Chapter 4A Information Failures Another type of market failure occurs when either buyers or sellers have incomplete or inaccurate information and the cost of obtaining better information is prohibitive. Information Failures Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Inadequate Buyer Information Asymmetric information Unequal knowledge possessed by the parties to a transaction Buyer has inadequate information on sellers Underallocation of resources Better information too costly Government corrects with inspections, laws against illegal advertising, licensing Asymmetric information is a source of potential market failure, causing society’s scarce resources to be allocated inefficiently. A potential party to a transaction may withdraw from the market due to fear of being exploited because he or she lacks information. LO6

Inadequate Seller Information Moral hazard problem One party alters behavior after contract is signed that is costly to other party Sellers have inadequate information on buyers Underallocation of resources May promote outcome it is trying to prevent Auto insurance, unemployment compensation, athletes guaranteed contracts A person who buys insurance may willingly incur more risk. LO6

Inadequate Seller Information Adverse selection problem Second party incurs major costs due to lack of information Occurs when the contract is signed Those most in need of insurance will be those who purchase it Prevents pooling of high and low risks Social security system prevents this Information know by the first party to a transaction is not known by the second party and the second party incurs a cost as a result. An example of this would be a life insurance company that offers a life insurance policy and advertises “no medical exam necessary” would attract those who have life-threatening diseases. The social security program, designed to insure against poverty in one’s old age, makes almost everyone participate creating a pool of both high and low risk individuals. LO6

Qualifications Ways to overcome information difficulties Consumers may buy product warranties Franchises provide uniform products or services Private firms can provide information Consumer reports, travel guides, credit reports The private sector can overcome some information problems by offering warrantees for products, no hassle return policies, and through publications that rate a product worthiness. Internet sites, like Facebook and Angie’s List, can be used as a source of finding information about different products and service providers. LO6