Provision of Information

Adverse Selection

When we studied the free market perspective, one of the assumptions we made was that both consumers and producers possessed Perfect Information. This assumption mean that both consumers and producers have full access to the same information and both stakeholders posses the same knowledge. In reality however, this is not always the case and in many cases either stakeholder can posses more information than the other. This is how Asymmetric Information creates a market failure. In some instances, producers have more information than consumers and in other situations consumers may have more information than producers. This can lead to what we call Adverse Selection and as such, this causes an overconsumption of underconsumption of a good in a market.

Adverse Selection where information is available to firms and not consumers

In a free unregulated market, it is possible for firms to possess more information about the quality of a good that they may not share fully with the consumer. For example, if someone was to buy a second hand car, the seller may hold back information about potential problems or maintenance issues, therefore the seller posses more information compared to the buyer. This will in turn cause a choice made by the buyer to not be based on perfect information.

Similarly, food producing firms may include ingredients that are harmful to consumers and consumers may be unaware of the ingredients included in the product.

Methods to Correct

Government Response - Regulation

Governments can impose regulation such as quality standards or safety features. For example in food production, governments can ban firms using certain ingredients in their products. For example, within the EU, foods can only contain additives that have passed EU food standards and are labelled "E-numbers". This regulation however, can increase the cost of production for firms and make it difficult for firms to sell across boarders. Similarly the costs for governments to enforce the laws can add additional costs for governments.

Government Response - Provision of Information

Another method governments can use is to either provide information directly themselves or force firms to provide the information to consumers. For example, in the UK, firms must use a standard traffic light system (see image) and highlight the amount of contents of the product. The idea of this system is to provide consumers with sufficient information about the products they are consuming and to highlight how much of their daily recommended allowance, that product contains. As we can see from the image, this label would highlight that the product contains 54% of the daily recommended amount of Saturated Fat, information the consumer may not have known without this system.

Government Response - Licensure

Governments can require firms or sellers to obtain a license to be able to provide a good or service. For example, many countries around the world require doctors to obtain a license in order to practice medicine. In order to obtain this, they must prove they posses the relevant experience and training. By requiring this, governments can ensure the provision of a good or service meets specific standards and that consumers are provided with sufficient knowledge that the seller is qualified.

Private Response - Screening

Screening is a process whereby, consumers gather more information about the product they are buying. Consumers may research the product or firm online and screening the product before they purchase the good. For example, a consumer wanting to purchase a new car could research reviews of car dealers or get a recommendation from a friend.

Private Response - Signalling

This method is used by the firms to convince consumers that the product being sold is a good quality. The firms may use their brand name that may shown reliability, providing information for consumers or using warranties to guarantee quality

Adverse Selection where information is available to consumers and not producers

Some examples of when a consumer may possess more information than producers occur in Insurance markets. When purchasing insurance, a consumer may posses more knowledge or withhold information from the seller of insurance, for example a particular health issue when purchasing health insurance. As a result, insurance firms may reduce the supply of insurance in order to protect themselves from the very high risk and as such insurance premiums tend to be much higher.

Methods to Correct

Private Responses

When firms need additional information on a consumer, they can require additional information from the consumer, such as a medical when purchasing health insurance. Similarly, some insurance companies can invalidate a consumers policy if they have been found to provide inaccurate information. Finally, some healthcare insurers can provide policies with different deductibles (the amount a consumer has to pay themselves for medical treatment). In theory, healthier individuals will opt for cheaper policies with higher deductibles as the likelihood of them needing to use it is low, where as unhealthier individuals will opt for more expensive policies with lower deductibles as the likelihood of them needing it is higher. This in theory would screen for firms those healthy vs unhealthy individuals, however in reality low income households can only afford the cheaper policies with higher out of pocket expenses, so this tends to create an inequitable system.

Government Response

In these situations, governments may respond by directly providing healthcare to avoid the problems with people providing inaccurate information in order to get insured. This is the case for many countries that provide free healthcare for its citizens. Alternatively, the government can provide social health insurance in order to provide consumers with some insurance, even if they are unable to get insured on the free market, such as Obamacare in the US.

Moral Hazard

What is Moral Hazard?

Moral Hazard occurs when one stakeholder takes risks but does not face the full cost of their risks. For example, imagine a company offered insurance for speeding tickets meaning you pay insurance premiums but the company will pay any fine you receive for speeding. As the consumer of that insurance policy, you are more likely to take a risk and speed, because you know the costs of the risk are covered by someone else. Therefore, in this example, the insurance encourages you to take higher risks than you would have if you didn't have the insurance.

2008 Financial Crisis and Moral Hazard

Some economists have argued that moral hazard contributed to the 2008 financial crisis and resulting global recession. Large financial institutions took more high risk financial loans (sub prime mortgages) and other high risk financial transactions (Collateralized Debt Obligations or CDO), as they believed the government would bail them out if they were to fail, which governments did. This was the belief of "To big to fail" that in the event the banks lost money, Governments would intervene to save the banks and this belief acted as the insurance for the large financial institutions to take the higher risks.

Methods to Correct

Providers of insurance can reward policy holders who do not claim or use their insurance with a discount for every year you have. For example, Car insures in the UK offer a "No Claims Discount" to drivers who do not claim from the insurance. This discount increases with every year a driver does not claim.

In the wake of 2008 financial crisis, governments introduce stricter regulation for financial institutions such as how much reserves they must hold with the central banks, as well as splitting retail banking from investment banking, so households savings were not used for risky investments.

Finally, for health insurance, firms can conduct additional screening of consumers and charge higher premiums for those who are considered higher risk or could face higher premiums when they renew, if they have took risker decisions with their health.

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