Information failure

What this lesson teaches

I can explain the causes of market failure: public goods, externalities and information failure.
Syllabus 8843, 2.2.2(b). Market Failure and its Causes: Markets may fail in terms of; non-provision of public goods due to non-rivalry and non- excludability; non-socially optimal levels of goods and services due to the presence of externalities and/or information failure

Make a guess

Young adults drink many sugary drinks because they underestimate the long-term health risk. What kind of market failure is this?

A negative externality, because too much sugar harms people's health.
Information failure, because buyers misjudge their own benefit.
No market failure, because adults choose freely what they drink.

Show the answer

Information failure, because buyers misjudge their own benefit.

The harm falls on the drinkers themselves. They overconsume because their perceived benefit is above the actual benefit.

When people misjudge the benefits or costs of a good, they buy the wrong amount.

Information failure happens when people lack the knowledge to judge the true benefits or costs of their choices.

Consumers may overestimate the benefit of a demerit good, such as sugary drinks, because they underestimate the long-term health harm. Their perceived MPB is above the actual MPB, so they overconsume.

Consumers may underestimate the benefit of a merit good, such as health screening, so they underconsume.

This is different from an externality: here, the harm or benefit falls on the buyer, who simply misjudges it.

Sort these

Sort each problem by the main source of market failure.

Groups: Negative externality, Positive externality, Information failure, Public good.

A worker's training also helps co-workers do better.
A factory's smoke makes nearby residents ill.
Late-night karaoke keeps neighbours awake.
Smokers underestimate their own risk of cancer.
No firm will supply street lighting for a town.
National defence protects everyone, payer or not.
Vaccination cuts the spread of flu to others.
People skip health screening, thinking they are fine.

Show the answer

Negative externality

A factory's smoke makes nearby residents ill. The residents are third parties who bear a cost they did not choose, so the factory overproduces.
Late-night karaoke keeps neighbours awake. The noise is a cost on people outside the deal, which the singers ignore.

Positive externality

A worker's training also helps co-workers do better. Co-workers gain without paying, so the worker buys less training than society would want.
Vaccination cuts the spread of flu to others. Others are protected too, a benefit the person getting vaccinated ignores.

Smokers underestimate their own risk of cancer. The harm falls on the smoker, who misjudges it and buys too much.
People skip health screening, thinking they are fine. They underestimate their own benefit from early detection, so they use too little.

Public good

No firm will supply street lighting for a town. No one can be stopped from using the light, so people free-ride and no firm can charge.
National defence protects everyone, payer or not. It is non-excludable and non-rival, so the market would provide none.

Demerit goods: Benefit overestimated: overconsumption.
Merit goods: Benefit underestimated: underconsumption.

Worked example: Sugary drinks

Many consumers enjoy sweet drinks now and underestimate the long-term risk of diabetes.

Their perceived benefit is above the actual benefit, once future health costs are counted.
So they drink more than they would with full information: Qp is above Qs.
Singapore's Nutri-Grade labels show sugar content clearly, to close the information gap.

Watch out for this

Information failure is the same as a negative externality.

With information failure, the buyer misjudges their own cost or benefit. With an externality, the cost or benefit falls on third parties.

Check your understanding

People skip health screenings because they underestimate how useful early detection is. What is this?

A negative externality, because untreated illness harms others.
Information failure leading to underconsumption of a merit good.
A public good problem, since everyone gains when screenings catch disease early.

Show the answer

Information failure leading to underconsumption of a merit good.

Right. The perceived benefit is below the actual benefit.