Microeconomics guide, Unit 7, step 27 of 28Previous step Next step

Step 27: Information Failure and Behavioural Economics

By the EconTutorials team. 11-minute read with 6 practice questions.

SyllabusIB 2.4, 2.10 (HL) · Cambridge 7.3

In 30 seconds

Markets work well only when buyers and sellers know what they are trading. When one side knows more (asymmetric information), markets can shrink or fail.
Adverse selection happens before a deal (hidden information); moral hazard happens after a deal (hidden actions).
Behavioural economics shows that real people have bounded rationality, bounded self-control and bounded selfishness, and fall into predictable biases.
Exam point: nudges change the choice architecture (for example, making pension saving the default) without banning anything; always evaluate them.

Video lesson coming soonA short animated lesson for this step will appear here.

When one side knows more: asymmetric information

You want to buy a second-hand phone online. The seller knows whether the battery dies after two hours or whether the screen has been replaced. You only see the photos. That gap in knowledge is called asymmetric information, and it can stop a market from working properly.

Key termAsymmetric information: a situation where one party to a transaction has more or better information than the other.

Standard models assume perfect information. When it is missing, people make choices they would not make with full knowledge, resources are misallocated, and we have a market failure. There are two main types.

Adverse selection and moral hazard

The classic example is the used-car market, studied by George Akerlof in his 1970 paper “The Market for Lemons”. A “lemon” is a bad car. Sellers know which cars are good and which are lemons. Buyers cannot tell, so they will only pay a price based on the average quality.

Key termAdverse selection: when hidden information before a transaction means the wrong (higher-risk or lower-quality) people or products are more likely to end up in the market.

Worked example

For example, half the used cars in a town are good (worth $10,000 to buyers) and half are lemons (worth $4,000). Buyers cannot tell them apart. What will buyers pay, and what happens next?

Step 1Expected value $ = 0.5 \times 10{,}000 + 0.5 \times 4{,}000 = 5{,}000 + 2{,}000 = \$7{,}000 $

Step 2Owners of good cars (worth $10,000) will not sell at $7,000, so they withdraw.

Step 3Only lemons are left, so buyers now expect a lemon and pay only $4,000.

The good cars disappear from the market even though there were buyers willing to pay $10,000 for them. Mutually beneficial trades do not happen: that is the market failure.

Insurance shows the same problem. At an average premium, high-risk people find cover a bargain while low-risk people drop out. The pool becomes riskier, premiums rise, and more low-risk people leave; in extreme cases the market collapses.

Key termMoral hazard: when one party changes their behaviour after an agreement, taking more risks because someone else bears the cost, and the other party cannot fully observe this.

Once your phone is insured, you may be less careful with it. A bank that expects a government rescue may make riskier loans. The risk-taker does not bear the full cost, so too much risk is taken.

Fixing information failure

Solution	How it helps
Warranties and guarantees	A seller who offers a 12-month warranty signals that the product is good; a seller of a lemon could not afford to.
Regulation and disclosure laws	Laws can require sellers to reveal information (car history, food ingredients, loan interest rates) and ban false claims.
Licensing and certification	Doctors, electricians and taxi drivers must hold a licence, so buyers can trust a minimum quality.
Deposits, excesses and no-claims bonuses	A rental deposit, or an insurance excess (the first part of a claim the customer pays), keeps some cost with the customer, which reduces moral hazard.
Screening and compulsory cover	Insurers use medical checks or driving records; making insurance compulsory keeps low-risk people in the pool, reducing adverse selection.
Reputation and reviews	Brands and online ratings give sellers a reason to stay honest.

Behavioural economics: real people, not robots

Traditional theory assumes consumers are rational: they have full information, weigh all costs and benefits, and maximise their own utility. Behavioural economics combines economics with psychology and asks how people actually choose. It finds three big limits.

Bounded rationality. The term comes from Herbert Simon. People have limited time, information and brainpower, so they use rules of thumb (heuristics) and settle for a choice that is “good enough” instead of the best possible one.
Bounded self-control. People know what is good for them but still give in to temptation: they plan to save, exercise or revise, then put it off. They put too much weight on today compared with the future.
Bounded selfishness. People are not purely self-interested. They give to charity, volunteer, tip in places they will never return to, and punish unfairness even when it costs them.

These limits show up as predictable biases:

Anchoring: relying too heavily on the first number you see. A jacket labelled “was $200, now $120” feels like a bargain because $200 is the anchor, even if $120 is the normal price.
Availability: judging how likely something is by how easily examples come to mind. After news reports of a plane crash, people overestimate the risk of flying and may drive instead, which is usually riskier.
Framing: the way a choice is presented changes the decision. Patients are more likely to accept an operation described as having a “90% survival rate” than one with a “10% death rate”, though the two are identical.
Loss aversion: losses hurt more than equal-sized gains feel good; in many experiments, roughly twice as much. People refuse fair bets and hold on to falling shares to avoid “locking in” a loss.
Default bias (status quo bias): people tend to stick with whatever option is already chosen for them, even when switching is easy.

