SRJC H2 ECONS 9757 Q3 MS

3 Information failure refers to situations in which economic agents have imperfect information regarding the benefits or costs of their actions as well as when information between the transacting parties is asymmetric in nature. (a) Explain how information failure could lead to market failure. [10] (b) Discuss the view that government intervention to correct the above market failure is always desirable. [15] (a) Intro:  Define market failure/ imperfect info / asymmetric info  Direction statement: Both sources of information failure lead to market failure as they lead to allocative inefficiency through overconsumption OR underconsumption Market failure refers to a situation where decisions made based on market forces of demand & supply fail to achieve efficiency in resource allocation and thus there is welfare loss to society. Imperfect information means that consumers (or sellers) do not have full relevant knowledge about the product and so they are not able to make a good decision. Consumers may have inaccurate, incorrect or incomplete information about the product. They may also have less information than sellers, in which case this leads to asymmetric information and thus market failure. Both forms of information failure lead to situations where consumers either overconsume or underconsume a particular good or service. This leads to allocative inefficiency and thus market failure. TS1: Imperfect information leads to partial market failure as the consumers fail to recognise the true benefit/cost of consuming a good and therefore under/over consume it leading to allocative inefficiency. Consumers and producers make cost-benefit decisions based on the information that they have. When the costs and benefits that they perceive of consuming certain goods and services are not accurate, this can result in them making decisions that do not maximise their welfare. An example of this can be seen in the market for sugary drinks. Consumers of sugary-drinks make decisions on how many drinks to consume based on the costs and benefits that they perceive of consuming those drinks. An exampl e of the benefits to a consumer would be the enjoyment of the taste and the burst of energy they may get when drinking those drinks. A cost that the consumer may perceive would be the price that they need to pay in order to purchase the drink. However, many consumers may fail to consider the possible long-term damage that consuming sugary drinks may have on their health. An example of this would be that regular consumption of such high amounts of sugar can lead to obesity and other related ailments such as diabetes. This is likely to be because the enjoyment of the sugary drinks is immediate whereas the health problems it may cause are often slow to occur and often do not show any outward signs until the problem is quite advanced. Thus consumers often discount theses costs involved in consuming sugary drinks and do not take them into account when making the decision on how many sugary drinks to consume.

This situation is illustrated in figure 1. In this situation, we assume that there are no positive externalities involved in drinking sugary drinks, making the marginal private benefit (MPB) the same as the marginal social benefit (MSB). Since the consumer fails to take into account the harm to their health, the marginal private cost perceived (MPC perceived) is less than the actual marginal private cost (MPC actual). Assuming there are no negative externalities involved, the actual marginal private cost is also equal to the marginal social cost (MSC). The consumers choose to purchase a quantity of drinks up to where the MPB is equal to their perceived MPC. This is because they believe this quantity maximises their welfare. However, since the actual MPC is higher than the perceived MPC, the quantity that will actually maximise their welfare is at Qs, where MPC actual intersects MPB. This results in a situation of overconsumption as Qm is more than Qs. For each unit between Qs and Qm, the costs to society (MSC) is greater than the benefits gained (MSB), resulting in there being a net loss of welfare for each unit consumed. The sum of these losses is seen by area E1BA, making up the deadweight loss as a result of overconsumption. Thus the imperfe ct information causes allocative inefficiency and the market fails. TS2: Asymmetric information leads to partial market failure in the form of causing adverse selection. This would lead to under consumption/under provision of a good leading to failure to achieve allocative efficiency. Asymmetric information refers to a situation in which the economic agents (e.g. consumers and producers) involved in a transaction do not have the same amount of relevant knowledge, resulting in a distortion of incentives and inefficient outcomes. Adverse selection is one outcome of asymmetric information and this leads to market failure. It describes a situation in which the uninformed side of the market must choose from an undesirable or adverse selection of goods. One situation we can see this happening is in the market for second-hand cars. The second hand car market best exhibits this. Sellers of second hand cars will have more knowledge of their cars than buyers. This includes any engine faults or other car issues. However, they are likely to withhold this information from buyers in order to sell their cars off at a higher price. Buyers are aware of this and thus offer a lower price for second hand cars. However, sellers of good quality second hand cars will not want to sell their cars at such a low price. This eventually results in sellers of high quality second hand cars leaving the market, resulting in only low quality second hand cars being available for sale, ultimately causing market failure.

TS3: Asymmetric information leads to partial market failure as it can lead to the moral hazard problem which leads consumers to overconsume goods that may have some risk of harm or underconsume goods that can minimise potential losses, thus leading to allocative inefficiency. Moral hazard occurs when one party has unequal information about the behaviour of the other party after the transaction has taken place. A common example would be in the case of fire insurance. The insurance company offers the insurance policy to a homeowner based on the expected risk of the house catching fire and the potential losses that may result. The asymmetry arises when the homeowner’s behaviour changes after he has purchased that insurance policy. Since the homeowner no longer bears the cost incurred of any fire damage, he is likely to underconsume any goods that serve as precaution to fires. An example of this would be that the homeowner is not likely to purchase enough fire alarms or fire extinguishers as he no longer has to bear the cost of the house catching fire and thus has no incentive to prevent those fires. At the same time, the homeowner may then overconsume certain risky goods. An example would be that the homeowner may now purchase electronic appliances that do not have sufficient fire safety standards or purchase furniture that can pose potential fire hazards. As such, the fact that the insured party no longer has to take on the costs involved with their house catching fire leads them to underconsume precautionary goods and overconsume risky goods. This leads to allocative inefficiency and the market fails. Level Marks Description L3 8-10  An answer that explains both types of information failure  Answer uses appropriate economic theory and diagrams to show WHY the market fails and the corresponding loss of welfare  Strong answers should be applied to appropriate contexts L2 5-7  One sided answer that only explains one type of information failure  OR answer that addresses both types of information failure but expla