the syllabus in full. You'll see these boxes throughout; each has one job:

Box	What it's for
Think about it	a question to get you thinking before a section; the answer comes in the section
Key point	the one idea you must not forget
Common mistake	an error examiners see every year, and how to avoid it
In the real world	where the economics shows up outside the classroom
Try this	something quick you can do yourself to test the idea
Worked example	full solutions with IB-style marks (M1 method, A1 answer, R1 reasoning)
Quick check	short questions to test yourself at the end of each section

1 Information and market failure

Markets work well only when buyers and sellers know what they are trading.

Think about it

You are buying a used phone online. The seller says it is 'in perfect condition'. How can you know? What might you do differently because you can't be sure?

The competitive market model assumes that buyers and sellers have perfect information: they know the quality of the goods, the prices and the risks. In many markets this is far from true. Asymmetric information exists when one party to a transaction has more or better information than the other.

The seller of a used car knows its history; the buyer does not. A person buying health insurance knows their own health and lifestyle better than the insurer. A doctor knows far more about the treatment a patient needs than the patient does. In each case the better-informed party may use the information to their advantage.

Asymmetric information is a market failure because it causes too much or too little of a good to be traded, or the wrong goods to be traded, compared with the outcome with full information. Resources are not allocated efficiently. Economists divide the problem into two types: adverse selection, which arises before a transaction, and moral hazard, which arises after it.

	Adverse selection	Moral hazard
When	before the transaction	after the transaction
Problem	hidden information about characteristics	hidden action: behaviour changes
Example	high-risk people buy insurance; sellers of bad cars sell	insured drivers take less care; banks take risks expecting bailouts

Quick check

1. Define asymmetric information.

2. Why is it a market failure?

3. Which arises before a transaction: adverse selection or moral hazard?

Answers: 1. one party has more information than the other 2. the quantity or quality traded is inefficient 3. adverse selection

2 Adverse selection

Hidden information can drive good products, or good customers, out of a market.

2.1 The market for lemons

In 1970 the economist George Akerlof described the used-car market. Some used cars are good; some are 'lemons' (faulty). Sellers know which kind they have; buyers cannot tell. Buyers therefore offer a price that reflects the average quality of cars on the market.

Owners of good cars find this average price too low, so many of them do not sell. Owners of lemons are happy with it, so they keep selling. The share of lemons on the market rises, so the average quality falls, so buyers lower the price they are willing to pay, so even more owners of good cars leave. In the extreme, the market for good used cars collapses.

Adverse selection is this situation: because of hidden information before a transaction, the 'wrong' goods or customers are selected into the market. The market shrinks, and transactions that would benefit both sides (selling a good car at a fair price) do not happen.

Figure 1. The market for lemons: adverse selection drives good cars out of the market.

2.2 Adverse selection in insurance

The same problem affects insurance. Each person knows more about their own risk (health, driving behaviour) than the insurer does. If the insurer charges a premium based on average risk, the policy is a good deal for high-risk people and a poor deal for low-risk people. High-risk people buy insurance; many low-risk people do not.

The insurer's pool becomes dominated by high-risk customers, so claims rise, so premiums rise, so more low-risk people leave. This is why individual health insurance can be very expensive and why some people cannot get insured at all.

WORKED EXAMPLE 1 Explaining adverse selection

Explain why healthy young people may choose not to buy individual health insurance. [4]

Solution

The insurer cannot observe each person's health risk exactlyR1

so it sets premiums based on average riskR1

For healthy young people, the premium is higher than their expected claims, so the policy is poor valueR1

They leave the market, the pool becomes riskier and premiums rise further: adverse selectionR1

Quick check

1. What did Akerlof's 'lemons' model show?

2. Why do low-risk people leave an insurance market?

Answers: 1. hidden quality information drives good products out of the market 2. premiums based on average risk are poor value for them

3 Moral hazard

When you don't bear the full cost of a risk, you take more of it.

