<2.10: ASYMMETRIC INFORMATION>

• We learned earlier in section 2.4 CRITIQUE OF CONSUMER & PRODUCER BEHAVIOUR that the competitive market mechanism presupposes that all firms and all consumers have PERFECT INFORMATION regarding products, prices, resources, and methods of production.  

• However, the real world is full of examples where firms, consumers, and resource owners are in situations where information is missing. 

• ASYMMETRIC INFORMATION refers to SITUATIONS WHERE BUYERS AND SELLERS DO NOT HAVE EQUAL ACCESS TO INFORMATION and usually results in an UNDERALLOCATION OF RESOURCES to the production of goods or services.

• ADVERSE (UNFAVOURABLE) SELECTION refers to situations when there is asymmetric information between a buyer and a seller BEFORE A DEAL which leads to an incorrect (ADVERSE/UNINFORMED) market decision being made. 

• This puts THE LESS KNOWLEDGEABLE PARTY at a DISADVANTAGE because it is more difficult for them to assess the value or risk of the deal. Meanwhile, the MORE KNOWLEDGEABLE PARTY has the ADVANTAGE, as they have access to all the relevant information and can more easily evaluate the quality of the agreement. 

• We will see with the aid of examples how this ultimately leads to an INEFFICIENT OUTCOME and USUALLY AN UNDERALLOCATION OF RESOURCES TO THIS MARKET.

• In this market, the SELLERS OF THE CARS HAVE MORE KNOWLEDGE ABOUT THE QUALITY AND THE HISTORY OF THEIR CARS THAN THE BUYER. 

• If we assume there are TWO TYPE OF CAR in this market, HIGH-QUALITY CARS (PEACHES) and LOW-QUALITY CARS  (LEMONS), and that only THE SELLER KNOWS WHETHER A CAR IS A LEMON OR NOT, but the BUYERS CAN'T DISTINGUISH BETWEEN THE TWO UNTIL AFTER PURCHASE.

  • • 1) Thus, BUYERS ARE, VERY WARY AND DO NOT WANT TO MAKE AN ADVERSE SELECTION, (in other words, they do not want to MAKE AN UNINFORMED BUYING DECISION) and are therefore ONLY WILLING TO PAY AN AVERAGE PRICE regardless of the true quality of the car. 

    • 2) This price is TOO LOW FOR SELLERS OF GENUINE HIGH-QUALITY 2ND-HAND CARS as they want a much higher price, therefore they will LEAVE THE MARKET.

    • 3) As they leave the market THE AVERAGE QUALITY OF THE REMAINING CARS FALLS which will eventually lead to more wariness from consumers who will only pay an even LOWER AVERAGE PRICE. 

    • 4) As the average price falls again those HIGHER THAN AVERAGE QUALITY CARS will leave and the cycle continues until only lemons are left in the market.

• So we can see that DUE TO ASYMMETRIC INFORMATION the market has FAILED to create A MARKET FOR HIGH-QUALITY SECOND-HAND CARS as it is impossible to set a fair price.

• We can also see that it is impossible to align a person who wants a 95% new phone with a genuine seller of a 95% new phone.

• In this market, the BUYERS OF INSURANCE HAVE MORE KNOWLEDGE ABOUT THE QUALITY OF THEIR HEALTH THAN THE SELLERS OF INSURANCE. 

• If we assume there are TWO TYPE OF INSURANCE CUSTOMERS, HEALTHY-PEOPLE and UNHEALTHY PEOPLE, and that only THESE BUYERS KNOWS THEIR OWN HEALTH, but the SELLERS HAVE NO WAY OF DISTINGUISH BETWEEN THE TWO UNTIL AFTER THEY PURCHASE INSURANCE:

  • • 1) Thus, INSURANCE COMPANIES ARE, VERY WARY AND DO NOT WANT TO GET RIPPED OFF BY MAKING AN ADVERSE SELECTION BY INSURING AN UNHEALTHY HIGH-RISK PERSON TOO CHEAPLY, AS THEY WILL EVENTUALLY COST THEM A LOT MORE IN TERMS OF MEDICAL BILLS IN THE LONG-TERM, as such, they WILL SET AN AVERAGE INSURANCE PRICE regardless of the person's actual risk level.

    • 2) This price will be TOO HIGH FOR GENUINELY HEALTHY PEOPLE as they want a much lower price given their LOW RISK, therefore they will LEAVE THE MARKET.

    • 3) As they leave the market THE AVERAGE HEALTH OF THE REMAINING PEOPLE WORSENS which will eventually lead to more wariness from the insurance company which will compel them to raise the AVERAGE PRICE even more. 

    • 4) As the average price rises again those HIGHER THAN AVERAGE HEALTHY PEOPLE will leave and the cycle continues until only UNHEALTHY PEOPLE are left in the market.

• So we can see that DUE TO ASYMMETRIC INFORMATION the market has FAILED to create A MARKET FOR INSURANCE FOR HEALTHY PEOPLE. 

