Role of Asymmetric Information in Market Function - Essay Example

?Using examples, explain the implications of asymmetric information for the function of markets at both the microeconomic and macroeconomic levels. Also discuss to what extent public policy can help to rectify market failure in such situations. Introduction The situation where the market produces more or less than the ideal or the optimal amount of a particular good, it is regarded as the market failure in terms of economics There are several factors that results in the market failure like externalities and monopoly power, and asymmetric information. In an analysis of the competitive market structure it is always assumed that the buyers and the sellers have perfect knowledge about the market. But in reality this does not happens. When the available information about any product is more with someone than the others then the arisen situation is of market failure and the phenomenon is termed as “asymmetric information” (Chauhan, n. d, p. 253). The information about the product is an important factor and if the quality of the goods could be judged about whether it being excellent or inferior then the price would have adjusted according to the quality differences. (Narayanan, 2004; Market Failure, n.d) Asymmetry and Market failure and the need of the government intervention A. Market failure and the used car market The situation of information asymmetry leading to market failure is best understood by the example of used cars. In a transaction of a used car, a seller would always know more than the buyer. Considering a case of a second hand Chevrolet Malibu which would cost $15,000 in an ‘average’ condition, if the condition of the car is ‘excellent’, that would cost $18,000 and if the condition of the car is ‘poor’, the car will be priced at $12,000. In this situation if the buyer is not perfectly aware of the condition and the quality of the car, he would be willing to pay the ‘average’ price which is $15000. The seller who has the information about the car’s quality knows that the car is in ‘excellent’ condition then he would not be ready to sell the car at $15000, which will lead to a situation where only ‘average’ or ‘poor’ quality cars will be supplied in the market. The buyer having the knowledge of market without any excellent car will be ready to pay not more than $13500 that is the average price of the cars, which are either in average or poor condition. This in turn will prevent the average car owners from offering their car at such a low price. So at the end the market forces will adjust itself to equilibrium for the poor cars at the selling price of $12000. This is an example of market failure where the market for the excellent and average cars does not exist due to the asymmetry of information. This is a situation of quality uncertainties where the high quality goods are driven out by the low quality goods. (Chauhan, n. d, pp. 224-225) This is explained with the help of a diagram: PH SH P E P’ E’ DH DH’ DH” 0 Q’ Q Figure 1 (a) PL p’ e' SL p e DL’ DL 0 q q’ Figure 1(b) Source: Chauhan, n. d, pp. 224-225 In the diagram Figure 1 (a) DH represents the demand for high quality goods, SH, the supply for high quality goods. They intersect at the point E where the quantity OQ must be demanded and it must be supplied at OP price. Due to the asymmetry of information, the same amount OQ is demanded at a lower price E”. As the buyers are uncertain about the quality of the product they treat the high quality good as the low quality good and hence the demand curve shifts downwards to DH’. At this lower price some of the seller refuses to sell the product which causes the supply to fall from OQ to OQ’. Hence the new equilibrium is at E’, where the DH’ intersects S H. The OQ amount of high quality goods is sold at a price OP’.As there exists quality uncertainty the demand curve is expected to further slide down to DH” which does not intersect with the supply curve SH at all. This shows how the market for high quality goods fails. In the figure 1(b), DL is the demand curve for low quality product and SL is the supply curve for the low quality product, which intersects at e making it the equilibrium point, where Oq amount of low quality good is transacted at Op price. The market failure leads to an upward shift in the demand curve from DL to DL’. It is evident from the figure that the sales of the low quality goods rises, which has been revealed by the increase from Oq at price Op to Oq’ at a higher price Op’. (Chauhan, n. d, pp. 224-225) Impact at the micro economic level Thus it becomes clear from the diagrammatic presentation that how the uncertainty in the market about the quality of the product due to asymmetry of information leads to the failure of the market. In the micro economic level the event has an adverse effect on the market where the superior quality goods are driven out and makes way for the inferior quality goods. The quality uncertainty as a result of the asymmetric information leads to the adverse selection where the goods of the different quality are sold at the same price. This is bad for the consumers at the micro level as they pay more for the inferior goods; hence there is a loss in their consumer surplus. The consumer surplus is a measure that estimates the benefits of the buyers that they receive by getting involved in the market. The loss in the consumer surplus implies a loss in the social welfare. The single price also affects the sellers adversely as sometimes they have to sell a superior quality product at a lower price implying a loss in the producer’s surplus as well. Either way the society is adversely affected where there is no availability