Think about it

Would you lock your bike as carefully if it were fully insured and you would get a brand-new one if it were stolen?

Moral hazard occurs when one party changes their behaviour after a transaction, taking more risks because they do not bear the full cost of those risks, and the other party cannot observe or control this behaviour.

Insurance. Once a person is insured, the cost of an accident or theft falls mainly on the insurer. The insured person may take less care: driving less carefully, leaving a house unlocked. Insurers' costs rise, and premiums rise for everyone.

Health care. If treatment is free or fully insured, patients may use more health services than they would if they paid, and doctors paid per treatment may recommend more treatment than necessary.

Banking. If large banks believe the government will rescue them in a crisis because they are 'too big to fail', they may take on riskier loans and investments, knowing that they keep the profits if things go well but taxpayers will cover the losses if things go badly. Many economists see this as one cause of the 2008 global financial crisis.

In the real world

During the 2008 financial crisis, governments in the United States and Europe spent hundreds of billions of dollars rescuing banks. The rescues prevented a deeper collapse but strengthened expectations of future bailouts, which is why regulators now require banks to hold much more capital.

Common mistake

Mixing up the two problems. Adverse selection is about who enters the market (hidden information, before); moral hazard is about how people behave once they are in it (hidden action, after).

Quick check

1. Define moral hazard.

2. Give an example from banking.

3. Why might free health care lead to moral hazard?

Answers: 1. taking more risk after a transaction because the costs fall on others 2. banks take risks expecting bailouts 3. patients and doctors use more services than if they paid

4 Private responses: signalling and screening

Markets develop their own ways of sharing information.

Markets do not simply accept information problems; firms and consumers develop ways to reduce them.

Signalling is action by the better-informed party to reveal information. A seller of a good used car offers a warranty: a lemon owner could not afford to. A well-known brand signals consistent quality, because the firm has a reputation to protect. Job applicants signal their ability with qualifications.

Screening is action by the less-informed party to gather information. Insurers ask for medical examinations or driving records; employers run tests and interviews; lenders check credit histories. Online reviews and ratings let buyers screen sellers using other customers' experience.

Insurers also reduce moral hazard by making the insured share the risk: an excess (deductible) means the insured pays the first part of any claim, and no-claims discounts reward careful behaviour.

Response	Used by	Example	Problem addressed
Warranty / guarantee	seller (signalling)	car dealer's 12-month guarantee	adverse selection
Brand reputation	seller (signalling)	established electronics brands	adverse selection
Qualifications	job applicant (signalling)	degrees, certificates	adverse selection in hiring
Medical checks, credit checks	insurer / lender (screening)	health questionnaires	adverse selection
Excess, no-claims discount	insurer	first $500 of each claim paid by the insured	moral hazard

Quick check

1. Distinguish signalling from screening.

2. How does an excess reduce moral hazard?

Answers: 1. signalling: informed party reveals; screening: uninformed party gathers 2. the insured bears part of the cost, so takes more care

5 Government responses

When private solutions are not enough, governments can require or provide information.

Regulation and legislation. Laws can require sellers to disclose information: food labelling, nutrition information, warnings on medicines, and rules against misleading advertising. Financial regulators require banks to hold more capital and to explain products clearly to customers.

Licensing. Governments license doctors, lawyers, electricians and pilots, guaranteeing a minimum standard of competence that consumers cannot check for themselves.

Provision of information. Governments publish information directly, for example school inspection reports, hospital performance data or health campaigns.

Compulsory insurance. Making insurance compulsory, as with car insurance or some national health insurance schemes, keeps low-risk people in the pool and so reduces adverse selection.

These policies have costs. Regulation must be enforced and can raise prices. Licensing can be used by professions to restrict entry and raise their own incomes. Too much regulation may reduce innovation. Good evaluation weighs these costs against the benefits of better information.

