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Market Failure: Asymmetric information and abuse of monoploy power – Topics:
ASYMMETRIC INFORMATION AND ABUSE OF MONOPLOY POWER
Imperfect information results in market failure
One of the conditions for perfect competitive markets is that all firms and all consumers have perfect knowledge regarding the product, price, resources and methods of production. However, markets in the real world are full of examples where consumers, suppliers and the owners of resources have to make decisions where at least some information is missing.
Asymmetric information is sometimes referred to as information failure, is present whenever one party to an economic transaction possesses greater material knowledge than the other party. Almost all economic transactions involve information asymmetries.
Asymmetric information explained
Sellers have more information than buyers
A market is a place (physical or virtual – e.g., Amazon.com) where groups of buyers and sellers meet to exchange goods and services for money. And where buyers determine the demand and sellers determine the supply, together with the means whereby they exchange their goods or services is called the market.
Information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other; i.e., the buyer and seller are not sharing all the information. This creates an imbalance of power in transactions, which can sometimes cause the transactions to go awry, a kind of market failure in the worst case. If one party has more information than the other they are in a position to gain an advantage. In most instances, the seller will have more information than the buyer.
Selling a used car is an easy example to understand. The used car salesman will know whether or not there are faults with any particular car, and where these faults lie. An unscrupulous car salesman may choose not to inform the potential customer of this fact. Without this knowledge the customer will have placed a greater value on the benefit he or she would gain from purchasing the car, than if he or she had perfect knowledge of the good. Our used car consumer is paying a price which is higher than she would have paid had she had all of the available information. Thus, asymmetric information leads to the failure of the used car market.
the market for used cars
How the market fails
Government responses to correct for asymmetric information leading to market failure
To ensure quality and safety standards for goods and services, governments can legislate. The goods and services being sold by firms must meet certain safety standards. These types of regulations can be found in industries such as: building and construction, food and beverage, health services and pharmaceuticals, etc.
Legislating, monitoring and enforcing such standards is often a bureaucratic and time consuming process, and can impede economic activity. For example, new medications must undergo rigorous and independent research to certify that they are both efficacious and safe. These certification procedures are lengthy and expensive, with some drugs taking up to ten years to be approved at a cost of upwards of a billion dollars.
There are very large opportunity costs in such regulation. For example, in the food service industry there are thousands of restaurants and commercial kitchens in any large city. All of these are regulated and monitored at a large cost to the tax payer.
Many governments around the world also have consumer protection laws. If a purchased good is not up to standard or fit for purpose, it can be returned to the seller for a replacement or reimbursement. Further, through consumer protection laws, consumers likely have the ability to sue manufacturers and service providers. For example, if a pharmaceutical manufacturer does not provide relevant information on the side effects of its medicines, consumers can sue for damages.
Providing information to consumers
Governments can make product information available to consumers and/or they can require that producers make the necessary information available, thus conferring a degree of protection for consumers making decisions about what to purchase and what not to purchase. An example here are the relatively new calorie “count laws” which are a type of law that require restaurant chains consisting of twenty or more locations nationwide to post food energy and nutritional information on the food served on menus, in a font equal to or larger than the size of the name of the item. Another good example are government prepared school league tables where schools are ranked on some measure of performance such as standardised tests and national examinations results. With this information parents can compare the performance of students at various schools in their communities and make choices accordingly.
There are difficulties in the government collecting and analysing such information, as well as disseminating and promoting such information so that consumers can make an informed decision. Again, there are very large opportunity costs in providing such information. Individual schools, tertiary institutions, and departments within education ministries all need to allocate significant time and expense in ensuring that such information is collected accurately and processed accordingly.
Another difficulty arises when it is practically impossible to eliminate the information asymmetries between a seller and a consumer. A doctor will have highly specialised and technical information about their patients that the patients themselves do not have. A doctor will selectively release information to a particular for their own gain, as this causes patients to demand more services than are necessary. Such a practice is termed “supplier-induced demand”; i.e. it is demand created by the supplier which would not have otherwise appeared had the client had the same information the supplier did.
Licensure means a restricted practice or a restriction on the use of an occupational title, requiring a license. A license created under a "practice act" requires a license before performing a certain activity, such as driving a car on public roads. A license created under a "title act" restricts the use of a given occupational title to licensees, but anyone can perform the activity itself under a less restricted title. For example, in Oregon, anyone can practice counselling, but only licensees can call themselves a "Licensed Professional Counsellors."
