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Market Failure: Information Asymmetry

Posted: Monday, 18 August, 2014. | By: Equipoise Bot

Markets with asymmetric information are those situations in which one party in a transaction has more or superior information compared to another. This could lead to a harmful situation because one party can take advantage of the other party’s lack of knowledge.

Information Asymmetry can lead to two main problems:

  1. Adverse selection: It is a form of market failure resulting when products of different quality are sold at a single price because of asymmetric information, so that too much of the low quality product and too little of the high quality product are sold.
    • Examples:
    • Market for used cars: Assuming initially equal proportions of high and low quality cars, the price would be considering price of the car as “medium”. However at this price, fewer high quality cars and more low quality cars will be sold. This shifts perceived demand curve and mix of cars shifts heavily to low quality. This continues till only low quality cars are sold.
    • Market for insurance: People who buy insurance know more about their health than any insurance company (even if it insists on a medical examination). Since unhealthy people are more likely to want insurance, their proportion in the pool increases. This will drive insurance costs higher. Healthy people will chose to stay away given the high costs till only unhealthy people remain. This is an extreme situation however and insurance companies take steps to reduce adverse selection.
    • Ways to reduce adverse selection: Unless sellers can provide information about quality to buyers, low quality goods will drive away high quality ones. Warranties are a used as signaling mechanism. Reputation of the seller also makes a difference. Developing a standard product will also help in assuring quality to buyers ( Ex: Mcdonald ). In the labor market, education is used to signal productivity as productive people find it easier to secure higher levels of education.
  2. Moral Hazard: Moral Hazard occurs when a party whose actions are unobserved can affect the probability or magnitude of payment associated with an event.  This is observed in the case of insurance. When one party is fully insured and cannot be accurately monitored by an insurance company, the insured party may take an action that increases likelihood that an accident or a injury will occur. In another case, sales people will have a tendency to shirk work if they have a flat salary structure (Not based on amount of goods sold). Moral hazard not only alters behavior; it also creates economic inefficiencies. This inefficiency arises because the insured individual perceives either the cost or the benefit of the activity from the true social cost or benefit.

Sources: www.investopedia.com; Microeconomics – Pindyck, Rubinfeld and Mehta.    

Stagflation:

Stagflation is the economic condition in which there is extremely slow economic growth and high unemployment (stagnation) accompanied by high inflation. The word itself is a portmanteau of the two words stagnation and inflation. It is a tricky situation to be in because policy measures to counter one condition could further aggravate the other – measures to stimulate growth could further raise inflation levels and measures to control inflation could further slow economic growth.

Causes:

Economists commonly state two possible causes for stagflation:

  1. When the productive capacity of an economy is sharply reduced due to an unfavourable supply shock – such as a sharp increase in oil prices. This leads to both an increase in prices and a decrease in production since production is now more costly and less profitable. Hence prices rise while the economy is slowing down.
  2. Conflicting macroeconomic policies – For example when the central banks allow a rapid increase in money supply by keeping interest rates low while the government causes stagnation by rigid regulation of the goods markets and/or the labour markets. Strict regulation limits economic growth while the growth in money supply drives up demand and hence prices.

The US Stagflation of the 70s
Markets1

From 1958 to 1973, USA experienced the "Post-War Boom". The economy grew by an average of 5% annually, fuelling a slow but steady rise in prices. In this period, the Federal Reserve's monetary policy was guided by diehard Keynesians who believed in the Phillips Curve which gives the relationship between unemployment and inflation. The Fed believed that the inverse relationship between unemployment and inflation was stable and decided to use its monetary policy to increase overall demand and keep unemployment low. They believed the only trade-off would be a safely rising inflation rate.

 

However, the unnaturally low unemployment in the 1960s caused a wage-price spiral. The government poured money into the economy to increase demand, making prices rise. Workers, noting the rise in prices, expected their wages to rise accordingly. For a while, employers were willing to raise wages, but then inflation began to rise faster than wages. Workers weren't willing to supply labour for lower wages, so unemployment increased even as inflation continued to rise. Industry faced a scarcity of labour and the growth was slowing.

 

The real kicker for stagflation came in with the OPEC’s oil embargo of 1973, which brought oil prices to record new levels. Prices skyrocketed across all U.S. industries. In 1970, inflation was 5.5 percent. By 1974, it was 12.2 percent, and then it peaked at a crippling 13.3 percent in 1979. The stock market ground to a halt. The annual return on bonds dropped below inflation levels.

 

Further reading: http://www.businessbookmall.com/Economics_16_Stagflation_and_the_Rise_of_Supply-Side_Economics.htm

 

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