2.10 Market Failure: Asymmetric Information (HL)

Asymmetric Information (AO2)

• Asymmetric information occurs when one economic agent has more knowledge about an economic transaction than the other.

  • • For example, if a car salesman knows more about the car they are selling than the buyer, this is asymmetric information.

    • This creates a market failure because one economic agent can exploit the other, causing unfair advantages. 

Asymmetric Information leads to 2 consequences:

1. Adverse selection: The decisions (selections) made when one party knows less than the other are not always optimal. For example, a used car dealer may know more about the cars than the buyer, and the buyer may therefore unknowingly choose a bad deal.

2. Moral hazard: When one party knows more than the other, they may take advantage of that. For example, if your car is insured, you may be more likely to take larger risks when driving.

So it can be seen that asymmetric information is not ideal. So how can we prevent this?

Responses to Asymmetric Information (AO3) (HL)

• Government responses: 

  • • Legislation & Regulation: Pass laws that make transactions more transparent. For example, force firms to keep advertisements honest or force cigarette firms to put health warnings on their products

    • Provision of Information: Ensure firms provide more information about their products (such as nutrition information for food or engine efficiency for cars)

• Private responses:

  • • Signalling: Reassure buyers that what they are buying is legitimate. For example, offer warranties or free refunds

    • Screening: Try to find out more information about the other party in the transaction. For example, employers screen job seekers before hiring them to ensure they are not lying on their resume