Asymmetric information and government actions to correct market failure By Yeaseul Park.

Asymmetric information and government actions to correct

market failureBy Yeaseul Park

Table of ContentsWhat is asymmetric information?

Two types of asymmetric information

What problems does it cause?

Government Actions1. Provide free information

2. Require product information before sale3. Create a compulsory system

Real Life Situation 1Transparency Challenge to Money Managers

Real Life Situation 2Age Trends Weigh on Health Plans

What is asymmetric information?One of the four types of market failures

Also referred as information failure

Definition = a situation where one party to a market transaction has more information about a product or service than the other, thus allowing one party to take unfair advantage (Brue)

Two possible types 1) when seller knows more than buyer2) when buyer knows more than seller

Two types of asymmetric information1. Seller knows more than buyer

Used cars: a used-car seller knows more about the actual quality of the car than the buyer does

Warranties: miss-selling of extended warranties by high street retailers on domestic electrical goods (ex. televisions and dishwashers)

2. Buyer knows more than seller

Insurance: a car insurance company cannot predict the accurate risks associated with each single driver

Sub-prime mortgages: lender does not know how likely a borrower is to repay his or her loan within given time

EXAMPLE EXAMPLE EXAMPLE EXAMPLE EXAMPLE EXAMPLE EXAMPLE EXAMPLE

What problems does it cause?Asymmetric information can cause two main problems in behaviors of consumers.

1. Adverse Selection= behavior that takes advantage of asymmetric information before a transaction ex) higher tendency of people with health risks to get a health insurance

-> the buyers have more information about the true value of the product

2. Moral Hazard= behavior that takes advantage of asymmetric information after a transaction ex) people with car insurance are likely to drive less carefully

-> the buyers no longer correspond the profiles they shared with the seller at the transaction

Attempts to obtain accurate information create marginal cost, therefore asymmetric information causes inefficiency in market.

Government ActionsAlthough there has been decline in asymmetric information

due to advancement of technology and more availability information, asymmetric information is still a big problem in

economy. Therefore, government sometimes takes actions to correct this market failure.

1. Provide free informationProvide information useful for making decisions for sellers or

buyers (what some government agencies are already doing)ex1) U.S. State Department cautioning tourists about visiting a particular regionex2) USDA (U.S. Department of Agriculture) publishing situations and outlooks for agricultural commodities

OR subsidize firms or organizations that take care of these duties

ex1) labor union gather and distribute information about job safety ex2) credit bureaus provide information to insurance companies

As a result: can reduce sellers’ or buyers’ cost for obtaining accurate information

2. Require product information before salePass a legislation that requires sellers

to provide accurate information about their product prior to the sale These information can be standardized

and strengthened with inspections and penalties

Ban false or exaggerated advertisement

ex) FDA (US Food and Drug Administration) requiring all firms to include food labeling on processed foods

As a result: can prevent sellers from taking unfair advantage by giving false information of their products

3. Create a compulsory systemCreate a system for a product where everyone has to buy it

for compulsoryex) making purchase of national insurance compulsory

- unhealthy citizens benefit from insurance premiums below their expected health costs

- healthy citizens can purchase insurance at lower rates

Such a government policy is called cross-subsidization – charging higher prices to one group of consumers in order to subsidize lower prices for another group

- healthy consumers pay a portion of health care for unhealthy consumers

As a result: avoid market inefficiency caused by adverse selection of consumers

Real Life Situation 1Transparency Challenge to Money ManagersThe Age (Melbourne, Australia), September 3, 2012

Summary:These days, recruiting professional money mangers for personal investment is a common practice, especially for retiring workers in Australia. However, there are over hundreds of financial advisers in Australia, and it is hard for investors to find the most suitable advisor for them. The only information potential investors can find about advisors is from words of mouth and reputation, which are hard to be tested in real.

“The managed funds industry controls about $1.89 trillion. There are slightly more than 18,000 financial advisers in Australia - some are in the superannuation sector, while others are in the managed funds industry.

Why this is an example of information failure:This is a good example of asymmetric information in the market because the producers hold more information about the service than the consumers.

Producers = financial advisors Product/service = money management service Consumer = investors

Investors have to depend on words of mouth and reputation when choosing their advisors. Some financials advisors probably have better reputation than their true money management abilities, and they can take advantage of this.

Result:Investors depend on reputation when choosing their advisors. They don’t choose the most suitable advisors for their investments, so they cannot make as much profit. There is inefficiency in the market.

Possible Solution: In the article, Dr Gruen suggests that government open a website where each advisor can post his or her standardized portfolio. The portfolios would include the advisor’s profession across the range of investment securities, so potential investors can have access to accurate quantitative information with paying very low or no cost.

Real Life Situation 2Age Trends Weigh on Health Plans The Washington Times (Washington, DC), February 7, 2006

Summary:This article is from way before Obamacare was established, when health plans were still dependent on individual insurances. Over year, many insurance companies found out that big portion of their insurance client pool consistent of retirees with average age of 59. This is not good for the companies because when there is too much of heavy-risk users, meaning majority of their clients is highly likely to get sick, the premium costs increase and their clients decrease. This results in much lower profit for insurance companies.

“For years, federal officials have watched the migration patterns among the FEHBP options for signs that one is getting top-heavy with costly seniors.”

Why this is an example of information failure:This is a example of asymmetric information in the market because the consumer holds more information about the true value of service than the supplier.

Producers = insurance companies Product/service = value of insurance Consumer = insurance clients

In this case, consumers show behaviors of adverse selection, meaning majority of the clients are old retirees. These people have higher chances of getting sick. Most younger workers, who are much less likely to need health costs, do not want to waste their money on insurance.

Result: Because insurance companies only have few high-risk clients, they cannot make much profit. Therefore, insurance companies have to raise the premiums, which is a bad news for retiree clients as well because they have to spend more for health costs.

Solution: Government could make compulsory national insurance system, so that everyone can afford a health insurance with lower premiums. When the client pool increase and there is more range of risk in clients, insurance companies can provide lower premiums, possibly even lower for people who are certified to be healthier.

Work cited"Age trends weigh on health plans." Washington Times [Washington, DC] 7 Feb

2006: A06. Opposing Viewpoints In Context. Web. 17 Oct. 2013.

Brue, Stanley L. "Government and Market Failure." Economics: Principles, Problems, and Policies. ByCampbell R. McConnell. 16th ed. New York: McGraw-Hill/Irwin, 2005. 572-75. Print.

Colander, David C. Economics. 6th ed. Homewood, IL: Irwin, 1993. 432+. Print.

Gorbatov, Sergey. "Adverse Selection." HR Boutique. N.p., 28 Dec. 2010. Web. 09Oct. 2013. http://hrboutique.blogspot.hk/2010/12/adverse-selection.html.

Pettinger, Tejvan R. "Asymmetric Information Problem." Economics Help. N.p., n.d.Web. 07 Oct. 2013.http://www.economicshelp.org/blog/glossary/asymmetric-information/.

Riley, Geoff. "Unit 1 Micro: Asymmetric Information." Tutor2u.net. Tutor2u, 12May 2012. Web. 09 Oct. 2013http://www.tutor2u.net/blog/index.php/economics/comments/unit-1-micro-asymmetric-information.

"Transparency challenge to money managers." Age [Melbourne, Australia] 3 Sept.2012: 10. Opposing Viewpoints In Context. Web. 9 Oct. 2013.