ECON 453

Asymmetric Information and Market

Failure

E. Nketiah-Amponsah
Department of Economics
Room W.18
enamponsah@ug.edu.gh

1 12/30/21
 ECON 453

Thông tin bất cân xứng

và Thất bại thị trường

E. Nketiah-Amponsah
Department of Economics
Room W.18
enamponsah@ug.edu.gh

2 12/30/21
 Learning Outcomes
 Explain how asymmetric information leads to market
failure
Market for used/second hand cars (George Akerlof)
 Explain Adverse Selection
Show how information asymmetry leads to adverse selection
 Explain Moral Hazard
Explain how information asymmetry leads to Moral Hazard
 Explain the principal-agent problem
 Identify ways of solving the information asymmetry
problem.

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 Learning Outcomes
 Giải thích: Thông tin bất cân xứng gây ra thất bại thị
trường như thế nào
Thị trường xe hơi đã qua sử dụng/ 2nd hand cars (George
Akerlof)
 Giải thích: Sự lựa chọn đối nghịch
Chỉ ra: Bất cân xứng về thông tin dẫn đến sự lựa chọn đối
nghịch như thế nào
 Giải thích: Rủi ro đạo đức
Giải thích: Bất cân xứng về thông tin gây ra Rủi ro đạo đức
như thế nào
 Giải thích: Vấn đề ông chủ và người đại diện
 Nhận diện các cách để giải quyết vấn đề bất cân xứng
thông tin.

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 Learning Outcomes
principal-agent problem: Vấn đề ông chủ và người đại
diện, hay còn gọi là vấn đề người ủy thác và người
nhậm thác, là một ví dụ điển hình của rủi ro đạo đức
information asymmetry: Bất cân xứng về thông tin vs
asymmetric information: Thông tin bất cân xứng

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 Information Asymmetry-Theory
• Traditional models/standard economic theory of demand
assume that individuals have complete information about
prices and other relevant market information.
– In purely competitive markets, all agents are fully informed about
traded commodities (perfect agency).
• However in practice, information is often highly imperfect and
this can result in decision-making that is socially inefficient.
• One aspect of this problem is that different parties in an
economic transaction/relationship may have different amounts
of information.
– Focus of this lecture will be on the ‘consumer’ (demand side);
how the amount of information available to a given consumer
could alter transaction and market outcomes.
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 Lý thuyết bất cân xứng thông tin
• Traditional models/standard economic theory of demand
assume that individuals have complete information about
prices and other relevant market information.
– In purely competitive markets, all agents are fully informed about
traded commodities (perfect agency).
• However in practice, information is often highly imperfect and
this can result in decision-making that is socially inefficient.
• One aspect of this problem is that different parties in an
economic transaction/relationship may have different amounts
of information.
– Focus of this lecture will be on the ‘consumer’ (demand side);
how the amount of information available to a given consumer
could alter transaction and market outcomes.
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Information Asymmetry-What is it?
• Asymmetric information occurs if one side of the market
is better informed than the other
– A situation in which one party in a transaction has more or
superior information compared to another.
– Asymmetric information exists when either the buyer or seller in
a market exchange has some information that the other does not
– Information Asymmetry refers to a situation where the buyer and
the seller of a commodity or service may have different amounts
of information about that commodity’s or service’s attributes.
• Implies the existing market price is not determined on full
information
• one or other party is making an uneducated assessment of
opportunity cost or perceived welfare benefits
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 Information Asymmetry-What is
it?
• AI is potentially a harmful situation because one party can
take advantage of the other party’s lack of knowledge.

• Asymmetric Information can cause the buyer or seller to

lower the demand or supply of the good in question.

• AI engenders market failure. In extreme situation. this may lead

to market failure where no exchange can take place.

– Justification/Rationale for policy intervention, e.g. compulsory car

insurance and offering a menu of insurance contracts.

