Asymmetric Information & Moral Hazard (Cambridge International A-Level Economics)

Information failure

• Information failure occurs when buyers and sellers do not have sufficient information to make informed decisions in a market.

  • Perfectly competitive markets assume perfect information
  • This means buyers and sellers have full knowledge of prices, quality, and product characteristics
  • In reality, one party often has more information than the other
  • This creates asymmetric information, which can lead to inefficient market outcomes

Asymmetric information

Asymmetric information exist in every used car sale. Sellers always know more about the car than the buyers

• Asymmetric information occurs when one party in a transaction has more information than the other.

  • This imbalance can distort market decisions
  • Buyers may purchase goods without fully understanding their quality or risks
  • Sellers may exploit their informational advantage

Pharmaceutical example

• A pharmaceutical company may know about potential side effects of a drug that consumers are unaware of

  • Consumers may therefore purchase more of the product than is socially optimal

• Asymmetric information can lead to problems such as adverse selection and moral hazard.

Adverse selection and moral hazard

• Adverse selection and moral hazard arise in the presence of asymmetric information, where one party has more information than the other in an economic transaction

Adverse selection

• Adverse selection occurs when individuals with higher risk are more likely to participate in a market.

  • It typically occurs before a transaction takes place
  • The party with less information cannot accurately distinguish between high-risk and low-risk individuals

Example: Insurance markets

• Individuals who expect to make claims are more likely to buy insurance

• Insurers cannot perfectly identify these higher-risk individuals

• As a result, insurers may raise premiums

• This can lead to:

  • Low-risk individuals leaving the market
  • A higher proportion of high-risk customers
  • Further increases in premiums

• This process can cause market failure.

Reducing adverse selection

• Firms may use strategies such as:

  • Risk assessments and background checks
  • Different pricing for different risk groups
  • Incentives for low-risk customers

Moral hazard

• Moral hazard occurs when individuals take greater risks because they are protected from the consequences of those risks.

  • It usually occurs after a transaction has taken place

• The protected party may change their behaviour because they do not bear the full cost of risky actions

Example

• A driver with comprehensive car insurance may drive less carefully because insurance will cover accident costs

• This can lead to:

  • Higher claim rates
  • Increased costs for insurers
  • Inefficient market outcomes

Reducing moral hazard

• Firms often introduce mechanisms such as:

  • Deductibles or excess payments
  • No-claims bonuses
  • Monitoring and policy conditions

• These measures encourage individuals to take greater responsibility for risk