Information Gaps

The Problem of Asymmetric Information

A key assumption of perfect market efficiency is perfect/symmetric information, where buyers and sellers have equal, complete knowledge.

In reality, information gaps and asymmetric information are common.

Information gaps: a situation where one party lacks the information needed to make an informed decision.

Asymmetric information: a situation where one party in a transaction has more or better information than the other.

These can distort decision-making and lead to market failure.

Consequences of Asymmetric Information

Information gaps:

Information gaps: can cause consumers to over/under-consume goods and services, leading to a misallocation of resources and market failure.

For example: a consumer may underconsume healthcare check-ups due to lack of information about their benefits, including the long-term value of preventive care such as catching cancers early.

Asymmetric information:

Asymmetric information: can lead to consumers making poor decisions, such as purchasing low-quality goods or services.

For example: a consumer may purchase a used car without knowing about defects that the seller is aware of and hiding, leading to a loss of utility.

Adverse selection:

Adverse selection: occurs before a transaction. The party with less information cannot judge quality accurately, so they assume the worst and are only willing to pay a low price. This drives high-quality goods out of the market.

For example: in the used car market, sellers know each car's history but buyers do not. Buyers assume every car may be low-quality, so sellers of good cars withdraw from the market, leaving only the poor ones behind.

Moral hazard:

Moral hazard: occurs after a transaction. One party changes their behaviour in a riskier way because they do not bear the full consequences of it.

For example: a driver with comprehensive car insurance may become less cautious, because the insurer rather than the driver bears the cost of an accident.

Result: Market Failure

Asymmetric information causes a misallocation of resources.

Markets may over-provide low-quality or harmful goods because buyers are unaware of defects.

Markets may also under-provide high-quality or beneficial goods because buyers cannot identify them.

This results in a loss of allocative efficiency.