Question

2. a) Describe the three methods for equalizing information in order to reduce information asymmetries. List an example for each. b) List two ways an uninformed party can restrict the ability of informed party to take advantage of hidden information. Z c) Can firms profitably price discriminate if there are information asymmetries? Explain.

Answer 1

2 a) The 3 methods to reduce information asymmetries are;

1. Guarantees & Warranties

These benefits offer a protection to consumers against faulty products. It offers them the security that a particular product is of superior quality and in case of any defects, the option of return/replacement to the seller is available for a given period of time. This feature is also useful in negotiating the prices as well.

Example: 3 months guarantee for used electronic appliances. This can improve the consumer confidence.

2. Taxes & Subsidies

Government intervention through policies is very common in case of market imperfection. The government complete the market or strike a balance between the gainers and losers through imposition of taxes and subsidies respectively.

Example: In the healthcare market The doctor (principle) stands to benefit the most due to asymmetric information by them thereby controlling the health care labour market. They can become better off by taking additional payments from the patients (agents). The government complete the market or strike a balance between the gainers and losers or the market imperfections. Normally, this is executed by imposing higher taxes on the doctor and subsidies to receivers of the healthcare services.

3. Industrial Standards

Industries should set some pre-conditions to be met for providing the goods and services. This ensures offering high-quality products and services in the market.

Example: A person with good health conditions is less likely to opt for life insurance as compared to someone who does not have optimum health conditions. A person can do immoral behaviour prior to the transaction due to the asymmetric information problem. For compensating on the unavailable information and to offset the risk of uncertainty, the health insurance company is empowered to increase all their premiums. It means the riskiest people price out the less risky customers. It’s essential to provide complete and true information to patients and insurance company.

b) Moral Hazards occurs when one party with extra information has more motivation or is more likely to behave inappropriately to benefit from a transaction. Or we can define it as one party take advantage of the hidden information/asymmetrical information. We can restrict this through

1) Build in incentives. To avoid moral hazard in insurance and workplaces, the firm should design a contract to give the other party (employee or insurance buyer) an incentive. Consider the case of insurance. Usually the insurance buyer have to pay the first £50 of an insurance claim. Insurance firms also make the process of getting money difficult. This means that you become more reluctant to make claims and so will try to avoid having your bike stolen in the first place.

2) Performance related pay. To avoid moral hazard in the labour market, there can be some form of performance evaluation and no guarantee of a job for life. For example the piece rate pay system.

3) Penalise bad behaviour. The government could bail out banks, but penalise those responsible for making the reckless decisions.

c) Price discrimination is a microeconomic pricing strategy where identical or largely similar goods or services are transacted at different prices by the same provider in different markets. Firms use consumer profiling to know the consumers’ willingness to pay and the information asymmetries between the consumer and the firm influence pricing behaviour. Information asymmetries and the presence of consumers with heterogeneous search costs lead to quicker upward pricing than downward adjustment. When there is information asymmetries between the consumer and the firm – namely, when the consumer cannot infer or know the current cost state with certainty, she will be charged the expected price of a more competitive firm which will make the firm more profitable than without information asymmetry.