Licenses are usually justified to regulate an activity whose incompetent execution would be threat to the public, such as surgery. For some occupations and professions, licensing is often granted through a professional body or a licensing board composed of practitioners who oversee the applications for licenses. This often involves accredited training and examinations, but varies a great deal for different activities and in different countries. Practicing without a license may carry civil or criminal penalties or may be perfectly legal.
Occupational licensing is inherently a form of restraint of trade. This can cause conflict with laws forbidding monopolistic practices if the licensing body favours its own licensees in ways that do not clearly protect the public. For example, by limiting the number of taxi licenses available in New York City, taxi fares are very expensive, and taxis can be very hard to find on occasions. In the United States, state licensing boards have been successfully prosecuted by the Federal Trade Commission for monopolistic activities.
Buyers have more information than sellers
Insurance services is an example of asymmetric information where the buyer will often have more information than the seller. The labour market is another example.
Moral hazard is a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost. It arises when both the parties have incomplete information about each other.
In certain circumstances, asymmetric information may lead to adverse selection or moral hazard. Consider adverse selection in life insurance or fire insurance. Higher-risk insurance customers, such as smokers, the elderly or those living in dry environments, may be more likely to purchase insurance. Surgeons purchasing medical malpractice insurance may be less careful as a result, knowing that they will be covered by the insurer if they make an error. With some income being guaranteed, individuals taking out unemployment protection insurance may not worry so much about losing their jobs.
In each of the cases above, the individual consumers purchasing insurance have information about their future intentions that the insurance company cannot possibly have. In the free market, moral hazard results in the under provision of resources to supply insurance services to the market. Insurance companies will look to protect themselves from the higher costs associated with risky behaviours of the consumers of insurance.
What is moral hazard?
Responses to moral hazarD
Insurance companies can attempt to reduce the instances of risky behaviour by having their clients make a co-payment or an excess when a claim is approved. For example, the author’s excess on his car insurance is $300. If he makes a claim for $2000, this excess or co-payment is subtracted from the final settlement. The insurance company will pay the panel beaters $1700 and he will need to pay them $300. Some co-payments in the US health insurance market can be very high, and the individual insurance holder may be required to make co-payments of tens of thousands of dollars each year for costly treatments.
Co-payments are designed by insurance companies to ensure that customers buying insurance take some responsibility for risky behaviours. The higher the co-payment, the less risky the behaviour becomes. Not only does the cigarette smoker face increased health insurance premiums for their risky behaviour, the co-payments required for expensive cancer treatments (drugs, surgeries, hospital stays) internalises the costs of such treatment on the cigarette smoker.
Insurance companies will have a range of policies. High premiums typically have low co-payments. Less costly premiums will be associated with high co-payments when a claim is made. Low income earners typically choose the less expensive insurance premiums and are faced with the higher deductibles when a claim is made. Thus, low income earners are more likely to reduce their risky behaviours, and high income earners are less likely to reduce theirs.
In the financial industry, moral hazard is regulated to prevent the type of risky behaviour that led to the global financial crisis of 2008 and the following great recession. This regulation comes at both a cost to banks in terms of their reduced profitability, as well as to governments and taxpayers that fund the regulation, compliance and enforcement regimes in place today.
Problems with Health insurance
Solutions to adverse selection
To avoid adverse selection, firms need to try and identify different groups of people. This is why there are more expensive health insurance premiums, or higher co-payments, for people who smoke and obese people.
Insurance firms will charge different rates to consumers depending on factors, such as:
However, by trying to protect themselves from high risk individuals, insurance companies will charge very expensive premiums or design policies with excessive co-payments. In the worst cases, insurance companies will refuse to cover the elderly or those with pre-existing medical conditions. Thus, those most in need of health insurance are those less likely to be able to obtain or afford it.
Governments may choose to provide health care services at very subsidised or zero cost for the whole population, and this is financed by taxpayers (The UK, Canada, Germany, New Zealand and France are examples). Another policy response is to implement a social health insurance scheme that covers the entire population of a country. Here, the oldest and sickest are guaranteed cover, and the youngest and healthiest cannot choose to opt out.
It is generally argued that direct provision and social health insurance schemes and systems are generally more expensive. However, the counterpoint to this is the US healthcare system which is largely private and social health insurance schemes apply only to the elderly and those living in poverty. Healthcare expenditure in the US market is around two and a half times that of the OECD (a club of mostly rich countries) average; see Figure right.
Student focus question: Should government run our health insurance?
The financial crisis of 2008 was the result of a wide range of contributing factors. One significant factor leading up to the financial crisis was the existence of moral hazards in the economy. The epicentre of the 2008 financial crisis was the financial sector, particularly related to housing. Conditions preceding the financial crisis were such that lenders faced moral hazards when evaluating the outcomes of lending and collateralizing assets.
