Markets work when both sides know what they are trading. With asymmetric information, they do not, and the market can fail.
Two kinds of problem
Adverse selection
The seller hides a fault, so the buyer cannot tell good from bad.
Moral hazard
Once insured, a driver takes less care, since someone else pays.
The points to remember
- Adverse selection: hidden information before the deal.
- Moral hazard: hidden action after the deal.
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The classic case is second-hand cars, where only the seller knows the car's real condition.
Our example (made-up numbers)
| Car | Worth to a buyer | Share of cars |
|---|---|---|
| Good car | €10,000 | Half |
| "Lemon" (faulty) | €4,000 | Half |
How the market shrinks
Buyers cannot tell
So they offer the average: €7,000.
Good cars leave
Owners of good cars will not sell for €7,000.
The market shrinks
Buyers now expect a lemon and offer even less.
Remember it as: When buyers cannot tell good from bad, the good ones leave.
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Moral hazard turns up wherever someone else carries the risk.
Moral hazard in real life
Insurance
A fully insured phone gets dropped more often.
Banks
Banks that expect a rescue take bigger risks, as before 2008.
Work
An employee paid the same whatever they do may slack.
The points to remember
- In each case prices do not show the true costs, so too much or too little is traded.
- Some markets shrink or disappear: a market failure.
No paper has set a long question on this micro alone yet; the specimen Paper 1 question on government responses (2.10.2) needs it as its first half. This is the Paper 1 part (a) shape.
Explain how asymmetric information can lead to market failure.
Model answer plan
See the answer broken into clear points, with guidance on how each point earns marks.
How the 10 marks are given
| Marks | What your answer needs |
|---|---|
| 9–10 | Theory fully explained, terms used correctly all the way through, the diagram included and fully explained |
| 7–8 | Theory explained, terms mostly right, the diagram included and explained |
| 5–6 | Theory partly explained, some terms, the diagram included |
| 1–4 | Theory only described or stated; few relevant terms |