2.9 Information failure

DEFINITIONS:

1. Information failure: Information failure occurs when all parties in an economic transaction do not have access to the same information, leading to suboptimal decisions.
2. Market failure: when the allocation of goods and services by a free market is not efficient.
3. Asymmetric information: Asymmetric information exists when one party in a transaction possesses more or better information than the other, often leading to an imbalance of power and potential market failure.
4. Moral hazard: Moral hazard arises when one party is able to take risks because they do not have to bear the full consequences of their actions, typically due to information asymmetry.
5. Merit goods: Merit goods are goods that are under-consumed if left to the market mechanism because individuals underestimate the true benefits to themselves and society.
6. Demerit goods: Demerit goods are goods that are over-consumed if left to the market mechanism because individuals underestimate the true costs to themselves and society.

Explain:

2.9.1 Information failure

Information Failure in economics occurs when individuals or firms do not have access to, or do not use, all available information when making decisions. This leads to suboptimal outcomes and market inefficiencies. Information failure can result from various factors, including:

7. Asymmetric Information: When one party in a transaction has more or better information than the other. For instance, in a used car market, sellers may know more about the condition of the car than buyers, leading to adverse selection.
8. Incomplete Information: When the available information is not sufficient for making fully informed decisions. This can occur in financial markets where investors may not have complete data on all investment opportunities.
9. Misleading Information: When information is incorrect or deceptive, leading to poor decision-making. For example, false advertising can mislead consumers about the benefits of a product. Information failure can lead to market inefficiencies, such as market failure or the misallocation of resources, because decisions are based on incomplete or incorrect information.

2.9.2 Asymmetric information and moral hazard

Asymmetric Information:

Asymmetric information occurs when one party in a transaction has more or better information than the other party. This imbalance can lead to inefficiencies and market failures. For example, in the used car market, sellers may know more about the car's condition than buyers. This can result in buyers overpaying for cars that are not as good as they believe, a problem known as adverse selection.

Moral Hazard:

Moral hazard arises when one party takes on more risk because they do not bear the full consequences of that risk. This typically occurs when individuals or organizations are insulated from the consequences of their actions, leading to riskier behaviour. For example, if a bank knows it will be bailed out by the government if it fails, it might engage in riskier financial practices than it otherwise would, since it does not fully face the consequences of a potential failure.

2.9.3 Merit and demerit goods

Merit Goods:

• Characteristics: These goods are often associated with significant social benefits and may be undervalued by individuals. Examples include education and healthcare.

• Rationale for Government Intervention: Governments might subsidize or provide merit goods to ensure they are consumed at a level that maximizes societal welfare. For instance, free or subsidized education can improve overall human capital and economic productivity. Demerit Goods:

• Characteristics: These goods can lead to significant social costs and are often harmful to both individuals and society. Examples include tobacco and excessive alcohol consumption.

• Rationale for Government Intervention: Governments might impose taxes, regulations, or bans on demerit goods to reduce their consumption and mitigate negative externalities. For example, higher taxes on cigarettes aim to reduce smoking rates and related health issues. In summary, merit goods provide societal benefits that are often under-consumed, leading to potential government provision or subsidies, while demerit goods impose societal costs that are often over-consumed, leading to potential government taxation or regulation.

2.9.4 Market Failure Caused by Information Failure

One cause of market failure is information failure, which happens when buyers or sellers do not have access to the necessary information to make informed decisions, leading to suboptimal outcomes.

Explanation:

1. Asymmetric Information: This occurs when one party in a transaction has more or better information than the other. This can lead to adverse selection and moral hazard.

• Adverse Selection: This happens before a transaction occurs, where one party takes advantage of having more information. For example, in the insurance market, those who are high-risk are more likely to purchase insurance, leading to higher costs for insurers.
• Moral Hazard: This occurs after a transaction, where one party may take on more risks because they do not bear the full consequences of those risks. For example, insured individuals might engage in riskier behaviour because they are covered by insurance.

2. Public Goods: Information is often a public good. Once provided, it is non-excludable (everyone can access it) and non-rivalrous (one person's use does not reduce availability to others). As a result, there may be under-provision of information by the market because firms cannot easily charge consumers.

Diagram:

Here's a simple diagram to illustrate the impact of information failure on market outcomes.

Real-world Example:

• Used Car Market: Known as the "market for lemons." Sellers have more information about the quality of the car than buyers. This information asymmetry can lead to adverse selection, where high-quality cars are driven out of the market because buyers are not willing to pay a high price for a car that might be of low quality.

Conclusion:

Information failure distorts the decision-making process of consumers and producers, leading to market outcomes that are not socially optimal. The government may intervene to correct these failures by providing information, regulating markets, or other measures to ensure a more efficient allocation of resources.