16.1The Problem of Imperfect Information and Asymmetric Information

allow more people to obtain insurance, and to reduce the costs of healthcare. For each year from 2000 to 2011, these costs grew at least double the rate of inflation. In 2014, healthcare spending accounted for around 24% of all federal government spending. In the United States, we spend more for our healthcare than any other high-income nation, yet our health outcomes are worse than comparable high-income countries. In 2015, over 32 million people in the United States, about 12.8% of the non-elderly adult population, were without insurance. Even today, however, more than a decade after the Act was signed into law and after the Supreme Court mostly upheld it, a 2022 Kaiser Foundation poll found that 42% of likely voters viewed it unfavorably. Why is this? The debate over the ACA and healthcare reform could take an entire textbook, but what this chapter will do is introduce the basics of insurance and the problems insurance companies face. It is these problems, and how insurance companies respond to them that, in part, explain the divided opinion about the ACA. Every purchase is based on a belief about the satisfaction that the good or service will provide. In turn, these beliefs are based on the information that the buyer has available. For many products, the information available to the buyer or the seller is imperfect or unclear, which can either make buyers regret past purchases or avoid making future ones. This chapter discusses how imperfect and asymmetric information affect markets. The first module of the chapter discusses how asymmetric information affects markets for goods, labor, and financial capital. When buyers have less information about the quality of the good (for example, a gemstone) than sellers do, sellers may be tempted to mislead buyers. If a buyer cannot have at least some confidence in the quality of what they are purchasing, then they will be reluctant or unwilling to purchase the products. Thus, we require mechanisms to bridge this information gap, so buyers and sellers can engage in a transaction. The second module of the chapter discusses insurance markets, which also face similar problems of imperfect information. For example, a car insurance company would prefer to sell insurance only to those who are unlikely to have auto accidents—but it is hard for the firm to identify those perfectly safe drivers. Conversely, car insurance buyers would like to persuade the auto insurance company that they are safe drivers and should pay only a low price for coverage. If insurance markets cannot find ways to grapple with these problems of imperfect information, then even people who have low or average risks of making claims may not be able to purchase insurance. The chapter on financial markets (markets for stocks and bonds) will show that the problems of imperfect information can be especially poignant. We cannot eliminate imperfect information, but we can often manage it.

16.1 The Problem of Imperfect Information and Asymmetric Information

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Analyze the impact of both imperfect information and asymmetric information
• Evaluate the role of advertisements in creating imperfect information
• Identify ways to reduce the risk of imperfect information
• Explain how imperfect information can affect price, quantity, and quality

Consider a purchase that many people make at important times in their lives: buying expensive jewelry. In May 1994, celebrity psychologist Doree Lynn bought an expensive ring from a jeweler in Washington, D.C., which included an emerald that cost $14,500. Several years later, the emerald fractured. Lynn took it to another jeweler who found that cracks in the emerald had been filled with an epoxy resin. Lynn sued the original jeweler in 1997 for selling her a treated emerald without telling her, and won. The case publicized a number of little-known facts about precious stones. Most emeralds have internal flaws, and so they are soaked in clear oil or an epoxy resin to hide the flaws and make the color more deep and clear. Clear oil can leak out over time, and epoxy resin can discolor with age or heat. However, using clear oil or epoxy to “fill” emeralds is completely legal, as long as it is disclosed. After Doree Lynn’s lawsuit, the NBC news show “Dateline” bought emeralds at four prominent jewelry stores in New York City in 1997. All the sales clerks at these stores, unaware that they were being recorded on a hidden camera, said the stones were untreated. When the emeralds were tested at a laboratory, however, technicians discovered they had all been treated with oil or epoxy. Emeralds are not the only gemstones that are treated. Diamonds, topaz, and tourmaline are also often irradiated to enhance colors. The general rule is that all treatments to gemstones should be revealed, but often sellers do not disclose this. As such, many buyers face a situation of asymmetric information, where two parties involved in an economic transaction have an unequal amount of information (one party knows much more than the other). Many economic transactions occur in a situation of imperfect information, where either the buyer, the seller, or both, are less than 100% certain about the qualities of what they are buying and selling. Also, one may characterize the transaction as asymmetric information, in which one party has more information than the other regarding the economic transaction. Let’s begin with some examples of how imperfect information complicates transactions in goods, labor, and financial capital markets. The presence of imperfect information can easily cause a decline in prices or quantities of products sold. However, buyers and sellers also have incentives to create mechanisms that will allow them to make mutually beneficial transactions even in the face of imperfect information. If you are unclear about the difference between asymmetric information and imperfect information, read the following Clear It Up feature. CLEAR IT UP What is the difference between imperfect and asymmetric information? For a market to reach equilibrium sellers and buyers must have full information about the product’s price and quality. If there is limited information, then buyers and sellers may not be able to transact or will possibly make poor decisions. Imperfect information refers to the situation where buyers and/or sellers do not have all of the necessary information to make an informed decision about the product's price or quality. The term imperfect information simply means that the buyers and/or sellers do not have all the information necessary to make an informed decision. Asymmetric information is the condition where one party, either the buyer or the seller, has more information about the product's quality or price than the other party. In either case (imperfect or asymmetric information) buyers or sellers need remedies to make more informed decisions.