Policy	Strengths	Weaknesses
Disclosure and labelling rules	cheap; empowers consumers	consumers may not read or understand labels
Licensing	guarantees minimum standards	may restrict entry and raise prices
Compulsory insurance	reduces adverse selection	low-risk people may resent paying
Financial regulation	reduces moral hazard and crises	compliance costs; may reduce lending

Quick check

1. How does compulsory insurance reduce adverse selection?

2. Give one disadvantage of occupational licensing.

Answers: 1. low-risk people must stay in the pool 2. it can restrict entry and raise prices

6 Asymmetric information in practice: health, finance and insurance

Three markets where information problems are especially serious.

Health care. Patients rarely know what treatment they need or how good a doctor is. This information gap is one reason why many countries provide health care publicly or regulate it heavily, and why doctors are licensed.

Financial markets. Financial products are complex. Before 2008, many investors bought mortgage-backed securities without understanding that they contained high-risk loans; the sellers knew more. Combined with moral hazard from expected bailouts, this contributed to the crisis. Since then, regulations require clearer disclosure and higher bank capital.

Insurance. Adverse selection and moral hazard are built into insurance markets. Insurers respond with screening, excesses and risk-based pricing; governments respond with compulsory insurance and regulation.

7 What is asymmetric information?

One side knows more.

Asymmetric information exists when one party in a transaction has more or better information than the other. This can lead to inefficient outcomes, such as markets shrinking or disappearing, because the less-informed party cannot judge quality or risk.

WORKED EXAMPLE 2 Examples (basic)

Give two examples of asymmetric information.

Solution

Seller of a used car knows its faults; buyer does notA1

Insurance buyer knows their own risk better than the insurerA1

8 Adverse selection

Hidden characteristics.

Adverse selection occurs before a transaction when one side has hidden information about quality or risk. In insurance, high-risk people are more likely to buy cover; insurers raise premiums; low-risk people leave; the pool becomes riskier.

WORKED EXAMPLE 3 Insurance (exam level)

Explain how adverse selection can cause health insurance premiums to rise.

Solution

Insurer cannot distinguish high- and low-risk buyersR1

Average premium attracts mainly high-risk buyersR1

Insurer raises premiums; low-risk buyers leave (spiral)R1

9 The market for lemons

Akerlof's insight.

In the used car market, buyers cannot tell good cars ('peaches') from bad ones ('lemons'), so they offer an average price. Owners of good cars withdraw them, so average quality falls, and the market may collapse.

WORKED EXAMPLE 4 Lemons (standard)

Explain why good used cars may be withdrawn from the market.

Solution

Buyers only pay an average priceR1

Owners of good cars receive less than the car is worth, so they keep itR1

10 Moral hazard

Hidden actions.

Moral hazard occurs after a transaction when one party changes behaviour because it does not bear the full consequences: insured drivers may drive less carefully; banks expecting bailouts may take excessive risks.

WORKED EXAMPLE 5 Banks (exam level)

Explain how government bailouts can create moral hazard.

Solution

Banks expect rescue if risky investments failR1

Incentive to take more risk than socially optimalR1

In the real world

The 2008 financial crisis led to debate about 'too big to fail' banks, whose expected bailouts were seen as encouraging excessive risk-taking.

11 Principal–agent problem

Different goals.

A principal (shareholder, patient, employer) hires an agent (manager, doctor, worker) who has more information and may pursue their own interests. Performance-related pay and monitoring are partial solutions.

Quick check

1. Give an example of a principal–agent problem.

Answers: 1. managers pursuing growth or high salaries instead of shareholder profit

12 Signalling

The informed side reveals quality.

Sellers or workers with high quality signal it: warranties, brand reputation, educational qualifications, certifications. A signal works if it is costly for low-quality sellers to imitate.

WORKED EXAMPLE 6 Education (standard)

How can a degree act as a signal in the labour market?

Solution

Indicates ability and persistence to employersR1

Costly for less able candidates to obtainR1

13 Screening

The uninformed side gathers information.

