IB Economics 2.10.2 Responses to Asymmetric Information Notes

1. In the previous section (2.10.1), we introduced the concept and types of asymmetric information.
2. We also saw that it often led to under-allocation of resources.
3. To prevent this under-allocation, both governments and private individuals have developed responses to asymmetric information:
   1. Government responses
      1. Legislation and regulation
      2. Provision of information
   2. Private responses
      1. Screening
      2. Signalling

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:

1. Improves product quality: ensures sellers meet minimum quality and safety standards.
2. Builds trust: increases consumer confidence by requiring transparency from sellers.
3. Protects insurers: discourages risky behaviour by enforcing regulations on insured parties:
   1. 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...).
   2. These rules reduce the likelihood of reckless actions by insured parties since they must comply with safety standards.
   3. In turn, insurers are protected from higher claims that could arise if insured parties act carelessly, knowing the insurer will cover the costs.
4. Promotes fair competition: prevents misleading practices and ensures equal information.
5. Safeguards public interest: ensures essential services meet safety and ethical standards.

Disadvantages

1. Administrative complexity: enforcement requires significant government resources and oversight, which has opportunity costs.
2. Compliance costs: raises expenses for businesses, particularly smaller firms, since they must allocate resources to ensure bureaucratic procedures.
3. Market inefficiency: overregulation may stifle innovation and reduce competition.