- In the previous section (2.10.1), we introduced the concept and types of asymmetric information.
- We also saw that it often led to under-allocation of resources.
- To prevent this under-allocation, both governments and private individuals have developed responses to asymmetric information:
- Government responses
- Legislation and regulation
- Provision of information
- Private responses
- Screening
- Signalling
- Government responses
Government responses: legislation and regulation, provision of information
Legislation and regulation
Governments can pass legislation requiring all goods and services to meet specific quality standards.
Advantages
Legislation and regulation have several advantages:
- Improves product quality: ensures sellers meet minimum quality and safety standards.
- Builds trust: increases consumer confidence by requiring transparency from sellers.
- Protects insurers: discourages risky behaviour by enforcing regulations on insured parties:
- Governments may require insured parties to follow safety guidelines (installing smoke detectors for fire insurance, limiting how much risk a bank can take with deposits...).
- These rules reduce the likelihood of reckless actions by insured parties since they must comply with safety standards.
- In turn, insurers are protected from higher claims that could arise if insured parties act carelessly, knowing the insurer will cover the costs.
- Promotes fair competition: prevents misleading practices and ensures equal information.
- Safeguards public interest: ensures essential services meet safety and ethical standards.
Disadvantages
- Administrative complexity: enforcement requires significant government resources and oversight, which has opportunity costs.
- Compliance costs: raises expenses for businesses, particularly smaller firms, since they must allocate resources to ensure bureaucratic procedures.
- Market inefficiency: overregulation may stifle innovation and reduce competition.
- Risk of avoidance: consumers or firms may bypass regulations, leading to black markets.
- Limited adaptability: regulations may not cover all scenarios, leading to gaps in protection.
Legislation and regulation: NFPA 101 fire safety regulations in the US
When: 1992-ongoing
Where: Commercial buildings across the US
What: Mandatory fire safety regulations requiring smoke detectors, fire alarms, and sprinklers.
How: The government enforced building codes and safety standards in the NFPA Life Safety Code (NFPA 101), adopted in 1992. Insurers also require compliance, reducing risky behaviour from property owners. Non-compliance risks fines or denial of insurance.
So: Regulations improve safety, protect insurers by minimising claims, and increase consumer trust. However, they raise compliance costs for small businesses and require significant government oversight. Some property owners may attempt to bypass these rules, leading to gaps in enforcement.
Provision of Information
- Governments often provide information regarding quality for numerous goods/services.
- This protects the consumers from making low quality and unsafe transactions.
- The government will either:
- Directly provide the information itself.
- Force the sellers to provide the necessary information.
Advantages
- Improves decision-making: ensures consumers and firms have the knowledge to make informed choices, reducing risks of adverse selection and moral hazard.
- Promotes transparency: encourages honest business practices by requiring disclosure of product and service details.
- Enhances market efficiency: Reduces uncertainty, allowing resources to be allocated more effectively.
- Encourages safer behaviour: Disseminates safety information to reduce risky behaviour by insured parties or firms.
However this method also may lack efficiency as:
- It is often impractical for governments to provide this information, because they have to collect it themselves, which can be difficult.
- If the government forces the sellers to provide the information, the sellers may still have some room to hide certain details, as governments cannot monitor everything that sellers do.
Licensure
- The government may force individuals in certain professions to get a license before they can start to work. This way, the government ensures an adequate quality standard in the market.
Examples where licensures are required for individuals to work are:
- Healthcare
- Education
However, by implementing licensing, it can:
- Limit the number of professionals that go into the market
- This will cause the prices in those markets to increase, due to lack of qualified staff
Private Responses for Adverse Selection. Where sellers know more information
Screening
Screening
A situation when the party with the less information is trying to get more information about the good/service.
- In this case the buyer, which has less information, attempts to get more information about the product they are going to purchase.
Examples include:
- Buyers trying to find information about the product they are trying to buy on the internet.
- Asking previous buyers informally on information regarding the quality of the good or service they bought from the same seller
However, buyers may not be able to fully protect themselves from the seller, as not all information can be found on the internet. Also, not all products might be of the same quality.
Signalling
Signalling
Signaling is a method used by the party with more information, to convince the party with less information that the good/service included in the transaction is of good quality.
