Information Gaps
Economics: Edexcel A A Level, topic 2.1.6
Information Needed for Decision-Making
Purchases are based on a belief that a particular good or service will provide satisfaction. These beliefs are based on information. So, information is very important for purchase decision-making.
What is asymmetric information?
- A situation of asymmetric information happens when both parties in a transaction have an unequal amount of information.
- Asymmetric information can cause a decline in prices or quantity of products sold.
The 'Lemons' problem
- Consider Marvin, who is buying a used car from a dealership.
- The car could either be a 'lemon', which is a defective vehicle, or a high quality vehicle. Because of asymmetric information, Marvin does not know which the car is.
- This is called a misallocation of resources.
- This limits his ability to make a rational choice and pay the appropriate price for the car.
Implications of Imperfect Information
Imperfect information can discourage buyers and sellers from participating in the market.
Thin and thick markets
- If buyers and sellers are discouraged from participating in the market, there will be fewer active in the market.
- This is a thin market.
- If there are many buyers and sellers, it's called a thick market.
Price signalling
- Buyers with imperfect information often think that price signals product quality.
- E.g A restaurant selling expensive food is often assumed to be of better quality than a cheaper alternative, like McDonalds.
- When buyers use market price to make assumptions about quality, markets can struggle to reach an equilibrium price and quantity.
Merit and Demerit Goods - Imperfect Information
Imperfect information is when buyers and sellers have unequal information. It can lead to the over and under consumption of goods in the free market.
Merit goods
- Consumers take into account only the private benefit.
- If they had perfect information, they might realise the additional benefits a merit good can bring.
- E.g they may realise how beneficial education is.
Demerit goods
- Consumers only realise the private gain.
- If they had perfect information, they might realise the negative effects consumption of the good can bring.
- E.g consumers may not realise the effect smoking can have due to imperfect information.
Test yourself on Information Gaps
What is asymmetric information?
Which industry is likely to have the biggest problem with information asymmetry?
Under which condition do buyers often think price signals product quality?
Which of the following is an example of a potentially under-consumed good in the free market due to imperfect information?
Which of the following goods may be over consumed in a free market due to imperfect information?