Information gaps and asymmetric information

Overview

Information gap and information asymmetry, adverse selection and moral hazard.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Distinguish between an information gap and information asymmetry.

   Model answer

   An information gap exists when the information needed for a good decision is missing for everyone involved, so buyer and seller are equally in the dark, as with the long-run effects of a newly introduced product. Information asymmetry exists when one party to a transaction knows materially more than the other, so the better-informed side can exploit the difference. The first leads to mistakes on both sides; the second leads to exploitation and to markets that shrink.

2. 2

   What is adverse selection?

   Model answer

   Adverse selection occurs before a transaction, when the better-informed party's private knowledge determines who chooses to trade. In insurance, people who know they are high risk are keenest to buy cover, so the pool of applicants is worse than average; the insurer raises premiums, which drives out lower-risk customers and worsens the pool further. In the used car market, sellers know the condition of their vehicle and buyers do not, so good cars are withheld and average quality on sale falls.

3. 3

   What is moral hazard?

   Model answer

   Moral hazard occurs after a transaction, when being insured or otherwise protected changes behaviour because the consequences now fall on someone else. A motorist with fully comprehensive cover may park less carefully; a firm confident of being rescued may take greater risks. The insurer cannot observe the change in care, so claims exceed what the premium was priced to cover, premiums rise for everyone, and the market operates less efficiently than it would with full information.

4. 4

   Explain the difference between adverse selection and moral hazard using an insurance example.

   Model answer

   Adverse selection happens at the point of buying the policy: someone who knows their health is poor is more likely to take out medical cover than someone who knows they are fit, so the insurer's customers are riskier than the general population. Moral hazard happens after the policy is bought: having obtained cover, the customer takes less care than before, because part of the cost of any loss now falls on the insurer. One is about who buys; the other is about how they behave afterwards.

5. 5

   Why can asymmetric information cause a market to shrink or disappear altogether?

   Model answer

   If buyers cannot tell good from bad, they will only pay a price reflecting average quality. Sellers of above-average items find that price too low and withdraw, which lowers average quality further, so buyers reduce their offer again. Each round drives out the best of the remaining sellers. In the extreme the process continues until only the worst quality is left and trade collapses, even though buyers and sellers of good items would both have gained from trading.

6. 6

   A dentist recommends treatment that the patient cannot evaluate. Explain the information problem and its consequence.

   Model answer

   The dentist has specialist knowledge of whether the treatment is needed and the patient does not, so the seller of the service is also the person advising on how much of it to buy. That is information asymmetry between a professional and a client. The patient may be sold more treatment than is necessary or, if suspicious, may refuse treatment that is genuinely required. Either way the quantity traded diverges from the efficient one, and trust rather than price does much of the rationing.

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