A moral hazard exists when a person or entity engages in risk-taking behaviour based on a set of expected outcomes where another person or entity bears the costs in the event of an unfavourable outcome. A simple example of a moral hazard is drivers relying on auto insurance. It is rational to assume that fully insured drivers take more risks compared to those without insurance because in the event of an accident, insured drivers only bear a small portion of the full cost of a collision.
One example of a moral hazard leading up to the 2008 financial crisis was financial institutions' expectations that regulating authorities would not allow them to fail due to the systemic risk that could spread to the rest of the economy. Financial institutions holding the loans that eventually contributed to the financial crisis were often some of the largest and most important banks to businesses and consumers. There was the expectation that if a confluence of negative factors led to a crisis, the owners and management of the financial institution would receive special protection or support from the government. There was the presumption that some banks were so vital to the economy, they were considered "too big to fail." Given this assumption, stakeholders in the financial institutions were faced with a set of outcomes where they would not likely bear the full costs of the risks they were taking at the time.
Another example of a moral hazard contributing to the 2008 financial crisis concerns the collateralisation of questionable assets. In the years leading up the crisis, it is commonly assumed lenders underwrote mortgages to borrowers using very relaxed credit standards – the so-called NINJA loans (No Income, No Job). Under normal circumstances, it is in the best interest of banks to lend money after thoughtful and rigorous analysis. However, given the liquidity provided by the collateralised debt market, lenders were able to relax their standards. Lenders made risky lending decisions under the assumption they would likely be able to avoid holding the debt through its entire maturity. Banks were offered the opportunity to offload a bad loan, bundled with good loans, in a secondary market through collateralized loans, thus passing on the risk of default to the buyer. Essentially, banks underwrote loans with the expectation that another party would likely bear the risk of default, creating a moral hazard and eventually contributing to the financial crisis of 2008.
Implicit government guarantees on bad loans also created a moral hazard for financial institutions, which ultimately contributed to the 2008 financial crisis. Quasi-government agencies such as Fannie Mae and Freddie Mac offered implicit support to lenders underwriting real estate loans. These assurances influenced lenders to make risky decisions as they expected the quasi-government institutions to bear the costs of an unfavorable outcome in the event of default.
Adverse selection refers to a situation where sellers have information that buyers do not, or vice versa, about some aspect of product quality. In the case of insurance, adverse selection is the tendency of those in dangerous jobs or high-risk lifestyles to get life insurance.
Adverse selection occurs because of information asymmetries and the difficulties in selecting customers.
Consequences of adverse selection
Adverse selection in health insurance
Suppose an insurance firm offered health insurance to the general public. It is likely to have the highest take up rate amongst unhealthy people. People who don’t exercise, people who smoke. They are the group most likely to need health care, therefore, it makes sense for them to take out insurance. Healthy people don’t see the point, if the price of health insurance is determined by the average unhealthy person.
If insurance premiums are based on the needs of smokers, then the premiums will be high. Therefore, there is no incentive for healthy people to take out the insurance.
Adverse selection for buyers
It is also possible that the seller will have better information than buyers, and sellers only sell the product when it is favourable to them.
Solutions to moral hazard
monopoly power and market failure
Explain how monopoly power can create a welfare loss
A monopoly is a market in which one firm sells a good or service that has no close substitutes and in which a barrier to entry prevents competition from new firms.
Markets for local telephone service, gas, electricity, and water are examples of local monopoly. GlaxoSmithKline has a monopoly on AZT, a drug that is used to treat AIDS. DeBeers, a South African firm, controls 80 percent of the world’s production of raw diamonds – close to being a monopoly but not quite one.
Monopoly arises when there are
While it does have a close substitute for drinking – bottled spring water – it has no effective substitutes for doing the laundry, taking a shower, or washing a car.
The availability of close substitutes is not static. Technological change can create substitutes and weaken a monopoly. For example, the creation of courier services such as UPS and the development of the fax machine and e-mail provide close substitutes for the mail-carrying services provided by the U.S. Postal Service and have weakened its monopoly. Broadband fibre-optic phone lines and satellite dishes have weakened the monopoly of cable television companies.
The arrival of a new product can also create a monopoly. For example, the technologies of the information age have provided opportunities for Google and Microsoft to become near monopolies in their markets.