• ONE WAY TO MAKE SURE UNHEALTHY PEOPLE PAY MORE AND HEALTHY PEOPLE DON'T GET PENALISED, IS TO OFFER CHEAP COVERAGE, WITH HIGH OUT-OF-POCKET COSTS* AND EXPENSIVE COVERAGE, WITH LOW OUT-OF-POCKET COSTS.

• THIS SYSTEM BASICALLY ALLOWS THOSE WHO ARE HEALTHY AND EXPECT TO GET SICK VERY RARELY A CHEAP INSURANCE POLICY, WHILST AT THE SAME TIME DETERRING UNHEALTHY PEOPLE WHO WILL GET SICK MUCH MORE OFTEN FROM TAKING THIS CHEAP POLICY AS IF THEY DO THEY WILL END UP HAVING TO PAY A LOT OF OUT-OF-POCKET COSTS EACH TIME THEY REQUIRE TREATMENT, HENCE THEY WILL PREFER TO TAKE THE HIGHER COST PLAN, WITH OWER OUT-OF-POCKET COSTS. 

• *OUT-OF-POCKET COSTS REFER TO A PAYMENT THAT THE PATIENT MUST PAY THEMSELVES ('OUT OF THEIR OWN POCKETS') USUALLY AS A % OF THE FEE.

--MR BOUNOUS' DILEMMA--

"A FEW BAD APPLES, SPOIL IT FOR THE REST..."

• WHY IS IT THAT STUDENTS' PERFORMANCES 'PICK UP' CLOSER TO PREDICTED GRADES AND/OR REPORT COMMENTS ARE DUE? WHY DO THEY MAKE PROMISES TO WORK EVEN HARDER FOR TEACHERS IN RETURN FOR THE 'BENEFIT OF THE DOUBT' SO THEY CAN GET A HIGHER GRADE? DO THEY ACT AS DILIGENTLY AFTER THE GRADE HAS BEEN GIVEN? DO THEY ONLY CARE ABOUT MAKING THEIR PARENTS HAPPY (OR 'OFF THEIR BACKS')?, DO THEY CARE THAT A TEACHER CAN LOSE THEIR JOBS FOR CONSISTENTLY 'OVER PREDICTING'? DO THEY FACE ANY CONSEQUENCES FOR THEIR DECEIT?

• DO YOU THINK TEACHERS ARE NOW WARY OF THE 'HAZARD' OF TRUSTING THEIR STUDENTS? WILL THEY START 'UNDER-PREDICTING' GRADES? WILL THEY SIMPLY USE THE SEMESTER EXAMS AS THE BASIS FOR THEIR GRADES? WON'T THAT DISADVANTAGE THOSE HONEST STUDENTS WHO WILL WORK HARDER AS PROMISED?

• Q. WHAT WOULD HAPPEN TO YOUR ATTITUDE IF YOU GOT AN 'UNCONDITIONAL OFFER' AFTER YOU WERE GIVEN THE BENEFIT OF THE DOUBT AND PREDICTED A 7???

• MORAL HAZARD occurs when there is asymmetric information between a buyer and a seller and a CHANGE IN BEHAVIOUR AFTER A DEAL. 

• That means ONE OF THE PARTIES ACCEPTS A DEAL WITH THE INTENTION TO CHANGE THEIR BEHAVIOR AFTER A DEAL IS MADE. 

• This happens when they believe they WON'T HAVE TO FACE THE NEGATIVE CONSEQUENCES OF THEIR ACTIONS. This puts the LESS KNOWLEDGEABLE PARTY AT A DISADVANTAGE because they are usually the ones who have to face the negative consequences instead. Thus, they MIGHT NOT HAVE AGREED TO THE DEAL IF THEY HAD KNOWN ABOUT THE CHANGE IN BEHAVIOUR IN ADVANCE. 

• This WARINESS leads to the less knowledgeable party charging higher prices to everyone, regardless of their honesty in order to compensate for the potential losses of those who change their behavior and act recklessly.

• BEFORE GETTING THEIR CARS INSURED drivers will be extra careful with their vehicles as they have to pay for damages and repairs themselves. 

• However, AFTER THEY GET INSURED, some drivers feel like they don’t have to be as careful anymore as they DO NOT FACE THE FULL CONSEQUENCES OF THEIR ACTIONS, in that the insurance will cover the costs if anything happens to their car. 

• This can lead to MORE RECKLESS DRIVING or just an overall INCREASE IN CARELESSNESS ON THE ROAD. 

• This WARINESS leads to insurance companies CHARGING HIGHER PRICES TO SAFER DRIVERS to compensate for the potential losses of drivers who change their behavior and act recklessly.

HOW DO YOU GET DRIVERS TO DRIVE MORE CAUTIOUSLY AFTER THEY GET INSURED?

• You INCENTIVISE THEM, by offering a 'NO-CLAIMS-BONUS', which means that if you don't get into any accidents and thus make no insurance claims then you will be rewarded with a LOWER COVERAGE FEE in your next plan.