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Asymmetric information

Asymmetric information

04/23/2021
Asymmetric information and adverse selection
Edubomb Edubomb

By: G.B. Budhathoki

Asymmetric Information

Asymmetric information refers to the information failure in the market. It occurs when one party of the market has greater material knowledge and information on the market than the other party. Generally, what we observe is that there is greater knowledge and information with the seller than with the buyer. However, it does not mean buyers will not have information. In reverse, sometimes buyers may have greater knowledge and information than the seller. But one thing is sure that there are asymmetries in the information between parties. Such asymmetry information may result in the misallocation of the resources due to the behavior of the firms as well as the individual. Hence, asymmetry of information can cause market failure.

This asymmetric information and corresponding market failure can be illustrated by using the classical example of the old car market. We know that seller will have more information regarding the car. The seller knows exactly what are the defects in the car. But, in comparison to the seller, there will be some information lack for the buyers. Buyers may know some information but certainly, miss some information. So, when buyers buy the car then probably there is be disequilibrium in the market. Here such misinformation can cause market failure.  The main reason for market failure is the misallocation of the resources among sellers and buyers.

The market will be efficient only when there is no market failure. For an efficient market, the market will be equilibrium when the social marginal cost is equal to the social marginal benefit I.e.

MSC = MSB

Supply = Demand

Let MSC be the marginal social cost and MSB be the marginal social benefit which is intersecting at point Ee which is the equilibrium point. At the equilibrium point, there is OPe price and OQe output.

Now consider In the case that there is asymmetric information in the product market, the seller in the old car market, hide some information or defects of cars and sells the buyers.  Buyers do not know the defects in cars, hence there is higher demand in the market than actual equilibrium demand in the market. This demand can be regarded as the Private marginal benefit which is shown in the following figures.

In the following figures, SMC and PMB curves are intersecting at point Ep which is an equilibrium point for private sellers. Here the price is OPp and the output is OQp. price and output are higher than the actual social marginal benefit. Hence the market is not efficient. There is disequilibrium in the market. This leads to market failure.

 

 

 

 

 

Adverse Selection

Adverse selection is a type of asymmetric information. It arises due to an unfair or unequal trade system in the market. When one party knows more material information than other parties then it can lead to the condition of asymmetric information and adverse selection. Adverse selection applies to both buyers and sellers.

Let’s take a simple example that, there is a buffet restaurant in Kathmandu, this restaurant sells foods at an equal price for all the customers. The restaurant will have more profit when less appetite customer buys food and will have less profit when more appetite customer buys it. Here restaurants cannot know the Appetite level of the customers. Only customers know the appetite level. Hence there is asymmetric information between customers and restaurants. Here more appetite customer gains more benefit eating more at less price. Such adverse selection leads to market failure.

Let’s take another example in the insurance market, there is adverse selection. Different people have higher risk health, average, and low-risk health. Generally, those people who have a higher risk of health will buy the insurance and there are less likely chances of buying insurance by low health risk people. It means generally only high-risk people buy the insurance policies. Hence there will be a high pool of high-risk people in buying the insurance policy hence insurance companies lose the money.

But insurance creates strategies that can deal with their losses. They offer the policies at different prices for different people.  It means cost and services or policy differentiation work better to make a profit for the insurance company. To overcome such risk, the insurance company introduce the co-payment and deductible policies for low-risk people. In deductible policy, the first insurance buyer pays some amount of money and the remaining is paid by the insurance company. However, in the co-payment policy, insurance pays a small amount of money in each visit to the doctor. Hence in this way, insurance creates a policy to lower the risk.

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