Information failure

What you'll learn

• What information failure means and why it causes market failure.
• How asymmetric information and moral hazard affect markets.
• Why merit goods tend to be under-consumed or under-produced.
• Why demerit goods tend to be over-consumed or over-produced, and how to evaluate this.

The starting point: markets need good information

A market works through the price mechanism: prices send signals to consumers and producers about scarcity, value and profitability.

For a market to allocate resources efficiently, decision-makers need reasonably accurate information about:

• the quality of the good or service
• the future benefits and costs
• risks and side effects
• prices of alternatives
• effects on other people

Allocative efficiency occurs when society’s welfare is maximised because resources are used where they create the greatest net benefit. In marginal terms, this is where marginal social benefit equals marginal social cost: $MSB=MSC$.

A marginal benefit or cost means the extra benefit or cost from one more unit.

• Marginal private benefit (MPB): extra benefit to the individual consumer.
• Marginal private cost (MPC): extra cost to the producer or consumer making the decision.
• Marginal social benefit (MSB): extra benefit to society as a whole.
• Marginal social cost (MSC): extra cost to society as a whole.

What is information failure?

Information failure is a cause of market failure, which means the free market leads to a net welfare loss or an inefficient allocation of resources.

It can happen because:

• consumers do not know long-term health effects, such as the risks of vaping or high-sugar diets
• producers do not know future demand or environmental impacts
• firms deliberately make information hard to compare, such as complex mobile phone contracts
• the benefits of a good arrive much later, such as education or pension saving
• consumers are affected by behavioural biases, such as overconfidence or short-termism

Information failure does not always mean there is no information. Often, there is too much complicated information, or information is technically available but difficult to understand.

Market failure caused by information failure

The standard diagram shows that consumers or producers act on perceived benefits and costs, not the full or true benefits and costs. This can cause under-consumption of merit goods or over-consumption of demerit goods.

In the merit good diagram, consumers underestimate the true benefit. The perceived demand curve lies below the true benefit curve, so the market produces and consumes only $Q_m$, below the efficient quantity $Q^{\ast }$. The triangle shows a deadweight welfare loss, meaning potential welfare that society misses out on.

In the demerit good diagram, consumers overestimate the benefit or underestimate the harm. The perceived demand curve lies above the true benefit curve, so the market produces and consumes $Q_m$, above the efficient quantity $Q^{\ast }$. The welfare loss comes from units where the marginal cost to society exceeds the true marginal benefit.

Asymmetric information and moral hazard

Asymmetric information is common in markets where quality or risk is hard to observe.

Examples include:

• a used car seller knowing more about the car’s faults than the buyer
• a borrower knowing more about their repayment risk than a lender
• a patient relying on a doctor’s expert advice
• an insurance customer knowing more about their own behaviour than the insurer

A related idea is adverse selection, where one side cannot observe risk before the transaction. For example, people most likely to need expensive healthcare may be most likely to buy health insurance, pushing up premiums.

Moral hazard happens after the transaction. For example, if a phone is fully insured, the owner may be less careful with it because the insurer bears much of the cost of damage.

Merit goods

Merit goods often have long-term private benefits and positive effects on others. Examples include:

• education and training
• vaccinations
• dental check-ups
• public libraries and museums
• pension saving
• home insulation and energy efficiency improvements

The word “judges” matters. Merit goods involve a normative judgement, meaning a value-based view about what people ought to consume more of.

Consumption of merit goods

Consumers may under-consume merit goods because they underestimate future benefits. For example, a young person might undervalue the future earnings and wellbeing benefits of education because the costs are immediate, while the benefits arrive years later.

There may also be affordability issues. If low-income households cannot afford dental treatment or insulation, the market outcome may be below the socially desirable level even if they understand the benefits.

Production of merit goods

Merit goods can also be under-produced. Firms may not produce enough training, research and development, green technology or preventative healthcare because the private profit is lower than the wider social value.

For example, a firm may underinvest in worker training if trained workers can leave for another employer. Society benefits from a more skilled labour force, but the firm cannot capture all those benefits.

Evaluating merit goods

The case for encouraging merit goods is strongest when information failure is large, benefits are long term, and there are wider social gains. Education can raise productivity, reduce unemployment and increase tax revenues. Vaccination can reduce pressure on the NHS and protect vulnerable groups.

Governments can respond through information campaigns, subsidies, direct provision, regulation or “nudges”. UK examples include state-funded education, NHS vaccination programmes and subsidies for some green energy improvements.

However, intervention has limits. It may be paternalistic, meaning the government overrides individual choices “for their own good”. It also has an opportunity cost: money spent subsidising one merit good cannot be spent elsewhere. Government failure is possible if schemes are poorly targeted, captured by producers, or based on weak evidence.

A balanced judgement is that merit goods justify intervention when the evidence of under-consumption is strong and the wider benefits are substantial. Direct provision may work best for essentials such as schooling, while information and subsidies may be better for choices like energy efficiency.

Demerit goods

Examples include:

• tobacco and some vaping products
• alcohol misuse
• gambling
• high-sugar drinks
• illegal drugs
• high-carbon goods where consumers ignore environmental harm

Again, this involves a normative judgement. Some people argue adults should be free to make informed choices, even if those choices are risky.

Consumption of demerit goods

Consumers may over-consume demerit goods because they underestimate health risks, addiction risks or financial harm. For example, gambling adverts may emphasise potential winnings while consumers underestimate the probability and long-term cost of losses.

Demerit goods often create wider costs too. Smoking can increase NHS costs and reduce workforce productivity. Alcohol misuse may create policing, healthcare and family-related costs.

Production of demerit goods

Demerit goods may be over-produced when firms respond to excessive demand or when producers do not face the full social cost of production. For example, fossil fuel production may be privately profitable while contributing to carbon emissions and climate change.

Firms may also have incentives to hide or minimise harmful information. This can worsen information failure if consumers rely on advertising rather than independent evidence.

Evaluating demerit goods

The case for reducing demerit goods is strongest when harms are severe, addictive, imposed on others, or difficult for consumers to understand. Policies include taxes, age restrictions, advertising bans, minimum pricing, plain packaging and public health information.

UK examples include tobacco duties, restrictions on cigarette packaging, the Soft Drinks Industry Levy, and minimum unit pricing for alcohol in Scotland.

But intervention is not automatically successful. Taxes on demerit goods can be regressive, taking a larger share of income from low-income households. If demand is price inelastic because of addiction, a tax may raise revenue but reduce consumption only slightly. Bans can create black markets. Regulation may also harm workers and firms in affected industries.

A strong evaluation should ask whether the policy changes behaviour, whether it targets the true information failure, and whether the benefits exceed the costs. For addictive goods with large external costs, tougher regulation may be justified. For goods where adults are well informed and harms are mainly private, lighter intervention may be more appropriate.

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