Information failure It exists when some, or all, of the participants in an economic exchange do not have perfect knowledge. Asymmetric information

Markets assume that consumers are rational actors who can make informed decisions about the private costs and benefits of a transaction.

How can you provide that information? A better provision of information about a product can help consumers make more rational decisions in a market situation. How can you provide that information? Advances in technology (particularly the internet) Product packaging and labelling

Second Hand Cars – Akerlof’s Model George Akerlof (1970) first outlined the problem using 2nd hand cars example: Owners know the full story of the car – buyers don’t Buyers are only willing to pay ave. prices for all cars – less than average quality & more than average quality So sellers tend not to sell better-than-average quality cars because they cannot get a high enough price AND sellers tend to get more money for less-than-average quality cars because buyers don’t know any better

Second Hand Cars – Akerlof’s Model Until... buyers catch on: now buyers aren’t willing to pay the old price, leading to even ave. quality cars not fetching enough for sellers to be happy According to Akerlof, eventually the market will disappear In reality, the market exists because buyers have more information than the model suggests, but still prices for 1-day-old cars are well below the ticket price of the new car because of asymmetric information

Asymmetric Information When the buyer or seller has more information than the other George Akerlof https://www.youtube.com/watch?v=N78gTX7VOwM

Principal Agent Problem The goals of the principals (those standing to gain or lose from a decision) are different from those of the agents making the decisions on behalf of the principals Eg. Shareholders vs. managers Eg. Children vs. parents

Extension: How do the government work to correct this market failure? Task – find out why there is information gaps in the following areas and how that creates market failure? Education Pensions Drugs Financial Services Advertising Extension: How do the government work to correct this market failure?

Education Suffers the ‘principal agent problem’ – principals are children, agents are parents Child suffers asymmetric info so parent has to act in interests of the child - encouraging achievement of eventual goals of the child But, in some cases, the parent doesn’t act in the best interest of the child for selfish reasons – the goals of the agent are different to those of the child (eg. parent wants the child at home to work & improve profits for the parent)

Pensions Asymmetric info. means workers pay too little into pensions when they are young (and the pension can do the most growing for them!) Young people can’t imagine growing old & ignore the potential loss of welfare from not starting early enough (opp. cost of saving seems too high)

Drugs Users have asymmetric information – they undervalue the loss in future welfare from current drug / alcohol / tobacco use Sellers often have more information than they share (eg. drug dealers have probably seen people in terrible trouble on drugs, but do not divulge it to their customers!)

Health Care Asymmetric info and principal agent problems exist Patients do not know about their health and treatment, but doctors do Doctors should be acting as agents for patients, recommending what it best for them But doctors (& dentists) may recommend what is most profitable, rather than what is best for the patient Also, patients hide information (moral hazard) when buying life insurance so insurance co’s have to find ways of estimating this information and may overcharge

Financial Services Financial institutions have more information about the products they sell than their customers Financial crisis of 2008 was a good example There was a moral hazard – making a decision in their own best interest knowing that there are potential adverse risks

Advertising Most advertising is persuasive advertising Designed to change attitudes on the part of the buyer Increases information failure on the part of the buyer to the benefit of the seller