Monopoly power refers to how much control a firm has when setting the price it charges for the good or service it provides. A sole supplier of a good has complete monopoly power and is the entire industry for that good or service. A firm with monopoly power will determine the price it receives in the market by controlling how much of the good or service it supplies to the market. A reduction in output will increase prices. As prices rise producer revenues increase, as too does the profitability of the firm. In the market, the producer surplus increases and the consumer surplus decreases. At reduced output in the market and higher monopoly prices the increase in producer surplus is less than the loss of consumer surplus. Thus, the market power of a monopolist results in a loss of social welfare.
What is a monopoly?
Market Failure and monopolies
As can be seen in Figure 2 above, the efficient free market equilibrium achieves Pe and Qe, which is where MC = AR. At this point the social welfare is maximised (consumer + Producer surplus). The efficient and socially optimal equilibrium can only be achieved when firms do not have the power to affect the market supply and thus the price; and where there is no government intervention in the market.
To maximise revenues and profits, the monopolist firm decreases output to QM, and as a consequence the price in the market will increase from Pe to PM. Now the value placed on an additional unit of consumption is greater than the cost of resources to firms to produce it. Society has a loss of welfare on all output that is produced between QM and Qe. In the diagram above the loss of welfare is represented by the shaded triangles a (loss of consumer surplus) and b (loss of producer surplus), as output is lost and price increases.
There is an inefficient under allocation of resources to the production of the good, and thus, there is loss of welfare and the market fails as a result of monopoly power.
Government responses to monopoly power
Government regulation usually applies to natural monopolies. A natural monopoly is when one firm has the ability to supply the entire market at lower prices than two or more firms. A natural monopoly faces downward-sloping average cost (AC) for the entire rage for which demand is applicable. The reason for its downward sloping AC curve is usually the initial investment in the infrastructure of the firm is large, but once in place, the marginal cost (MC) of production is low, for example hydro power. This high establishment cost is a strong barrier to entry and a natural monopoly could undercut any would be competitor so they could not survive. Natural monopolies often involve some kind of network, for example water, phone, and rail.
Governments can implement various price regulations; e.g., marginal cost pricing, where price equals marginal cost which is allocatively efficient and is what could be produced if the natural monopoly was a prefect competitor. The government could regulate to where rice equals average cost (P = AC), and the monopoly only makes normal profits. Both policies result in lower prices and greater output than would otherwise be the case.
Trade liberalisation is the removal or reduction of restrictions or barriers on the free exchange of goods between nations. This includes the removal or reduction of tariff obstacles, such as duties and surcharges, and nontariff obstacles, such as licensing rules, quotas and other requirements.
In a closed economy, a domestic monopoly will have enough market power influence price. A monopoly firm can increases prices directly or indirectly by limiting the supply of a good or service – a decrease in demand results in an increase in price. High levels of profitability can often be achieved in an unregulated domestic monopoly, and because of this, these types of firms can be X-inefficient – average cost is greater than the minimum that would otherwise be achieved in a competitive environment. Whereas, in a country open to international trade, such domestic monopolies will face competition from (often highly efficient) international competitors. For domestic industries to survive and be profitable, product quality and efficiencies must be made to reduce average cost in order to be price competitive with imported goods and services.
Monopolies and anti-competitive practices
Nationalisation is the process of transforming private assets into public assets by bringing them under the public ownership of a national government or state. A natural monopoly may be transferred to the government which then runs the firm in the best interests of society by increasing output and reducing prices (e.g., using marginal or average cost pricing).
A monopoly is characterised by the absence of competition, which can lead to high prices and inferior products and services. Governments attempt to prevent monopolies through the use of antitrust laws (e.g., the US) and competition laws (e.g., Europe). Mergers between firms that would result in considerable monopoly power may be vetoed by governments. Firms that are too dominant in a market may be broken up into separate firms which then compete against each other, or they may be forced to sell some business units.
Firms can be forced to cease anti-competitive practices. In 2001 – aeons ago in internet time – the European Commission sent a sternly worded missive to Microsoft. It accused the software maker of having illegally extended its dominance in operating systems for personal computers (PCs) into adjacent markets, for instance by tying Windows to programs that play music and videos. The legal action lasted more than a decade and took many turns, but Microsoft eventually had to unbundle its Windows monopoly from other software, in particular by giving consumers the choice of which web browser they want to use.
Currently, the commission presented Google, one of the brightest stars in the modern tech firmament, with a similar “statement of objections”, as the charge sheet in European Union (EU) antitrust cases is called. Google, it argues, has followed a strategy to “preserve and strengthen its dominance in internet search” by tying this service and some of its popular apps to Android, its mobile operating system, which powers around 80% of all new smartphones (see chart). As in the Microsoft case, Google may ultimately be forced to unbundle its package of software and services.
beer market monopoly power
Student focus question: Should governments intervene in the beer market?
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