Uninformed parties screen: insurers require medical checks and use deductibles; employers use interviews and tests; lenders check credit scores. Screening reduces adverse selection.

Quick check

1. How does a deductible (excess) reduce moral hazard?

Answers: 1. the insured bears part of the loss, so has an incentive to be careful

14 Government responses

Regulation and information.

Governments respond with: compulsory disclosure (nutrition labels, financial product information), licensing of professionals, consumer protection laws, mandatory insurance (pooling risk), and regulation of financial institutions.

WORKED EXAMPLE 7 Regulation (exam level)

Evaluate mandatory health insurance as a response to adverse selection.

Solution

Brings low-risk people into the pool, stabilizing premiumsR1

Reduces choice; may be costly for low-income householdsR1

15 Information in healthcare

Patients and doctors.

Patients rarely have the knowledge to judge diagnoses or treatments; doctors may over-treat if paid per procedure (supplier-induced demand). Governments regulate medical professions and provide public healthcare to address this.

Quick check

1. What is supplier-induced demand?

Answers: 1. providers using their information advantage to increase demand for their services

16 Information and online markets

Ratings and reviews.

Online platforms reduce information asymmetry through ratings, reviews and seller histories, though fake reviews create new problems.

Quick check

1. How do online reviews reduce information asymmetry?

Answers: 1. buyers learn about quality from others' experiences

17 Diagram: underconsumption from information failure

MPB versus MSB.

When consumers underestimate the benefits of a good (education, preventive healthcare), their demand (MPB) lies below the true benefit (MSB), causing underconsumption and welfare loss, similar to a positive consumption externality.

WORKED EXAMPLE 8 Information failure (standard)

Explain why information failure leads to underconsumption of preventive health checks.

Solution

Consumers underestimate future benefitsR1

Demand below socially optimal levelR1

18 Mixed review: worked problems

Bringing the ideas together.

WORKED EXAMPLE 9 Mixed problem (exam level)

Distinguish adverse selection from moral hazard, with insurance examples.

Solution

Adverse selection: before purchase, high-risk buyers more likely to insureR1

Moral hazard: after purchase, insured take less careR1

19 Additional exam-style practice

Paper 1 and Paper 2.

WORKED EXAMPLE 10 Paper 1 part (b) (exam level)

Using real-world examples, evaluate government responses to asymmetric information. [15]

Solution

Explain asymmetric information, adverse selection, moral hazardR1 R1

Regulation, disclosure, licensing, examplesR1

Limitations and judgementR1 R1

20 Asymmetric information in labour markets

Hiring.

Employers cannot fully observe workers' productivity; workers know more about their effort. Probation periods, references and performance pay address this.

Quick check

1. Why do firms use probation periods?

Answers: 1. to observe productivity before making a permanent commitment

21 Financial markets and information

Complex products.

Complex financial products (mortgage-backed securities before 2008) were hard for buyers to evaluate; credit rating agencies had conflicts of interest. Better disclosure and regulation aim to correct this.

Quick check

1. What role did information failure play in the 2008 financial crisis?

Answers: 1. buyers did not understand the risks of complex mortgage securities

22 Behavioural links

Information and biases.

Even with information available, consumers may not use it well due to bounded rationality. Simplified labels (traffic-light nutrition labels) combine information provision with behavioural insights.

Quick check

1. Why might traffic-light food labels work better than detailed nutrition tables?

Answers: 1. they are easier to process quickly

23 Evaluating signalling and screening

Private solutions.

Private solutions (warranties, reputation, screening) work well in many markets, but may be insufficient where stakes are high or information is very complex, which justifies regulation.

