Definition
Information gap: a situation where buyers or sellers lack the full information needed to make the welfare-maximising decision.
Symmetric information: buyers and sellers have equal access to the same facts, the condition a market needs to allocate efficiently.
Asymmetric information: one party to a transaction knows more than the other.
Imperfect information: people lack the full picture, so their decisions do not reflect the true costs and benefits.
- An efficient market assumes symmetric information, so price signals reflect the true costs and benefits of a good.
- Asymmetric information breaks this because the better-informed side can act on knowledge the other party lacks.
- Imperfect information on either side means choices no longer track the true value of a good.
Example
- A used-car seller who knows faults the buyer cannot see holds asymmetric information, the classic market for lemons.
- A borrower knows their own risk of default better than the lender, another case of asymmetric information.
- Smokers underestimate the long-term harm of cigarettes, a demerit good; this imperfect information leads to over-consumption.
Misallocation of Resources
Definition
Merit good: a good under-consumed because people undervalue its private benefits, such as education or health checks.
Demerit good: a good over-consumed because people underestimate its private harm, such as cigarettes or sugary drinks.
- With too little information, consumers under-consume merit goods and over-consume demerit goods.
- With asymmetric information, the better-informed side can exploit the other, for example by overcharging or selling poor quality.
- Either way the market outcome drifts from the social optimum, so resources are misallocated and welfare falls.
Case study
- UK banks mis-sold payment protection insurance (PPI) to customers who did not understand or need it.
- The seller's information advantage (asymmetric information) let it exploit the buyer, a clear market failure.
- The FCA later forced billions in compensation, showing the scale of the misallocation.
Closing the Gap
- The larger the information gap, the larger the misallocation of resources.
- Labelling, regulation and advice can narrow the gap and improve decisions.
Exam technique
- State whether the problem is symmetric, imperfect or asymmetric information.
- Link the gap to under- or over-consumption, then to the resulting welfare loss.
Common Mistake
- Do not confuse asymmetric information with both sides simply having little information.
- Asymmetric information means one party specifically knows more than the other.
Self review
- What is symmetric information?
- What is asymmetric information?
- How does imperfect information lead to a misallocation of resources?
- Give an example of asymmetric information.
