# Information failure

> CIE A-Level Economics · Unit 3: Government Microeconomic Intervention
> Source: https://www.owlsprep.com/study/cie-9708-u3-information-failure/

This sub-topic explains how incomplete or unequal information between market participants causes misallocation of resources and market failure. You will learn core types of information failure and how governments can respond.

**Prerequisites:** [Core concepts of market failure](https://www.owlsprep.com/study/cie-9708-u3-market-failure/)

## Learning objectives

- Define information failure and distinguish between symmetric and asymmetric information
- Identify the two key outcomes of asymmetric information: adverse selection and moral hazard
- Explain how information failure leads to over/under consumption of merit and demerit goods
- Evaluate government policies to correct information failure

## Definition and Key Types of Information Failure

**Information Failure** — A type of market failure that occurs when one or more participants in an economic transaction do not have full information required to make a welfare-maximising rational decision.

*Example:* A new smoker underestimating the long-term risk of lung disease from tobacco consumption.

Information failure can take three broad forms, depending on who lacks information:
1. Incomplete information: All parties to the transaction lack full information
2. Asymmetric information: One party has more information than the other
3. Misinformation: One or more parties receive actively incorrect information

**Worked example:** Identify the type of information failure in this scenario: A second-hand car seller knows the car has a hidden transmission fault that the potential buyer cannot detect.

1. First, recall the definition of asymmetric information: it occurs when one party to a transaction has more information than the other party.
2. In this scenario, the seller has private information about the car's fault that the buyer cannot access before purchase.
3. Therefore, this is a clear case of asymmetric information.

## Asymmetric Information: Adverse Selection and Moral Hazard

Asymmetric information is the most impactful form of information failure, and leads to two distinct market outcomes: adverse selection and moral hazard, differentiated by when the information gap impacts behavior.

**Adverse Selection** — A pre-transaction market outcome where asymmetric information causes low-quality goods or services to drive high-quality alternatives out of the market.

*Example:* The classic 'market for lemons' (low-quality second-hand cars).

**Moral Hazard** — A post-transaction change in behavior, where a party takes on more risk because the cost of that risk is borne by another, less informed party.

*Example:* A driver taking more risks after purchasing comprehensive car insurance.

**Worked example:** Is the following scenario adverse selection or moral hazard? A person takes out private health insurance, then starts skydiving regularly.

1. First, distinguish the two concepts: adverse selection occurs before a transaction is completed, while moral hazard occurs after the transaction when behavior changes.
2. In this case, the person changes their behavior to take more risk only after the insurance contract is finalized, and the insurance company cannot observe this change in behavior.
3. Therefore, this scenario describes moral hazard, not adverse selection.

## Information Failure and Merit/Demerit Goods

Information failure is the primary explanation for why merit goods are under-consumed and demerit goods are over-consumed in a free market. Consumers' lack of information about long-term costs and benefits leads them to make decisions that do not maximise their own welfare, resulting in market failure.

**Merit and Demerit Goods** — Merit goods are under-consumed because consumers underestimate their long-term private benefits; demerit goods are over-consumed because consumers underestimate their long-term private costs.

*Example:* Merit good = preventative healthcare; Demerit good = sugary processed drinks

**Worked example:** Explain how information failure causes over-consumption of demerit goods.

1. Information failure for demerit goods means consumers do not have full, accurate information about the long-term private costs of consumption.
2. For example, many young tobacco users underestimate the risk of addiction and long-term heart disease, so they value the short-term private benefit of smoking more than the actual total long-term private cost.
3. This leads consumers to demand a higher quantity of tobacco than they would if they had full information, resulting in over-consumption and a net welfare loss.

## Policies to Correct Information Failure

Governments use a range of policies that directly target the information gap, rather than just changing prices through taxes or subsidies. Common policies include mandatory product labeling, public information campaigns, mandatory disclosure laws, and outright bans for extreme cases of information failure.

**Worked example:** Evaluate mandatory graphic warning labels on cigarette packs as a policy to correct information failure.

1. The root information failure here is that consumers underestimate the long-term health risks of smoking. Warning labels directly provide correct information to consumers at the point of purchase.
2. This policy is low-cost for government, directly targets the cause of market failure, and can encourage existing smokers to quit and discourage new smokers from starting.
3. Limitations include that addicted smokers often ignore warning labels, and consumers become desensitized to the graphics over time. It also cannot address other factors like peer pressure or addiction that drive consumption.
4. Overall, it is an effective complementary policy, but unlikely to fully correct the market failure on its own.

## Common pitfalls

- **Wrong:** Confusing adverse selection and moral hazard
  - Why it fails: The two concepts are often mixed up because both are outcomes of asymmetric information, but they occur at different points in the transaction.
  - Correct: Always check timing: pre-transaction information gaps that select low quality products = adverse selection; post-transaction change in risky behavior = moral hazard
- **Wrong:** Assuming all information failure leads to market failure
  - Why it fails: Small information gaps that do not change consumer or producer decisions do not cause a misallocation of resources.
  - Correct: Only conclude market failure occurs if the information failure leads to output deviating from the socially optimal level, reducing total welfare.
- **Wrong:** Claiming information failure only affects consumers
  - Why it fails: Many students only discuss information failure from the consumer side, but producers can also lack information.
  - Correct: Information failure can affect producers too, for example when firms underestimate the future demand for new green technology, leading to under-investment.
- **Wrong:** Assuming government policies always fix information failure
  - Why it fails: Governments can also have incomplete information, and policies can be captured by industry lobbyists leading to government failure.
  - Correct: Always evaluate both the advantages and limitations of policies in essay questions for full marks, as CIE examiners expect balanced evaluation.

## Cheatsheet

| Concept | Key Definition | Example |
| --- | --- | --- |
| Information failure | Missing/unequal info leads to wrong decisions | Underestimating tobacco health risks |
| Asymmetric information | One party has more info than the other | Second-hand seller knows hidden fault |
| Adverse selection | Pre-transaction: low quality drives out high quality | Market for 'lemons' (bad second-hand cars) |
| Moral hazard | Post-transaction: risky behavior after contract | Risky driving after getting car insurance |
| Merit good | Underconsumed due to underestimated benefits | Preventative healthcare |
| Demerit good | Overconsumed due to underestimated costs | Tobacco |

## What's next

Information failure is a core form of market failure that underpins almost all government microeconomic intervention. Many policies designed to correct other market failures like externalities also address information gaps, so understanding this concept will help you analyze almost any intervention topic in the exam. Next, you will learn how governments use price-based policies like taxes and subsidies to correct information failure and other types of market failure, and how to evaluate the effectiveness of different interventions in different contexts. You can also deepen your understanding of merit goods and public goods to prepare for longer essay questions.

- [Taxes and Subsidies for Market Failure](https://www.owlsprep.com/study/cie-9708-u3-taxes-and-subsidies/)
- [Buffer Stocks](https://www.owlsprep.com/study/cie-9708-u3-buffer-stocks/)
- [Maximum and Minimum Prices](https://www.owlsprep.com/study/cie-9708-u3-maximum-and-minimum-prices/)

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