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Imperfect and Asymmetric Information Cause Misallocation

Definition

Asymmetric information: a situation in which one party to a transaction has more or better information than the other, leading to a misallocation of resources and market failure.

  1. Markets allocate efficiently only if buyers and sellers are well informed.
  2. Imperfect information means people lack the full facts, so they choose badly.
  3. Asymmetric information means one side knows more than the other.
Note
  • Information gaps lead to a misallocation of resources.
  • Asymmetric information is a specific case where knowledge is unequal.

Information Gaps Push Consumption Away From the Optimum

  1. With too little information, people under-consume merit goods and over-consume demerit goods.
  2. With asymmetric information, the better-informed side can exploit the other.
  3. Either way, the market outcome drifts from the social optimum.
Example
  • A used-car seller knows the faults a buyer cannot see.
  • A borrower knows their own risk better than the lender does.

Asymmetric Information Can Cause Adverse Selection or Moral Hazard

  1. Adverse selection happens before a deal is made, when the better-informed side's hidden characteristics distort who takes part in the market.
  2. Moral hazard happens after a deal is made, when one side changes its behaviour because it no longer bears the full risk.
  3. Both distort market outcomes away from the social optimum, but the timing and the appropriate fix differ.
Example
  • In the second-hand car market, sellers of good cars struggle to prove their quality, so buyers assume the worst and offer a lower average price, pushing good cars out of the market: a case of adverse selection.
  • A driver with fully comprehensive insurance may take less care locking their car, since the insurer bears the cost of any theft: a case of moral hazard.

Monopoly Power Raises Price and Cuts Output

  1. A firm with monopoly power can restrict output and raise price above marginal cost.
  2. This produces a welfare (deadweight) loss compared with a competitive market.
  3. The result is an inefficient allocation of resources.
Note
  • Price above marginal cost signals allocative inefficiency.
  • Some consumer surplus is lost, and some is transferred to the firm.

Monopoly Misallocates by Restricting Output

  1. The monopolist produces less than the socially optimal quantity.
  2. Consumers pay more and buy less than in a competitive market.
  3. The lost mutually beneficial trades are the welfare loss.
Example
  • A dominant firm can hold output back to keep its price high.
  • Buyers who valued the good above its cost go without it.

Monopoly Is Not Always Harmful

  1. Large firms may gain economies of scale that lower costs.
  2. Monopoly profit can also fund research and innovation.
  3. On balance, monopoly is a market failure, but dynamic efficiency gains can offset it.

Factor Immobility Traps Resources in the Wrong Place

  1. Resources, especially labour, are not perfectly mobile.
  2. So they cannot always move to where they are most valued.
  3. The result is a misallocation and structural unemployment.
Note
  • Geographical immobility is the barrier to moving location.
  • Occupational immobility is the barrier to changing job type.

Immobility Is Either Geographical or Occupational

  1. Geographical immobility
    1. Housing costs and family ties stop workers moving to where the jobs are.
  2. Occupational immobility
    1. A lack of transferable skills stops workers switching industries.
Example
  • A laid-off worker in one region may not afford to move south for work.
  • A redundant miner may lack the skills for a very different job.

Targeted Policy Can Reduce Immobility

  1. Training tackles occupational immobility by building new skills.
  2. Relocation subsidies and housing policy ease geographical immobility.
  3. On balance, immobility wastes resources, but targeted policy can reduce it.

Name the Imperfection, Then Match It to the Right Analysis

Exam technique
  • Name the imperfection: imperfect or asymmetric information, monopoly power, or factor immobility.
  • For monopoly, show the higher price and lower output, then weigh the static loss against economies of scale and innovation.
  • For immobility, say whether it is geographical or occupational and match the policy.
Common Mistake
  • Do not confuse asymmetric information, where one side knows more, with both sides simply being poorly informed.
  • Do not assume monopoly is always harmful; consider economies of scale and innovation.
  • Do not confuse geographical with occupational immobility.
Self review
  • Distinguish imperfect from asymmetric information.
  • Why does monopoly power cause a welfare loss?
  • Why is monopoly not always harmful?
  • Distinguish geographical from occupational immobility.
  • Why does factor immobility lead to market failure?
  • Distinguish adverse selection from moral hazard, with an example of each.
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1.8.6 Market imperfections Revision Guide

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