- In this case, as the seller has more information than the buyer, they will convince the buyer that the good sold is of high quality. This can be accomplished through:
- Warranty
- Brand name
- Price signalling
- luxury and high quality products usually have higher prices
- Certifications
However, signalling may not be enough to provide complete information for the buyers, and the sellers might even use those signals to mislead the buyers, leading to inaccurate information.
Case studyTesla’s Pricing and Brand Reputation
Context:
Tesla uses signalling strategies to convey the quality and reliability of its electric vehicles (EVs). This includes offering extensive warranties (8 years or 150,000 miles on batteries) and maintaining a premium pricing strategy. Tesla also leverages its strong brand reputation as a pioneer in sustainable technology.
Effects of Tesla’s Signalling Strategies:
- Increased Consumer Trust:
Tesla’s warranties reassure buyers about battery durability, addressing concerns over high replacement costs. Consumer trust in Tesla contributed to it holding 65% of the U.S. EV market share in 2022. - Market Differentiation:
The premium pricing strategy signals superior quality and innovation, enabling Tesla to dominate the high-end EV market and invest in research and development. - Limited Accessibility:
Tesla’s high prices exclude middle-income consumers, slowing the broader adoption of EVs and creating opportunities for competitors offering more affordable models. - Risk of Overreliance on Reputation:
High-profile product recalls, such as brake and safety system issues in 2023, have the potential to erode consumer trust, damaging Tesla’s signalling advantage.
Questions:
- Explain how Tesla’s warranty policies and premium pricing act as signals to reduce asymmetric information.
- Evaluate the extent to which signalling strategies contribute to Tesla’s success in the EV market.
Government Responses for Adverse Selection. Where buyers knows more information
- This situation, where buyers have more information than sellers mostly occurs with healthcare insurance. Therefore to counteract this:
- Direct Provision: Governments can directly provide this service for zero or low cost to its citizens to ensure that everyone has access to healthcare insurance.
However, the government will have to finance this using its tax revenues to support to its citizens. This money could have been used for alternative purposes (opportunity cost), e.g education, national defence, other public goods, etc.
Case studyNational Health Service (NHS) – Direct Provision of Healthcare
Context:
The NHS, established in 1948, provides universal healthcare funded through taxation. By directly delivering healthcare services, the NHS eliminates the need for private insurance, addressing information asymmetry between providers and consumers.
Effects of NHS Direct Provision:
- Universal Access to Healthcare:
The NHS ensures that all UK residents, regardless of income or risk profile, can access healthcare. By 2023, over 68 million people were served annually. - Reduced Information Gaps:
The NHS’s standardized care provision ensures transparency about costs and services, eliminating concerns about hidden fees or variable quality in private markets. - Strain on Resources:
Rising demand has led to long waiting times, with non-urgent procedures taking an average of 13 weeks in 2023. These delays have sparked debates about NHS funding and efficiency. - Economic Equity:
NHS funding through progressive taxation ensures that wealthier individuals contribute proportionally more, promoting economic fairness in healthcare access.
Questions:
- Explain how the direct provision of healthcare by the NHS reduces information asymmetry in the healthcare market.
- Evaluate the impact of progressive taxation in ensuring equity in healthcare funding.
- Discuss the extent to which funding constraints affect the NHS’s ability to meet growing demand for healthcare services.
Private Responses for Adverse Selection. Where buyer knows more information
Screening
- An example for private insurance firms is to have a range of different insurance options where individuals within specific risk groups would be charged a higher price.
- The insurance company can do a research and survey about the individual being insured to know which insurance option to offer.
However this screening by insurance firms may disturb equity. This is because if an individual who is from a low income household is considered a high risk patient, they will have to be charged more, which they might not be able to afford.
Responses to Moral Hazard
Screening
- In insurance markets, to prevent moral hazard, private firms can make the buyer to cover a part of the insurance payments by themselves, though out of pocket payments.
- This will make the buyer face the costs of a risky behaviour which may persuade them to lead a less risky lifestyle.
However, as mentioned previously with other solutions, this can cause buyers from lower income household to struggle more, as they do not have the financial means to cover for their risks.
