Asymmetric Information, Merit Goods and Demerit Goods
Asymmetric information exists when one party to a transaction has more or better information than the other, causing two related problems.
Before you start
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Method
- Distinguish adverse selection (a pre-transaction problem, caused by hidden information about the other party or the product before an agreement is made) from moral hazard (a post-transaction problem, caused by hidden action after an agreement is made, once incentives to behave carefully have changed).
- Apply a two-step test to a scenario: does the problem arise from not knowing something about the other party before agreeing (adverse selection), or from a change in behaviour after a contract removes some of the consequences of that behaviour (moral hazard)?
- Classify a good as merit or demerit by asking whether individuals under- or over-value it due to imperfect information about its true costs or benefits, rather than testing for excludability or rivalry (the test used for a public good).
- Note that a merit good typically also generates a positive externality (e.g. education benefits society, not just the individual), so both the information failure argument and the externality argument can support government intervention in the same market.
- Learn government responses to information failure: information campaigns, mandatory labelling and advertising restrictions to correct under- or over-valuation for merit and demerit goods; and compulsory insurance, excesses/deductibles or no-claims discounts to reduce adverse selection and moral hazard in insurance markets.
- For an evaluation question, weigh how far the specific market failure is really about asymmetric information against how far it is caused by other factors, such as an externality or the market power of a small number of large firms.
Worked example
Classify the following two scenarios as examples of adverse selection or moral hazard, and justify each classification: (a) a healthy person decides not to buy private health insurance, because the premium reflects the average risk of a pool that includes many less healthy people; (b) a driver with fully comprehensive car insurance starts parking less carefully and driving a little faster than before.
- For scenario (a), identify when the information problem occurs: before any contract is signed, the insurer cannot easily tell healthy applicants from unhealthy ones, so it must charge a premium based on the average risk of everyone who applies.
- Explain the consequence: because the premium reflects average risk, it looks like poor value to the healthiest people, who leave the insurance pool, pushing the average risk (and therefore the premium) up further; this is adverse selection, since it changes who chooses to participate in the market before a transaction is completed.
- For scenario (b), identify when the change occurs: after the insurance contract is already in place.
- Explain the consequence: because the driver no longer bears the full financial cost of an accident, they have a reduced incentive to take precautions, so their behaviour becomes riskier than before; this is moral hazard, since it is a change in behaviour caused by reduced consequences after a transaction, not a problem of selecting who enters the market.
Practice questions
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Q1Define asymmetric information.Show answer
Answer: A situation in which one party to a transaction has access to more or better information than the other party.
Q2Define adverse selection and give one example.Show answer
Answer: A pre-transaction problem where hidden information means the wrong types of buyer or seller are drawn into a market; for example, sellers of poor quality used cars ('lemons') know more about a car's true condition than buyers do.
Q3Define moral hazard and give one example.Show answer
Answer: A post-transaction problem where one party changes their behaviour, usually taking on more risk, because they no longer bear the full consequences of that behaviour; for example, a fully insured person taking fewer precautions against loss or damage.
Q4Give an example of a merit good.Show answer
Answer: Education, healthcare, or vaccination.
Q5Give an example of a demerit good.Show answer
Answer: Tobacco, alcohol, or high-sugar food and drink.
Q6Explain in one sentence why merit goods are not classified as public goods.Show answer
Answer: Merit goods are usually excludable and rivalrous (a private good in a technical sense) and are under-consumed because of imperfect information, not because a market for them is missing.
Exam-style questions
Written in the style of a A Level Economics exam paper, with a full mark scheme.
Explain, using an example, how moral hazard can arise in the market for insurance.
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Assess whether asymmetric information is the main cause of market failure in the market for private health insurance.
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See real A Level Economics past-paper questions, with official mark schemes →
Free printable worksheet
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