of the excellent quality used car in the market, forcing the consumers to buy the inferior quality cars. The loss in the consumer surplus is shown with the help of the following diagram: Price E Du (Uninformed Demand) S PU F B PI A D1 (Informed Demand) 0 Demand Y1 Yu Source: Week3 Market Failure Due to information Asymmetry adverse selection and signaling, n. d In the above figure the vertical axis represents the Price and the horizontal axis represents the demand. Du is the demand is the demand schedule when the consumers have perfect information and DI is the demand schedule when the consumers have perfect information about the situation. S is the supply schedule. Provided the consumers had adequate information about the quality of the good they are eager to buy, the amount bought would had been YI, as the consumers are not adequately informed about the good they end up buying Yu. Hence there is a loss in the consumer surplus is: APIE – (OPUBYU – OECYu) = APIE – (PUEF – FBC) = APIPUF + FBC and the gain in the producer’s surplus from the over-consumption of the good is PUBAPI. Hence the net loss to the society is: APIPUF + (AFB + ABC) – (APIPUF + AFB) = ABC. (Week 3 market Failure Due to Information Asymmetry Adverse Selection and Signaling, n. d) Impact at the macroeconomic level The secondary market where the second hand goods are sold has a significant effect on the overall economy. The consumer shifts their preferences between the new markets and the second hand markets according to their modification in the income, which results in adequate elasticity of substitution of goods between the new markets and the second hand markets making the market interdependent. Hence a shock or disequilibrium in any of the market has an impact on the other in context to its price, demand and supply. There is an existence of gap between the demand and supply in both the markets, which results in an opposite effect due to the slow adjustment in the second hand market. A shock in the second hand market affects the level of price of the new car market of the whole economy. The disequilibrium in one market creates a momentary hindrance in the price movement on the same direction as in the second hand market. In this case where the asymmetry of information leads to the market failure in the secondary market, this also affects the new car market of the economy. As a result of the existence of the single price in the market at which the excellent conditions car owners are not ready to sell their car, they retain it back. As the owners already posses a car they show no interest in taking a new car hence the demand for the new car falls in the market. Owing to the excess supply, the price level of the cars falls in the new market. (Prado, 2010, p. 1) Public policy In the used car market when the market fails owing to the asymmetry in the information, there arises the need of public intervention. There are certain reforms that have to be initiated in the used car markets to prevent the market failure. The law should be enacted in such a way that forces the used car market dealers to provide a statutory warranty for used cars to the customers, which should be based upon the age and the mileage of the vehicles. This would make the customer believe that the quality of the car sold by the dealer is good and hence they will be ready to accept the price at which the dealers are ready to offer. If the customer meets some problem during the period of the statutory warranty the dealer will have to fix up the problem, unable to do so the dealer must replace the car or refund the consumer. The statutory warranty period has to be for a sufficient period, which would ensure by that time the consumer gets to know the quality of the product. It is also suggested that a warranty period be as long as the loan period. The state has to ensure that the dealers inspect the used cars on the safety issues and the dealers should provide the durability and a certification to its customers where the satisfactory and adequate condition of the car has been ensured. State has to have regulation and control over the certificate issuing case, which should ensure that no false certification is done. The State backing will bring confidence in the customer to believe in the dealers. The State can help by enacting a federal automotive information-reporting act that ensures the availability of useful information about the present and previous auto sales. This would play an important role in identifying the existence of information about the discrimination if any in auto lending and sales and the accessibility of credit at fair rates and also other relevant information. (Fueling fair practices, n. d, pp.16-24) B. Market failure and the Credit market Imperfect information or asymmetric information also causes failure in the financial credit market. Taking the example of US during the period 2000 to 2007 when it was going through a financial innovation, which led to exceptional increase in the availability of loans with low interest rates for low-income American households. The banks, which were responsible for issuing the sub- prime loans to the households with low credit, they in return were able to sell them to the Wall Street investments banks. The investment banks were then working on repackaging the individual home mortgages with similar loans into asset-backed securities. This was transformed into a bond, which could be sold to the investors. The interest payments made to the investors would grow over the lifetime. The investment banks took the aid of the credit rating agencies. The credit rating agencies declared the asset backed securities of the investment grade and