32 Imperfect market information |

Imperfect market information

Define information failure. Incomplete or inaccurate data means consumers or producers make different decisions than if they had full information

How can information failure cause market failure? Perfect information enables rational decision making. Imperfect, inaccurate, incomplete, uncertain or misunderstood information means economic agents make different decisions than if they had full information.

What causes information failure? Imperfect information can be the result of

Misunderstanding the true costs or benefits of a product eg immunisation Uncertainty about costs and benefits eg should young workers buy into pension schemes

when economic conditions in 40 years’ time are uncertain? Complex information eg what is the best health care treatment? Inaccurate or misleading information eg some advertising ‘oversells’ benefits Addiction eg drug addicts may be unable to stop consumption of harmful substances Asymmetric information a party in a transaction has more information than another.

Give examples of asymmetric information. A garage can use its expert knowledge to persuade less informed consumers to pay for unnecessary work. A sick patient fails to reveal their illness to an insurance company.

How can asymmetric information lead to market failure? If buyers and sellers have different information one party has an incentive to exploit the other. Ignorance causes economic agents make different decisions than if they had full information.

Merit goods

What is a merit good? Products that have more private benefits than consumers recognise

Why are merit goods undervalued? The full private benefits of merit goods are undervalued if consumers take decisions based on inaccurate data ie because of information failure.

Why are merit goods a source of market failure? Inaccurate information means consumers underestimate a product’s private benefits. Given all the facts and figures they would buy more of the item. Information failure means merit goods are under consumed

Give examples of merit goods. Examples of merit goods include

Preventative health care eg inoculations Education and training eg higher education Sporting activities eg gym membership

Use a graph to show market failure through under consumption of a merit good

Consumers with inaccurate information make different decisions than if they had full data. Eg if potential students underestimate the increased future earning power of graduates when estimating private benefits, the demand curve for degree courses is D1.

The vertical distance between D1 and D2 is the amount by which marginal private benefits are underestimated. True marginal social benefit is given by D2.

The equilibrium level of output delivered by a free market, Q1, is allocatively inefficient. SMB = SMC at Q2. The market has under consumed by (Q2 – Q1).

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Explain the link between merit goods and positive externalities. Many merit goods with undervalued private benefits also produce positive externalities. For instance

Preventative health provision such inoculations also reduces absenteeism The Arts and museums also help create a sense of national identity and shared culture Sports participation also leads to improved health and team working skills

Why do governments encourage the consumption of merit goods? Under consumption of merit goods such as education causes market failure because:

Private benefits are undervalued and higher than consumers realise and Merit goods often generate positive externalities benefiting third parties

Demerit goods

What is a demerit good? Products that have less private benefits than consumers recognise

Why are demerit goods overvalued? The full private benefits of merit goods are overvalued if consumers take decisions based on inaccurate data ie because of information failure.

Why are demerit goods a source of market failure? Inaccurate information means consumers overestimate a product’s private benefits. Given all the facts and figures they would buy less of the item. Information failure means demerit goods are over consumed

Give examples of demerit goods. Examples of demerit goods include cigarette smoking, excessive alcohol consumption, illegal drugs and processed foods high in fat, salt and calories

Use a graph to show market failure through over consumption of demerit good

The demand curve D1 for cigarettes reveals consumer’s own of marginal private benefit. Information failure means consumers overestimate the benefits of smoking when calculating willingness to pay.

MSB is found by estimating and deducting from D1, overvalued private benefits.

The equilibrium output in a free market, Q1, is allocatively inefficient. SMB = SMC at Q2. The market has over consumed by (Q1-Q2).

Explain the link between demerit goods and negative externalities. Many merit goods also generate negative externalities. For instance

Smokers overlook the harmful impact of ‘passive smoking’ on non-smokers Excessive alcohol consumption can cause illness, absenteeism and antisocial behaviour Excessive consumption of unhealthy foods high in fat, salt and calories can create extra

health care costs and absenteeism from work

Why do governments discourage the consumption of merit goods? Over consumption of demerit goods such as cigarettes causes market failure because:

Private benefits are overvalued – the product is more harmful than consumers realise Demerit goods often generate significant negative externalities that harm third parties

Why are merit and demerit goods controversial? Some economists argue state and consumer estimates of private costs and benefits diverge because of differing value judgements rather than from information failure