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Asymmetric Information: Quality Uncertainty

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Question:

Discuss about the Asymmetric Information for Quality Uncertainty.

 

Answer:

The Actual Problem

The marketplace has goods of different quality. There are those products of high quality while others are of poor quality. Usually, the owners or the sellers of commodities have more information concerning the quality of goods they possess than the potential buyers. The potential purchasers are also aware that the vendors understand more about the quality of the product than they do. This information asymmetry results in the problem of quality uncertainty that significantly impedes market equilibrium and hence the market failure.

The article makes use of used cars to demonstrate how the asymmetric information causes market failure. Since many critical mechanical parts and other components are concealed from the view and not easily reachable for scrutiny, it becomes difficult for the potential buyer of a used car to establish quality until after the acquisition. Thus, the purchaser’s best presumption is that the car is of average quality and will be prepared to pay the price of an average quality car. This situation indicates that the seller of never-abused, watchfully preserved and excellent used car will not find a sufficiently high price to make the selling of his or her car worthwhile (Akerlof, 1970). Such owners will withdraw their cars from the market thus reducing the average quality of automobiles in the marketplace making the purchasers to alter downward their outlook for any used vehicle. As a result, market failure takes place since there are sellers of high-quality vehicles who value their cars most in that they cannot give them out at a lower price. Both the owners and the buyers could benefit from the trade, but, regrettably, the purchasers’ lack of information hinders this reciprocally beneficial trade from happening.

Asymmetric Information

Asymmetric Information refers to a scenario where one party to market dealing has more material information compared to the other party (Arnold, 2013). This situation often manifest when the seller of a service or good possesses greater knowledge than the consumer. However, it is also possible that the consumer may have more information than the owner of a product. Therefore, asymmetric information exists due to information failure in some business or economic transactions.

Several market transactions exist that avail a favorable environment for the existence of asymmetric information in the society. As a result, it becomes difficult for one to eliminate asymmetric information completely. For instance, the adverse selection that is often encountered in health insurance market is a result of information failure. The purchaser of health insurance cover comprehends more about his or her health than the insurance firms. Those individuals with concealed severe health issues have more incentive to take a medical insurance cover (Case, Fair, & Oster, 2014). By doing so, they pass the burden to the insurance companies who are unable to determine the condition of their health precisely due to information failure.

Moreover, the adverse selection resulting from information failure is also present in credit markets. The information uncertainty makes it difficult for the lending institutions to discern between the bad and good credit risks. Since it is only the borrower who knows whether or not he or she will repay the debt, the borrowers always take this advantage to rob the credit granting institutions.

 

The Costs of Dishonesty

The costs of dishonesty are those expenses that result from the misrepresentation of information in a market transaction either by the seller or the consumer. The consequence of such behavior does not only affect the parties to the economic transaction but the entire society (McTaggart, Findlay, & Parkin, 2015). One of the costs of dishonesty in a transaction is that those legitimate businesses are eliminated from the market by dishonest dealings. There could be potential consumers of high-quality commodities and potential sellers of such products in the market. However, the presence of vendors who wish to sell a product of poor quality as a product of high quality distorts the expectation of buyers concerning goods in the market and therefore reduces their willingness to pay a high price for even good products. The owners of high-quality goods will withdraw them from the market and marketplace becomes dominated by products of poor quality (Akerlof, 1970). This situation demonstrates market failure.

A higher price is also another cost of dishonesty in a transaction. For example, the unhealthy individuals have higher tendencies of taking health insurance cover thus increasing the proportion of unhealthy persons in the pool of insured people. Since the unhealthy individuals often lie about their health conditions, the prices of the insurance policies reflect the overheads of sicker than the average consumers. In a nutshell, the prices of the policies will be higher to the extent that the healthy ones are discouraged from purchasing the insurance and even others drop the health cover because of their low risk of illness. This situation will increase the number of unhealthy individuals in the community as those who opt out the health insurance are likely to have substandard care when they fall sick. Therefore, it reaches a point where most individuals who take health cover are unhealthy. The insurance will now become exceedingly expensive, and in the extreme, the insurance enterprises may discontinue selling the insurance.

Furthermore, the entire economy is affected adversely by dishonesty in market transactions. For example, the inability to distinguish between the low and high-risk borrowers makes the lending institutions to hike the interest rates (Arnold, 2013). The interest rates are also driven up by the high demand for credit from low-quality borrowers. Therefore, the high costs of borrowing discourage potential high-quality borrowers a scenario that may reduce investments and consumption in the economy.

Role of Insurance

Uncertainty about the quality of the products purchased is a major issue in a market characterized by information failure. The purchasers often have concerns that the asset may cause them more money after the acquisition. However, in the presence of institutions that counteract the impact of quality uncertainty, then the adverse effects of information failure for consumer durables can be minimized. For example, the guarantees make the seller incur the expenses of repairing the purchased good for a specified period and thus eliminating the issue of quality uncertainty from the consumer. 

 

Bibliography

Akerlof, G. A. (1970). Critically Review the paper entitled The Market for "Lemons": Quality Uncertainty and the Market Mechanism . The Quarterly Journal of Economics , 488-500.

Arnold, R. A. (2013). Economics. Mason, Ohio: South-Western.

Case, K. E., Fair, R. C., & Oster, S. M. (2014). Principles of economics. Harlow, England: Pearson.

McTaggart, D., Findlay, C. C., & Parkin, M. (2015). Economics. Frenchs Forest, N.S.W: Pearson.

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