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 Search vs Experience Goods and
Asymmetric Information
 Search goods: consumers can determine its
characteristics with certainty prior to purchase

 Experience goods: consumers can determine

its characteristics only after purchase
 Asymmetric information is more prevalent with/under
experience goods

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 Examples of Markets (Selected)
Characterized by Asymmetric Information
• Medical services (Healthcare): A doctor/health provider
knows more about medical services than does the
patient/client.
• Insurance (Health) : An insurance buyer knows more about
his riskiness than does the insurance company.
• Used cars (Second Hand Cars): The owner of a used car
knows more about it (quality) than does a potential buyer.
• Labour Market: Workers know their ability or reliability but
firms (employers) might not.
• Market for loanable funds (Bank lending)
• Education
• Pensions
• ‘Drug Users’
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 Akerlof’s Lemons Principle
• George Akerlof (1970), a Nobel laureate, developed a
model of imperfect information to explain what happens
in the used car market.

• It was the first economic model to have incorporated

asymmetric information using 2nd hand cars (lemons)
– Has since been applied extensively beyond the used car market,
e.g., bank lending and insurance markets; education etc

• Some background on Akerlof’s model

 Akerlof’s Lemons Principle
• If potential buyers know only the average quality of used
cars, then market prices will tend to be lower than the true
value of the top-quality cars. Owners of the top-quality
cars will tend to withhold their cars from sale.

– In a sense, the good cars are driven out of the market by the
lemons. Under what has become known as the Lemons Principle,
the bad drives out the good until no market is left.
 Market for Used Cars (Lemons)
• In Ghana, one market characterized by asymmetric
information is the market for used cars (also sale of used
refrigerators and other electronic gadgets).
• The greater the information asymmetry between sellers
and buyers of used cars, the greater the scope for
deception and fraud.
 Example: Market of Lemons (used cars)
 Assume there are two types of used cars in the market: Good cars and
Bad cars
 Every seller knows the exact type of his/her car
 However, buyers only knows distribution of each type

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 An Illustration
 In particular, buyers know that
 50% of the cars for sale are good
 50% are lemons
 Assume, Good cars worth 30,000 and Bad cars worth 16,000
 In this situation, what should a buyer offer for a car of unknown
type?
 A risk neutral buyer will offer expected value of the car
 Expected value here is the probability weighted average value:
(1/2)*(30,000) + (1/2)*(16,000) = 23,000

– Thus if quality cannot be assessed, the buyer is willing to pay at most a

price that reflects the average quality. However, sellers of good quality
cars will not want to sells at the price for the average quality
– What will happen in the market for cars?
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 Market for Lemons
 At this offer price, which type of cars do you think
would be bought and sold in the market place?

 Yes, only the lemons (bad cars)

 All good car sellers will pull out of the market

characterized by asymmetric information

 This is an example of market failure for good cars

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 Market for Lemons
 What are some of the potential remedies for asymmetric
information? How do we restore the market?

 3 months warranty of power-train or buy back policy (lemon

laws)
 Independent inspection by a mechanic
 Third party insurance for repairs
 Disclosure laws requiring sellers to disclose all known
defects

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Asymmetric
Information
in a Product
Market

Initially, the seller has some information that the buyer does not have;
there is asymmetric information. As a result, D1 represents the
demand for the good and Q1 is the equilibrium quantity. Then, the
buyer acquires the information that she did not have earlier and there
is symmetric information. The information causes the buyer to lower
her demand for the good so that now D2 is the relevant demand curve
and Q2 is the equilibrium quantity. Conclusion: Fewer units of the
good are bought and sold when there is symmetric information than
when there is asymmetric information.
Asymmetric
Information
in a Factor
Market

Initially, the buyer (of the factor labor), or the firm, has some information that the
seller (of the factor) does not have; there is asymmetric information. Consequently,
S1 is the relevant supply curve. W1 is the equilibrium wage, and Q1 is the
equilibrium quantity of labor. Then, sellers acquire the information that they did
not have earlier, and there is symmetric information. The information causes the
sellers to reduce their supply of the factor so that now S2 is the relevant supply
curve, W2 is the equilibrium wage, and Q2 is the equilibrium quantity of labor.
Conclusion: Fewer factor units are bought and sold and wages are higher when
there is symmetric information than when there is asymmetric information
 Is There Market Failure?
• Asymmetric information seemingly resulted in “too much” or
“too many” of something – either too much of a good being
consumed or too many workers working for a particular firm.

