Introduction to Microeconomics
(L11100)
Section Seven: Market Failure
Lectures 26-28
Section Outline
7.1
7.2
7.3
7.4
Imperfect information (Lecture 26)
Externalities (Lecture 27)
Public goods (Lecture 28)
Summary and exam hints
7.1 Imperfect Information
7.1.1 Importance of Information
7.1.2 Asymmetric Information
7.1.3 Adverse Selection
7.1.4 Moral Hazard
7.1.5 Summary
Application
“Insurance fraud costs UK £1.6bn” BBC Website 9th
May 2007
•Fraudulent claims cost £4m a day adding £40 to
premiums on average
•Deliberate spills/cigarette burns on carpets were
common. Goods “stolen” on holiday like watches and
cameras too.
•1 in 10 claimed to have acted in this way
•How does this arise and what effects can it have?
7.1.1 Importance of Information
Through out the module we assumed information
has been perfect:
•Perfect competition (entry and exit)
•Consumer theory (prices and quality)
•Markets (equilibrium and shifts)
However, what happens if this is not the case and all
agents are not perfectly informed? How are model
outcomes affected? How are resources allocated?
7.1.2 Asymmetric Information
A common occurrence is when one agent in a transaction
has more or better information that the other – this is
known as asymmetric information
For example, consider e-Bay: a person selling a second
hand good knows exactly the quality of it whereas the
buyer does not
Or
A person selling a second hand car knows if it is a
“cherry” (good quality) or a “lemon” (low quality)
(Akerlof, 1970)
It is not just about sellers having more information
though – in some cases buyers are better informed e.g.
insurance markets (see later)
Whichever situation arises, there is an issue of hidden
characteristics – things that one side of a transaction
knows about itself that the other side would like to
know but does not.
Example – in monopoly, we saw the firm would ideally
price discriminate at the first degree but cannot as there
are hidden characteristics amongst buyers who do not
reveal their willingness to pay individually
How are hidden characteristics revealed?
Signals - observable indicators of hidden characteristics
A major device is self-selection whereby buyers chose
from a range of options and the choice reveals their
hidden characteristics
Examples – mobile phone contracts; peak and offpeak travel; unlimited access or pay-as-you-go gyms
7.1.3 Adverse Selection
Some buyers and sellers don’t necessarily want to transact
with each other due to hidden characteristics
The uninformed might not wish to deal with the informed
e.g. people selling second-hand cars will be more likely
to try and offload lemons (poor quality) ones than
cherries (high-quality) ones.
A buyer will only be willing to pay a lower price and so
anyone with a cherry would not bother selling and the
spiral continues
Thus, the only people selling will have the lowest quality
cars
Similarly in the insurance market those most likely to
benefit from life insurance are the least healthy and as
premia rise, only the least healthy remain as buyers
Adverse selection – where the uninformed side of a
deal gets exactly the wrong people trading with it
Adverse selection can lead to inefficiency in resource
allocation which suggests markets could develop
institutions to deal with it
Examples of Adverse Selection in Markets
Car insurance – women and young male drivers
Labour markets – ability is hard to assess so
increasing wages increases productivity (so-called
efficiency wages)
Paid blood donation – where incentives are
offered to donate, there is an adverse selection
problem
Government response – regulation of information
flows e.g. advertising, labelling (food), cigarettes etc
7.1.4 Moral Hazard
Analysis so far centres on hidden characteristics. What if
instead there are hidden actions?
Principle–Agent relationship:
In which one party, the principle, hires a second
party, the agent, to perform a task on the first
party’s behalf
Three issues arise:
1. The agent takes an action that affects the principle
2. The principle cannot observe the actions of the agent
3. The principle and agent cannot agree what the agent
should do
For example, a manager’s promotion depends on his sales
team’s performance. What if the sales team doesn’t work
very hard? What if the sales team travels a lot? What if
the sales team doesn’t like doing presentations at
conferences but the manager wants it to?
Moral hazard arises – a situation where the informed
side takes the “wrong” action
For example, in insurance markets, a policy holder
may take unobservable actions that affect the
probability of a loss being incurred e.g. smoking
when covered by life insurance, speeding in cars,
not taking care of goods on holiday etc
Take the example of fire insurance for homes:
Marginal benefits
Units of all other goods
Units of all other goods
Expected total damage
Units of care
Units of care cost £1 each
MB
Units of care
No insurance
With insurance
MB
1
Units of care
Units of all other goods
Units of all other goods
Will take care up to where MB = MC
MB1
MB
Units of care
Moral hazard reduces welfare by the black shaded area
7.1.5 Summary
•Information is rarely perfect
•Its role is to act as a signal in markets
•Hidden characteristics lead to asymmetry in
information
•Hidden actions lead to moral hazard
•Both features lead potentially to inefficient outcomes
unless the market develops institutions or means to
deal with them