Quick check

1. Why might warranties not solve all information problems?

Answers: 1. they cover only some defects and may not be offered by all sellers

24 Common misconceptions and links

Students often think…	Actually…
asymmetric information means buyers are always worse off	sometimes the buyer knows more (insurance)
adverse selection and moral hazard are the same	before vs after; hidden information vs hidden action
warranties are screening	warranties are signalling by the seller
regulation always solves information problems	it has costs and may restrict competition

How 2.10 connects to the rest of the course

Topic	Connection
2.8 Externalities	another source of market failure
2.4 Behavioural economics	limited information and bounded rationality
2.11 Market power	information advantages and barriers to entry
3.6 Monetary policy	financial stability and bank regulation

25 Exam-style question with markscheme

Try this under exam conditions (about 15 minutes) before reading the markscheme.

Figure 2. Prices of certified and uncertified used cars of the same model.

Text A. Certified used cars have been inspected and come with a 12-month warranty. Dealers say buyers will pay much more for them because they 'don't want to buy a lemon'.

(a) Define asymmetric information. [2]

(b) Calculate the price premium for certified cars as a percentage of the uncertified price. [2]

(d) Explain how adverse selection could reduce the size of the used-car market. [4]

Markscheme

Part	Answer	Marks
(a)	one party to a transaction has more information	A1
	than the other	A1
(b)	(18 500 − 15 200) ÷ 15 200 × 100	M1
	= 21.7%	A1
(c)	sellers know quality, buyers do not	R1
	certification and warranty signal quality	R1
	lower risk of buying a lemon	R1
	willingness to pay rises	R1
(d)	buyers offer only the average price	R1
	owners of good cars unwilling to sell	R1
	average quality falls	R1
	market shrinks	R1

Examiner's comments. In (c), the best answers used the term 'signalling'. In (d), weaker answers described moral hazard; the question is about who enters the market.

26 Check your understanding

Section A: multiple choice

1. Adverse selection occurs

A. before a transaction, because of hidden information B. after a transaction, because behaviour changes C. when prices fall D. in perfect competition

2. Moral hazard occurs when

A. sellers hide quality B. buyers have perfect information C. a party takes more risk because it does not bear the full cost D. prices are regulated

3. A seller offering a warranty is an example of

A. screening B. signalling C. moral hazard D. a tax

4. An insurer requiring a medical check is

A. signalling B. moral hazard C. a subsidy D. screening

5. An excess in an insurance policy reduces

A. adverse selection B. moral hazard C. competition D. premiums for all

6. Compulsory insurance reduces

A. adverse selection B. moral hazard C. competition D. regulation

7. Banks taking risks because they expect bailouts is

A. adverse selection B. signalling C. screening D. moral hazard

8. Occupational licensing aims to

A. raise all prices B. remove competition C. guarantee minimum standards D. subsidize firms

Section B: structured

9. Distinguish between adverse selection and moral hazard, with examples. [4]

10. Explain how asymmetric information contributed to the 2008 financial crisis. [4]

11. Evaluate the use of regulation to deal with asymmetric information. [6]

Answers

1. A 2. C 3. B 4. D 5. B 6. A 7. D 8. C

9. Adverse selection: hidden information before (high-risk people buy insurance); moral hazard: hidden action after (insured drivers take less care).

10. Sellers of complex securities knew more than buyers; risky loans hidden; moral hazard from expected bailouts.

11. Labelling, licensing and capital rules improve information and stability; but compliance costs, restricted entry, regulatory capture; private solutions exist; judgement.

27 Summary and topic map

Idea	Remember
Asymmetric information	one party knows more than the other
Adverse selection	hidden information before; lemons; insurance pools
Moral hazard	hidden action after; insurance, health care, bailouts
Signalling	informed party: warranties, brands, qualifications
Screening	uninformed party: checks, tests, reviews
Government	regulation, licensing, information, compulsory insurance

Before the exam, make sure you…

•classify the problem as before (adverse selection) or after (moral hazard)
•give a specific market example for each
•distinguish signalling from screening
•evaluate regulation including its costs

Asymmetric Information on one page

Cover this page with a sheet of paper and try to rebuild it from memory. Whatever you can't recall is what to revise next.

Figure 3. Topic map for Asymmetric Information.

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