“Lemons” and Other Examples of Imperfect Information

Consider Marvin, who is trying to decide whether to buy a used car. Let’s assume that Marvin is truly clueless about what happens inside a car’s engine. He is willing to do some background research, like reading Consumer Reports or checking websites that offer information about used car makes and models and what they should cost. He might pay a mechanic to inspect the car. Even after devoting some money and time collecting information, however, Marvin still cannot be absolutely sure that he is buying a high-quality used car. He knows that he might buy the car, drive it home, and use it for a few weeks before discovering that car is a “lemon,” which is slang for a defective product (especially a car). Imagine that Marvin shops for a used car and finds two that look very similar in terms of mileage, exterior appearances, and age. One car costs $4,000, while the other car costs $4,600. Which car should Marvin buy? If Marvin were choosing in a world of perfect information, the answer would be simple: he should buy the cheaper car. However, Marvin is operating in a world of imperfect information, where the sellers likely know more about the car’s problems than he does, and have an incentive to hide the information. After all, the more problems the sellers disclose, the lower the car’s selling price. What should Marvin do? First, he needs to understand that even with imperfect information, prices still reflect information. Typically, used cars are more expensive on some dealer lots because the dealers have a trustworthy reputation to uphold. Those dealers try to fix problems that may not be obvious to their customers, in order to create good word of mouth about their vehicles’ long term reliability. The short term benefits of selling their customers a “lemon” could cause a quick collapse in the dealer’s reputation and a loss of long term profits. On other lots that are less well-established, one can find cheaper used cars, but the buyer takes on more risk when a dealer’s reputation has little at stake. The cheapest cars of all often appear on Craigslist, where the individual seller has no reputation to defend. In sum, cheaper prices do carry more risk, so Marvin should balance his appetite for risk versus the potential headaches of many more unanticipated trips to the repair shop. Similar problems with imperfect information arise in labor and financial capital markets. Consider Greta, who is applying for a job. Her potential employer, like the used car buyer, is concerned about ending up with a “lemon”—in this case a poor quality employee. The employer will collect information about Greta’s academic and work history. In the end, however, a degree of uncertainty will inevitably remain regarding Greta’s abilities, which are hard to demonstrate without actually observing her on the job. How can a potential employer screen for certain attributes, such as motivation, timeliness, and ability to get along with others? Employers often look to trade schools and colleges to pre-screen candidates. Employers may not even interview a candidate unless he has a degree and, sometimes, a degree from a particular school. Employers may also view awards, a high grade point average, and other accolades as a signal of hard work, perseverance, and ability. Employers may also seek references for insights into key attributes such as energy level and work ethic.

How Imperfect Information Can Affect Equilibrium Price and Quantity

The presence of imperfect information can discourage both buyers and sellers from participating in the market. Buyers may become reluctant to participate because they cannot determine the product's quality. Sellers of high-quality or medium-quality goods may be reluctant to participate, because it is difficult to demonstrate the quality of their goods to buyers—and since buyers cannot determine which goods have higher quality, they are likely to be unwilling to pay a higher price for such goods. Economists sometimes refer to a market with few buyers and few sellers as a thin market. By contrast, they call a market with many buyers and sellers a thick market. When imperfect information is severe and buyers and sellers are discouraged from participating, markets may become extremely thin as a relatively small number of buyer and sellers attempt to communicate enough information that they can agree on a price.

