merged

Example 21: The city of Springfield can place a limitation on the number of Montys that can be
fished out of Lake Springfield each year. The most economically efficient approach would be to
auction off Monty fishing licenses to the high bidder. That would ensure that the limited supply of
Montys would go to the user with the most valuable use.
Asymmetric Information
Another source of market failure is asymmetric information. One party to an exchange may have
information that the other party doesn’t have. Asymmetric information may result in a market
producing more or less than the optimal quantity.
Example 22: Fifty years ago, tobacco companies knew a lot more about the dangers of cigarette
smoking than the average cigarette smoker knew.
Asymmetric information may result in adverse selection. When adverse selection occurs, the
party lacking information will be confronted by a different selection than expected.
Example 23A: If an auto insurance company charges “one rate” for all drivers, the company may
expect a normal selection of drivers to apply for a policy. But the actual selection will consist
mainly of “high risk” drivers.
Example 23B: Under the Affordable Care Act, insurance providers may not deny coverage or
charge higher premiums based on pre-existing conditions. If there were no individual mandate
requiring most individuals to purchase health insurance, a person could wait until they developed
a health problem before purchasing health insurance. A person could not be denied coverage or
charged higher premiums based on this pre-existing condition. Individuals in good health would
have no incentive to purchase health insurance, since they could always purchase the health
insurance that they need after they develop a health problem. Thus, only those with health
problems would purchase health insurance. This adverse selection of purchasers would mean
that health insurance premiums would have to be very high.
Asymmetric information may result in moral hazard. Moral hazard occurs when one party to an
exchange changes his or her behavior after the exchange in a way unexpected by and
detrimental to the other party.
Example 24: After drivers acquire an auto insurance policy, their driving habits may deteriorate
since their personal risk of loss from an auto accident is reduced.
Economists disagree on how severe a problem is created by asymmetric information. Some
economists see asymmetric information as a major flaw in the market system and believe that the
less informed party (usually the consumer) suffers large losses as a result.
Other economists argue that information is usually available, though at a cost. They assert that
the decision as to how much information to acquire is best left to the consumer.
Example 25: Barney is in the market for a used car. Barney is a big guy and often suffers from
alcohol-induced clumsiness, so he is looking for a car that is roomy and easy to climb into and out
of. Moe owns a used car that is roomy and easy to climb into and out of. Moe knows a lot about
the car’s history for reliability. Barney does not. This asymmetric information may cause Barney to
buy a car that he would not want or to agree to pay a price that is more than he would be willing
to pay if he were better informed.
However, Barney has the option of acquiring more information. He can take the car to a trusted
mechanic to have it checked out. He can research the reliability of cars of the same make and
model. He can pay for a service that will give him a history of the car. Barney will decide how
much cost he is willing to incur to increase the information he has about the car.
FOR REVIEW ONLY - NOT FOR DISTRIBUTION
Market Failure 27 - 10