gave those AAA ratings. This initiated the institutional investors to buy these bonds from the investment banks. The sponsors who purchased the bonds were guaranteed by the AAA ratings that the investment was safe. The investors who bought these bonds were financial institutes such as state pension funds, the hedge funds, the money market funds, the sovereign wealth funds, and other institute like this. These institutes often used the money of the taxpayers for buying the bonds from the big investment banks like Morgan Stanley, Goldman Sachs and Bear Stearns at the Wall Street. The banks assured the investors about the quality of the bank. The condition was all the more exaggerated by the AAA ratings of the credit rating agencies, which made the investor believe that at the time of necessity they can acquire the money back by selling them off in the market. Hence the information here available to the investors was wrong. There was an asymmetry of the information in the financial market in US about the loans. The banks that bought the low-income American mortgages knew that the bonds were of poor quality. With a better information in the financial market, the bond would had found fewer investors and the availability of credit in the market would had been less. This would had prevented the availability of subprime loans in the economy which in turn would had prevented the Americans from buying houses who could not afford it. If the wrong rating provided by the credit rating agencies were realized then the financial institutions would not had bought the bonds. (Welker, 2011) Impact at the microeconomic level On the microeconomic level, the excess supply of the bonds in the financial market made the Wall Street banks sell the bonds. This caused an excess supply in the bond market. It was also informed that due to the excess supply of the bonds in the market. This caused the rise of the parallel economy where they betting against the bonds leading to credit default swaps. The Wall Street banks were misguided by the asymmetric information and hence when they were selling the bonds back to the investor they were perfectly aware of the poor quality of the bonds. (Welker, 2011) Impact at the macroeconomic level On the macroeconomic level the subprime crisis that mainly emerged due to the asymmetry of information in the credit market had an adverse effect on the whole economy and the world economy as a whole. The subprime loan crisis that emerged in US quickly spread all over the world as investors started pulling the capitals from the countries, even from those places where there were very low risks. The financial crisis caused due to the asymmetric information provided by the credit rating agency caused the investors to switch on their investment preferences from asset holding to property holding which in the course affected the real sector. The lower interest rates ensured the availability of the credit in the market and the house prices were driven high. The changed perception on expected returns on the assets due to the share slump made the investors prefer holding of house against holding of assets. This switched preferences resulted in the price rise in the housing sector and the price escalated due to the additional speculative demand. The price rise gave rise to the formation of the housing price bubbles and the resulted burst of the bubble resulted in the real sector failure and the in the process affected the global economy. (Bursting of the US housing bubble, n. d) Policy Implication The credit rating agencies should be under severe regulations, which provided the wrong information. The State should mandate it for the financial institute that they should not get the rating from their choice of rating agencies, instead the rating would be done by the agencies fixed by the State which would include member from the State financial Department. The State has to ensure strict supervision and regulations of the financial firms; a committee has to be formed which will help in identifying the building up of systematic risks. Every possibility has to be addressed which can create a threat to the financial stability of the economy. There must be stronger capital standards and prudential benchmarks for all the financial companies. The hedge funds and the private pools of resources should be registered. There must be a presence of ample supervision on the financial institutions and the financial markets. There must be enough regulation in the security market and an inclusive directive for all the over the counter derivatives. The payment, clearing and the settlement system must be supervised robustly. The consumers and those who invest must be protected from the financial exploitation. State should regularize the consumers from unjust, misleading and abusive practices of the financial institutions by imposing stronger regulations, which would improve the transparency of the institute. (Nanto, 2009, pp.6-10) Conclusion Though the Asymmetric information calls for the government intervention in some cases there are certain things that complicates the issue. Firstly the private market can deal with the asymmetry of information sometimes by using its own method of signaling and screening. Then it is not always that the government possesses better information compared to the private market. Steps and measures have to be taken by both the government and the private firms to narrow the gap between the asymmetry and symmetry of the information. 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Fueling fair practices, (n. d), available at: http://www.aecf.org/~/media/PublicationFiles/fuelingfairpractices.pdf (accessed on May 25, 2011) Read More