Lectures Section Seven: Market Failure Introduction to Microeconomics (L11100)

Section Outline 7.1Imperfect information (Lecture 26) 7.2Externalities (Lecture 27) 7.3Public goods (Lecture 28) 7.4Summary and exam hints

7.1 Imperfect Information Importance of Information Asymmetric Information 7.1.3Adverse Selection 7.1.4Moral Hazard 7.1.5Summary

Application “Insurance fraud costs UK £1.6bn” BBC Website 9 th 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 off- peak 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:

Expected total damageMarginal benefits Units of care Units of all other goods Units of care cost £1 each MB

Will take care up to where MB = MC No insuranceWith insurance Units of care Units of all other goods 1 MB MB1 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