• The point is whether or not the asymmetric information

fundamentally changes the outcome from what it would be if
there were symmetric information.

• The presence of asymmetric information does not guarantee that

the market fails. What matters is whether the asymmetric
information brings about a different outcome than the outcome
that would exist if there were symmetric information. If this
occurs, the case for market failure can be made.
 Information Asymmetry and Moral
Hazards
• The existence of asymmetric information leads to the problem of moral hazards

• What then is Moral hazards?

• Moral Hazard occurs when one party in an economic relationship seeks to gain from
a situation which is not prevented in the relationship.
• Normally refers to the disincentives created by insurance for individuals to take
measures that would reduce the amount of care demanded.
• In the healthcare literature, it particularly refers to the additional quantity of health
care demanded, resulting from a decrease in the net price of care attributable to
insurance.

• It is said to refer to immoral behavior that takes advantage of asymmetric

information after a transaction.

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 Information Asymmetry and Moral
Hazards
• The implication of the last example is that insurance
companies will increase their premiums

• Since insurance policyholders taking unnecessary risks

make more claims, the insurance companies will be
forced to raise their premiums, and all policyholders,
including those careful people that look after their
property, will have to pay more.

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 Information Asymmetry and Adverse
Selection
• Asymmetric information lead to adverse
selection.
– Adverse Selection occurs before the transaction
– Moral hazard arises after the transaction
• So what is adverse selection?
• Adverse selection occurs when as a result of
information asymmetry a party to an economic
relationship wrongly chooses another party.

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 Information Asymmetry and Adverse
Selection
• It is said to refer to the immoral behavior that
takes advantage of asymmetric information
before a transaction.
• For instance poor information on the part of
insurance companies can result in higher-risk
consumers (patients) being more likely to buy
insurance.
• The insurance company ends up with an adverse
mix of customers.
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 Agency
• Asymmetric information lies at the heart of the principal-
agent problem.
• The market ‘solution’ to imperfect information is the
agency relationship
• ‘Principal’ (patient) appoints ‘agent’ (health provider) to
advise them in making decision
– The goal of the principal (those standing to gain or lose from a
decision ) are different from those of the agents making the
decision on behalf of the principals (e.g. Shareholders vs
managers)
– Principal combines information with preferences to
make decision as if were perfectly informed
– More usually agent combines information with
principal’s (expressed) preferences to make decision
(doctors make decisions for patients)
 The Principal-Agent problem
• This is frequently the basis upon which agents are
employed.

• However given the asymmetry of information, it will be

very difficult for the principal to judge in whose interest
the agent is operating.

• For instance a second-hand car dealer may "neglect" to

tell you about the rust on the underside of the car, or that
it has a history of unreliability/over-heating.

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 Supplier induced demand in the
Health Care Market
• SID is The change in demand associated with the
discretionary influence of providers, especially physicians,
over their patients (clients). Demand that is provided for
the self-interests of providers rather than solely for patient
interest.
– The ‘gap’ between perfect and imperfect agency
• First observed for hospitals – “A bed built is a bed filled”
(‘Roemer’s Law’, 1961)
• More generally, observation that when faced with shock to
equilibrium (increase supply), health providers respond by
‘inducing demand’ (shifting the demand curve) for their
services
SID Affects the Relation between Physician
Supply and Price
S1
D2 S2
D1

p3
p1
p2

q 1 q2 q3

In a physician services market where physicians can set prices, initial

equilibrium is p1, q1. An (exogenous) increase in the number of physicians
would have been expected to lower prices to p2 and increase quantities to q2. By
increasing demand to D2, however, physicians can not only increase quantity,
but push price even beyond p1.
 Potential Solutions to The Problems
that Arise from Information
Asymm.
• The obvious solution is to obtain better information.
– Consumers might talk to other people who have purchased a
product or used a particular supplier to ascertain whether the
supplier’s product is good.
• Another solution is to employ an agent to find out the right
information

• Product liability laws

• Restrict opportunistic behaviour

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