Market failure is the allocation of either goods or services that are not economically efficient. By redistributing these resources, at least one individual can yield some sort of economic gain without negatively impacting an alternative party.
Imperfect Information is one of these market failures. This is when a dissimilarity of information exists between two parties in a transaction; usually between a vendor and consumer, resulting in welfare losses. Governments can directly address, or discourage participation with, imperfect information, through various state interventions. “The Market for Lemons: Quality Uncertainty and the Market Mechanism” (Akerlof, 1970) explains the issues presented resulting from imperfect information.
Imagine a second-hand car market whereby sellers have information in their car. When buyers come to this market, they are happy to pay up to the true value of the car. However, they only have the price to make a decision. This is an example of asymmetric information.
We assume sellers are content to vend the cars for more than half their true value. If there was perfect information, the transaction between the two parties would result in all the cars being sold somewhere between the true value, and half the true value; a mutually beneficial outcome. However, the buyers only know the information of the cars sold on the previous day which poses an issue. The buyers are only willing to spend up to the average price of the cars on the day before since they are unaware of the current quality of cars for that day. Assuming the most expensive car’s average price is exactly the average price of the cars sold on the day before, no one is willing to buy it and subsequently, it is removed from the market. As the days pass, the top end of the market is eliminated and so the average price continues to decrease. Eventually the market is reduced to just bad cars, referred to as lemons.
This process is referred to as adverse selection; when selection of the market is dictated from the previous period or information. Adverse selection occurs within insurance markets; as a result of hidden attributes. When insurance companies are setting a premium for, say car insurance, the quote is generated by information provided by the driver. These include model of the car, location, age etc.
However, certain attributes of the driver cannot quantifiably be obtain, such as how risky the drive is. This asymmetrical information means that for insurance companies, to make a profit, will increase premiums. This prices safer drivers out of the market who would, with perfect information, have a low price of insurance. This is a missing market; only missing due to the lack of perfect and verifiable information (Stevens, 2017). In an attempt to tackle this, insurance companies, categorise bands of age, with younger drivers being assumed to be more dangerous. This leaves the safer, older drivers with lower premiums. Issues are still present within the younger group however, where both sides of the extreme occur regarding driver characteristics. To further combat the information disparity, telematics technology is offered by many insurers.
This black box allows the company to take a bayesian approach; where companies individually consider a period using information based on the previous one. In this case, driving style of the individual is tracked on a month-on-month basis, varying the premium to better reflect driving ability. Currently, the decision for telematics lies with the consumer, and so the market failure still exists. Governments could implement a law stating that all drivers in this category must have a telematics device fitted. Thus, this blanket policy would cause the entire group to have a personalised premium, which would allow the safer drivers to get a lower price.
Another issue that could be tackled by government intervention is when bad drivers with a telematics device transfers insurance companies, in order to clear their poor driving records. If the government were to introduce database that collates all data from drivers, and this information was available to insurance companies, they could immediately give a more accurate insurance quote, as they would have the information on the driver characteristics of the individual. Conversely, in certain markets, It has been argued that categorisation does not work (Hoy, 1984), perhaps where the categorisation is based on the information provided by the other party. The senders’ information may be of misleading quality or inaccurate to the receiver, as the incentives of the two parties are not coherent (Fischer et al., 2001).
In private health insurance, the state of a persons health is largely unknown to the insurance company (Stevens, 2017). Companies request information from the individual, however is in many cases, is unverifiable. It is in the consumers interest to get a low premium; however in the insurance company’s to give a accurate quote, as the money is a representative of the risk. This results in welfare loss that the insurance company would not want to bear; providing a service valued greater than the premium. In response, premiums are raised across the board to compensate. This time, healthy people are priced out of the market.
. Governments could implement a government controlled health care scheme which is compulsory for all members of the public. The UK implemented such a scheme, the National Health Service (NHS). The NHS is not funded through premiums based on individual condition, but rather through general taxation, which is independent to a persons state of health.
This means that unhealthier individuals can get the same level of care as the healthy people, while both can stay in the market. Since the scheme is compulsory to the entire population, a missing market will not occur. It can be argued that businesses should incorporate technological innovation.
“Advanced telematics systems” that “have demonstrated returns after just three months” (Amsterdam, 2017). “If the firms’ production costs are very disparate, then it is the high-cost firm which will adopt the new technology, while the low-cost firm does not.” (Reinganum, 1983, p.68). Reinganum bases his conclusion on a model developed under the assumption that firms have imperfect information regarding the chance of a rival firm also taking on that technology, and associated post adoption costs. This seemingly illustrates the reason why many businesses appear to be failing to take up technology, even though it may result in benefits which were “well-known” (Pickup, 2017). Pickup noted that it was especially apparent in smaller businesses. Governments could impose a transparency law on firms having to declare intent on adopting a new technology, eliminating that aspect of uncertainty among rivals.
Governments could also subsidise businesses who utilise this technology in such a way that should the venture fails, the company would have some consideration, eg. 0% interest. This would hedge the company; encouraging their experimentation with the new technology. Advertising may be purposely deceptive to increase sales.
Back in 2015, it was found that Volkswagen diesel cars had software to detect when they were being tested, altering performance accordingly to reduce emissions (Hotten, 2015). This allowed them to falsely market their cars as low emission and clean. This results in welfare loss as, in light of the true performance information, customers that initially bought this car may have decided differently.
The loss in the market value of the car is the deadweight loss. Governments often have laws prohibiting false advertising and misinformation, however in this situation, there was an issue with the verification of the information. Although a company may still perform such false advertising, the rules and regulations means that governments can penalise them for wrong doing, such as issuing fines or forcing recalls. Volkswagen chose to settle at a price of $14.7 Billion, much of which is to offset the welfare loss; compensating customers for the loss in value their vehicle (Isidore.
et al. 2016). When particulars about a commodity, service or individual are withheld, incorrect or unverifiable, it can cause parties of a transaction to make irrational decisions, or to act overly precautious. The resulting welfare losses could be avoided, had perfect information been present. Governments can intervene in markets to reduce the discrepancy of information and subsequently reduce the associated welfare losses.
The government interventions I have cited fall into two categories. The first, is a direct reduction in the market failure. My example of this was the UK government creating the NHS, with its funding being independent of the individuals state of health, eliminating the possibility of imperfect information. The service being obligatory to the entire population also takes away the possibility of a missing market. The second are deterrents such as laws. Although imperfect information may occur, if it is a violation of the regulations set by the government, they are able to act in hindsight; in an attempt to correct the resulting welfare losses, issuing the respective party with penalities.
This makes it much more unlikely that parties will intentionally affiliate themselves with imperfect information.