Information gaps

Question 1

Symmetric information

Answer 1

Each party has access to equal information

Question 2

Asymmetric information

Answer 2

Where one party has more / less information than another

Question 3

Asymmetric information leads to:

Answer 3

Adverse selection and moral hazard, both forms of market failure

Question 4

Adverse selection

Answer 4

Adverse selection occurs when there is asymmetric (unequal) information between buyers and sellers
For example, buyers of insurance may have better information than sellers, those who want to buy insurance are those most likely to make a claim, therefore firms are reluctant to sell insurance
Sellers of second-hand goods may have better information about the true quality of the good than buyers, therefore, buyers are reluctant to pay a decent price because they fear getting a ‘dud’

Question 5

How market failure arises from insurance company’s inability to assess people’s healthiness (example of adverse selection)

Answer 5

Firm can’t distinguish between healthy and unhealthy
AC is offered
Healthier people, who’s cost of insurance is below the AC, exit the market
AC rises
Process continues
Not everybody has health insurance leading to market failure and external costs