Question

Explain how the presence of asymmetric information can adversely affect the functioning of a market. 70marks essay exam question answer please. this will be on my exam so would be greatly appreciated. Typed only please or legible writing.

Answer 1

In most, if not all, markets, asymmetric data is inherent. A patient admitted to a hospital is likely to have less knowledge about illness and treatment options than the doctor does to take a basic example. Markets compensate for this by developing relationships between agencies where both parties are motivated to achieve a successful outcome. In the case of the clinic, the doctor has an obligation to diagnose appropriately and correctly administer medications, or else he may be sued for malpractice or his reputation may have suffered.

The insurance company may increase all premiums to offset the risk of uncertainty in order to compensate for a lack of information. This means that the most risky individuals (who allegedly have the highest value of insurance) are effectively pricing out some of the less risky individuals Adverse selection theoretically leads to a sub-optimal market even when both parties deal rationally in an exchange. Once recognized, this suboptimality provides an incentive for entrepreneurs to take risks and encourage a more successful outcome.

In financial markets such as borrowing and lending, asymmetric data is an issue. The borrower has much better information about his financial state in these markets than the lender. The creditor has trouble knowing if the default is likely to be the borrower. To some degree, by looking at past credit history and evidence of stable income, the lender can try to overcome this. It gives only limited information, though. The consequence is that higher rates will be charged to borrowers to offset the risk. If there was perfect information, this risk premium would not have to be paid by banks.

Some economists argue that the internet has helped reduce asymmetric data incidence. While visiting hotels and restaurants, for instance, visitors should look at online reviews to get a better idea of what to expect. Good reviews are built on selling second-hand products via market places like Ebay. There is therefore an incentive to sell only correctly priced products.