Asymmetric Information & Moral Hazard (Cambridge (CIE) A Level Economics): Revision Note

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 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