When Price Mixes with Imperfect Information about Quality

A buyer confronted with imperfect information will often believe that the price reveals something about the product's quality. For example, a buyer may assume that a gemstone or a used car that costs more must be of higher quality, even though the buyer is not an expert on gemstones. Think of the expensive restaurant where the food must be good because it is so expensive or the shop where the clothes must be stylish because they cost so much, or the gallery where the art must be great, because the price tags are high. If you are hiring a lawyer, you might assume that a lawyer who charges $400 per hour must be better than a lawyer who charges $150 per hour. In these cases, price can act as a signal of quality. When buyers use the market price to draw inferences about the products' quality, then markets may have trouble reaching an equilibrium price and quantity. Imagine a situation where a used car dealer has a lot full of used cars that do not seem to be selling, and so the dealer decides to cut the car prices to sell a greater quantity. In a market with imperfect information, many buyers may assume that the lower price implies low- quality cars. As a result, the lower price may not attract more customers. Conversely, a dealer who raises prices may find that customers assume that the higher price means that cars are of higher quality. As a result of raising prices, the dealer might sell more cars. (Whether or not consumers always behave rationally, as an economist would see it, is the subject of the following Clear It Up feature.) The idea that higher prices might cause a greater quantity demanded and that lower prices might cause a lower quantity demanded runs exactly counter to the basic model of demand and supply (as we outlined in the Demand and Supply chapter). These contrary effects, however, will reach natural limits. At some point, if the price is high enough, the quantity demanded will decline. Conversely, when the price declines far enough, buyers will increasingly find value even if the quality is lower. In addition, information eventually becomes more widely known. An overpriced restaurant that charges more than the quality of its food is worth to many buyers will not last forever. CLEAR IT UP Is consumer behavior rational? There is much human behavior that mainstream economists have tended to call “irrational” since it is consistently at odds with economists’ utility maximizing models. The typical response is for economists to brush these behaviors aside and call them “anomalies” or unexplained quirks. “If only you knew more economics, you would not be so irrational,” is what many mainstream economists seem to be saying. A group known as behavioral economists has challenged this notion, because so much of this so-called “quirky” behavior is extremely common among us. For example, a conventional economist would say that if you lost a $10 bill today, and also received an extra $10 in your paycheck, you should feel perfectly neutral. After all, –$10 + $10 = $0. You are the same financially as you were before. However, behavioral economists have conducted research that shows many people will feel some negative emotion—anger or frustration—after those two things happen. We tend to focus more on the loss than the gain. Economists Daniel Kahneman and Amos Tversky in a famous 1979 Econometrica paper called this "loss aversion", where a $1 loss pains us 2.25 times more than a $1 gain helps us. This has implications for investing, as people tend to “overplay” the stock market by reacting more to losses than to gains. Behavioral economics also tries to explain why people make seemingly irrational decisions in the presence of different situations, or how they "frame" the decision. We outline a popular example here: Imagine you have the opportunity to buy an alarm clock for $20 in Store A. Across the street, you learn, is the exact same clock at Store B for $10. You might say it is worth your time—a five-minute walk—to save $10. Now, take a different example: You are in Store A buying a $300 phone. Five minutes away, at Store B, the same phone is $290. You again save $10 by taking a five-minute walk. Do you do it? Surprisingly, it is likely that you would not. Mainstream economists would say “$10 is $10” and that it would be irrational to make a five minute walk for $10 in one case and not the other. However, behavioral economists have pointed out that most of us evaluate outcomes relative to a reference point—here the cost of the product—and think of gains and losses as percentages rather than using actual savings. Which view is right? Both have their advantages, but behavioral economists have at least shed a light on trying to describe and explain systematic behavior which some previously had dismissed as irrational. If most of us are engaged in some “irrational behavior,” perhaps there are deeper underlying reasons for this behavior in the first place.

