Question 3 (ACJC H2 2017 Prelims)

Consumers’ demand for a good or service is often distorted by imperfect information.

Some examples of such markets are medical services, infant milk powder and home
appliances.

a) Explain how different types of imperfect information can lead to an inefficient [10]
allocation of resources.

Question Analysis

Command Word Explain

Content Word ”imperfect information”
“inefficient allocation of resource”
Context Medical Services/ Infant Milk Powder/ Home
Appliances

Schematic Plan

Markets failure in case of imperfect information.

Imperfect information

Medical Services
Infant Milk Powder
Home Appliances

Market failure occurs when the free market fails to achieve an allocatively
efficient outcome – that is, the point where society’s welfare is maximised,
such that no one can be made better off without making someone else worse
Introdu off.
ction
Imperfect information may come in various forms, such as missing or lack of
information, inaccurate or persuasive information, as well as asymmetric
information.
Imperfect information in consumption of medical services may lead to an
inefficient allocation of resources. This arises because there is a lack of
awareness of the full private benefits of, say, consuming vaccinations. As a
result, consumers tend to underestimate the benefits of getting vaccinated.
Body
#1
Consumers, being utility maximisers, will consume vaccination up to the point
where MPBperceived = MPC, at 0Qp. MPBperceived can include the benefits
perceived to be gained from consuming vaccination such as improved
immunity, while MPC will comprise the price of vaccination. Society, which
 prefers if society’s welfare is maximised, will prefer consumption up to the point
where MPBTrue = MPC assuming no MEB and MEC, which is where MSB =
MSC, at 0Qs.

Hence, vaccines are under-consumed since 0Qp < 0Qs. Resources are under-
allocated to vaccine production, and hence, consumption.

This leads to a deadweight loss to society (shaded area) because the

additional cost of consuming QpQs to society is lower than its additional benefit
to society. This leads to allocative inefficiency. Society could be better off if
more vaccines were produced and consumed. Hence, the market fails.
Imperfect information in the case of infant formula milk advertising may also
lead to an inefficient allocation of resources as persuasive advertising may
mislead parents psychologically into believing that a particular brand is better
than another.

Infant formula milk producers often aggressively advertise their infant milk
powder with messages and claims that will appeal to parents, making them
believe they are giving the best to their children and these messages and
claims are often unsubstantiated- such as ‘premium formula milk’, or ‘better
Body
immunity’.
#2
This may cause the demand for a particular firm’s infant milk powder to be
higher than it should be i.e. DDperceived to be greater than DDactual hence
consumer paying a higher price for infant milk than the benefits the consumer
had expected to enjoy (price paid is higher than actual benefits received).
Successful persuasive advertisements hence leads to over-consumption of
such goods leading to loss of consumers’ surplus. Inaccurate persuasive
information thus leads to over-allocation of resources to the production of
those goods.
 Inefficient allocation of resources may also be due to the presence of
asymmetric information between the consumers and producers in the market.
When one economic agent knows more than the other, the outcome of the free
market transaction will be sub-optimal.

Take the home appliances market as an example. The manufacturers of home

appliances knows how safe their products are but consumers would not.
Manufacturers of less safe home appliances will be able and willing to supply
their home appliances at a lower price than manufacturers of safer home
appliances.

Consumers lack the information about how safe home appliances from the
different manufacturers are. Hence they are unable to compare and make
rational decisions to maximise their satisfaction from their purchases.

Body Without perfect information on the level of safety of the product, consumers
#3 will be willing to pay a lower price than they would compared to if they had the
perfect information.

Asymmetric information in this case would lead to the home appliance market
adversely selecting less safe home appliances than the safer ones. The lower
price consumers are willing to pay will not attract manufacturers of safer
appliances to enter the market (as revenue received for each item sold may
not be sufficient to cover the cost required to produce the safer appliance –
more reliable fuse, better quality casing, better design, etc). In this case, the
market would have failed as it would have under- allocated resources to the
firms producing safer home appliances where consumers would have
increased utility (safer living environment) by purchasing the safer home
appliance.

Note: An example on moral hazard can also be used.

Conclu Hence, the markets above fail to achieve allocative efficiency in the presence
sion of imperfect information.