Mechanisms to Reduce the Risk of Imperfect Information

If you were selling a good like emeralds or used cars where imperfect information is likely to be a problem, how could you reassure possible buyers? If you were buying a good where imperfect information is a problem, what would it take to reassure you? Buyers and sellers in the goods market rely on reputation as well as guarantees, warrantees, and service contracts to assure product quality. The labor market uses occupational licenses and certifications to assure competency, while the financial capital market uses cosigners and collateral as insurance against unforeseen, detrimental events. In the goods market, the seller might offer a money-back guarantee, an agreement that functions as a promise of quality. This strategy may be especially important for a company that sells goods through mail- order catalogs or over the web, whose customers cannot see the actual products, because it encourages people to buy something even if they are not certain they want to keep it. L.L. Bean started using money-back-guarantees in 1911, when the founder stitched waterproof shoe rubbers together with leather shoe tops, and sold them as hunting shoes. He guaranteed satisfaction. However, the stitching came apart and, out of the first batch of 100 pairs that were sold, customers returned 90 pairs. L.L. Bean took out a bank loan, repaired all of the shoes, and replaced them. The L.L. Bean reputation for customer satisfaction began to spread. Many firms today offer money-back-guarantees for a few weeks or months, but L.L. Bean offers a one year money-back guarantee. In the past, L.L. Bean offered a lifetime money-back guarantee, which allowed customers to always return anything they had bought from L.L. Bean, no matter how many years later or what condition the product was in, for a full refund. L.L. Bean has very few stores. Instead, most of its sales are made by mail, telephone, or, now, through their website. For this kind of firm, imperfect information may be an especially difficult problem, because customers cannot see and touch what they are buying. A combination of a money-back guarantee and a reputation for quality can help for a mail-order firm to flourish. Sellers may offer a warranty, which is a promise to fix or replace the good, at least for a certain time period. The seller may also offer a buyer a chance to buy a service contract, where the buyer pays an extra amount and the seller agrees to fix anything that goes wrong for a set time period. Service contracts are often an option for buyers of large purchases such as cars, appliances and even houses. Guarantees, warranties, and service contracts are examples of explicit reassurance that sellers provide. In many cases, firms also offer unstated guarantees. For example, some movie theaters might refund the ticket cost to a customer who walks out complaining about the show. Likewise, while restaurants do not generally advertise a money-back guarantee or exchange policies, many restaurants allow customers to exchange one dish for another or reduce the price of the bill if the customer is not satisfied. The rationale for these policies is that firms want repeat customers, who in turn will recommend the business to others. As such, establishing a good reputation is of paramount importance. When buyers know that a firm is concerned about its reputation, they are less likely to worry about receiving a poor-quality product. For example, a well-established grocery store with a good reputation can often charge a higher price than a temporary stand at a local farmer’s market, where the buyer may never see the seller again. Sellers of labor provide information through resumes, recommendations, school transcripts, and examples of their work. The labor market also uses occupational licenses to establish quality in the labor market. Occupational licenses, which government agencies typically issue, show that a worker has completed a certain type of education or passed a certain test. Some of the professionals who must hold a license are doctors, teachers, nurses, engineers, accountants, and lawyers. In addition, most states require a license to work as a barber, an embalmer, a dietitian, a massage therapist, a hearing aid dealer, a counselor, an insurance agent, and a real estate broker. Some other jobs require a license in only one state. Minnesota requires a state license to be a field archaeologist. North Dakota has a state license for bait retailers. In Louisiana, one needs a state license to be a “stress analyst” and California requires a state license to be a furniture upholsterer. According to a 2013 study from the University of Chicago, about 29% of U.S. workers have jobs that require occupational licenses. Occupational licenses have their downside as well, as they represent a barrier to entry to certain industries. This makes it more difficult for new entrants to compete with incumbents, which can lead to higher prices and less consumer choice. In occupations that require licenses, the government has decided that the additional information provided by licenses outweighs the negative effect on competition. CLEAR IT UP Are advertisers allowed to benefit from imperfect information? Many advertisements seem full of imperfect information—at least by what they imply. Driving a certain car, drinking a particular soda, or wearing a certain shoe are all unlikely to bring fashionable friends and fun automatically, if at all. The government rules on advertising, enforced by the Federal Trade Commission (FTC), allow advertising to contain a certain amount of exaggeration about the general delight of using a product. They, however, also demand that if one presents a claim as a fact, it must be true. Legally, deceptive advertising dates back to the 1950s when Colgate-Palmolive created a television advertisement that seemed to show Rapid Shave shaving cream being spread on sandpaper and then the sand was shaved off the sandpaper. What the television advertisement actually showed was sand sprinkled on Plexiglas—without glue—and then scraped aside by the razor. In the 1960s, in magazine advertisements for Campbell’s vegetable soup, the company was having problems getting an appetizing soup picture, because the vegetables kept sinking. To remedy this, they filled a bowl with marbles and poured the soup over the top, so that the bowl appeared to be crammed with vegetables. In the late 1980s, the Volvo Company filmed a television advertisement that showed a monster truck driving over cars, crunching their roofs—all except for the Volvo, which did not crush. However, the FTC found in 1991 that the Volvo's roof from the filming had been reinforced with an extra steel framework, while they cut the roof supports on the other car brands. The Wonder Bread Company ran television advertisements featuring “Professor Wonder,” who said that because Wonder Bread contained extra calcium, it would help children’s minds work better and improve their memory. The FTC objected, and in 2002 the company agreed to stop running the advertisements. As we can see in each of these cases, the Federal Trade Commission (FTC) often checks factual claims about the product’s performance, at least to some extent. Language and images that are exaggerated or ambiguous, but not actually false, are allowed in advertising. Untrue “facts” are not permitted. In any case, an old Latin saying applies when watching advertisements: Caveat emptor—that is, “let the buyer beware.” On the buyer’s side of the labor market, a standard precaution against hiring a “lemon” of an employee is to specify that the first few months of employment are officially a trial or probationary period, and that the employer can dismiss the worker for any reason or no reason during that time. Sometimes workers also receive lower pay during this trial period. In the financial capital market, before a bank makes a loan, it requires a prospective borrower to fill out forms regarding incomes sources. In addition, the bank conducts a credit check on the individual’s past borrowing. Another approach is to require a cosigner on a loan; that is, another person or firm who legally pledges to repay some or all of the money if the original borrower does not do so. Another approach is to require collateral, often property or equipment that the bank would have a right to seize and sell if borrower does not repay the loan. Buyers of goods and services cannot possibly become experts in evaluating the quality of gemstones, used cars, lawyers, and everything else they buy. Employers and lenders cannot be perfectly omniscient about whether possible workers will turn out well or potential borrowers will repay loans on time. However, the mechanisms that we mentioned above can reduce the risks associated with imperfect information so that the buyer and seller are willing to proceed.

16.2 Insurance and Imperfect Information

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Explain how insurance works
• Identify and evaluate various forms of government and social insurance
• Discuss the problems caused by moral hazard and adverse selection
• Analyze the impact of government regulation of insurance

Insurance is a method that households and firms use to prevent any single event from having a significant detrimental financial effect. Generally, households or firms with insurance make regular payments, called premiums. The insurance company prices these premiums based on the probability of certain events occurring among a pool of people. Members of the group who then suffer a specified bad experience receive payments from this pool of money. Many people have several kinds of insurance: health insurance that pays when they receive medical care; car insurance that pays if their car is in an automobile accident; house or renter’s insurance that pays for stolen possessions or items damaged by fire; and life insurance, which pays for the family if the insured individual dies. Table 16.1 lists a set of insurance markets. Type of Insurance Who Pays for It? It Pays Out When . . . Health insurance Employers and individuals Medical expenses are incurred Life insurance Employers and individuals Policyholder dies Automobile insurance Individuals Car is damaged, stolen, or causes damage to others Property and homeowner’s insurance Homeowners and renters Dwelling is damaged or burglarized Liability insurance Firms and individuals An injury occurs for which you are partly responsible Malpractice insurance Doctors, lawyers, and other professionals A poor quality of service is provided that causes harm to others TABLE 16.1Some Insurance Markets All insurance involves imperfect information in both an obvious way and in a deeper way. At an obvious level, we cannot predict future events with certainty. For example, we cannot know with certainty who will have a car accident, become ill, die, or have his home robbed in the next year. Imperfect information also applies to estimating the risk that something will happen to any individual. It is difficult for an insurance company to estimate the risk that, say, a particular 20-year-old male driver from New York City will have an accident, because even within that group, some drivers will drive more safely than others. Thus, adverse events occur out of a combination of people’s characteristics and choices that make the risks higher or lower and then the good or bad luck of what actually happens.

How Insurance Works

A simplified example of automobile insurance might work this way. Suppose we divide a group of 100 drivers into three groups. In a given year, 60 of those people have only a few door dings or chipped paint, which costs $100 each. Another 30 of the drivers have medium-sized accidents that cost an average of $1,000 in damages,

Simpler explanation — Cambridge AS & A Level Economics

hazard In Section 6.4, it was explained that the underconsumption of merit goods and the over consumption of demerit goods is because consumers make choices based on imperfect information. It was assumed that all consumers have the same information when making decisions on what or what not to consume. This is not always true. The quality of information available to consumers varies and can lead to a misallocation of resources. buyer lacks full information, there is a tendency to overestimate the benefits of consumption.

The demand curve is above that if the consumer had perfect information; too much is being bought at too high a price. In many markets in real life, sellers generally know more about what is being sold than buyers. A typical example is the market for used cars or scooters. Buyers find it difficult to know whether they are buying a good quality car or scooter, or one of low quality. Because they do not know, buyers will only be prepared to offer an average price for what may turn out to be a good quality car or scooter.

The owners of good quality cars or scooters would not want to sell at an average price. The result is that the only cars or scooters sold would be poor quality. The market has failed; poor quality cars and scooters have driven good quality ones out of the market. This is an example of asymmetric information. Assymetric information occurs when one party in the market, usually the seller, has some information that the other party, usually the buyer, does not have.