Worked example

For example, you are offered a coin toss: heads you win $110, tails you lose $100. Is it a good bet for a rational person? Why do many people refuse?

Step 1Expected value $ = 0.5 \times 110 + 0.5 \times (-100) = 55 – 50 = +\$5 $

Step 2A risk-neutral rational person accepts, since the expected gain is positive.

Step 3With loss aversion, if a $100 loss feels about twice as bad: felt value $ \approx 0.5 \times 110 – 0.5 \times 200 = 55 – 100 = -45 $

The bet “feels” negative, so the person turns it down. Loss aversion explains a choice that standard theory says is a mistake.

Nudges and choice architecture

If people make predictable mistakes, governments and firms can design choices to help them. Richard Thaler and Cass Sunstein popularised this idea in their 2008 book Nudge.

Key termNudge: a change in the way choices are presented that steers people towards a better decision without banning any option or significantly changing financial incentives.

Key termChoice architecture: the design of the environment in which people make decisions, such as the default option, the order of choices and how information is framed.

Real examples:

Pension auto-enrolment. In the UK, from 2012 employers have had to enrol eligible workers in a workplace pension automatically. Workers can opt out, but default bias means most stay in, so saving for retirement rose sharply.
Organ donation opt-out. Wales moved to an opt-out system in 2015 and England followed in 2020: adults are treated as willing donors unless they register a decision not to donate. The default is switched from “no” to “yes”.
Other nudges: healthy food at eye level in canteens; letters telling late taxpayers that “most people in your area pay on time”.

Common mistakeCalling a tax or a ban a nudge. A sugar tax changes prices, and a smoking ban removes a choice, so neither is a nudge. A nudge keeps every option open and works through how the choice is presented.

Evaluation

For nudges: they are usually cheap to run, they keep freedom of choice (supporters call this “libertarian paternalism”), and they can have large effects, as auto-enrolment shows. They tackle the real cause of the problem, which is the bias, not a lack of money.

Against nudges: some effects are small or fade over time; critics see them as manipulative or paternalistic (who decides what is “better” for you?); firms use the same tricks to sell more, not to help; and governments are run by people who have biases too, so nudges can be badly designed. For deep problems, such as pollution or very low incomes, a nudge alone may be too weak and stronger tools such as taxes, regulation or subsidies are needed.

On behavioural economics itself: it is more realistic, but it offers many separate biases rather than one simple model, and some experimental results have been hard to repeat. Rational choice remains a useful starting point.

Exam tipIB HL and Cambridge 9708 A Level reward precise definitions plus a real example. For asymmetric information, say who has the extra information and whether the problem arises before (adverse selection) or after (moral hazard) the deal. For behavioural economics, name the bias, link it to a specific real nudge such as pension auto-enrolment, and evaluate: cost, effectiveness, freedom of choice, and whether a stronger policy is needed.

Practise: 6 questions

Try each one on paper first, then check the worked answer.

EasyQ1. Distinguish between adverse selection and moral hazard, with one example of each. Show worked answer

Adverse selection comes from hidden information before a deal: e.g. people with poor health are more likely to buy health insurance at an average premium.
Moral hazard comes from hidden actions after a deal: e.g. after insuring a bike, the owner stops locking it carefully.

EasyQ2. A supermarket sets “save more” pension sign-up as the default for new staff, with a simple opt-out. Which bias does this use, and is it a nudge? Show worked answer

It uses default (status quo) bias: people tend to stay with the pre-selected option.
It is a nudge because no option is banned and there is no significant financial penalty for opting out; only the choice architecture has changed.

MediumQ3. 60% of used bikes are good (worth $500) and 40% are poor (worth $200). Buyers cannot tell them apart. What will they pay, and why might good bikes leave the market? Show worked answer

Expected value $ = 0.6 \times 500 + 0.4 \times 200 = 300 + 80 = \$380 $.
Owners of good bikes worth $500 are offered only $380, so many refuse to sell. The share of poor bikes rises, the expected value falls further, and eventually mostly poor bikes are traded: adverse selection.

MediumQ4. Explain how an insurance excess of $250 reduces moral hazard. Show worked answer

With an excess, the customer pays the first $250 of any claim themselves. Because careless behaviour now has a direct cost to them, they have an incentive to take care (lock the car, look after the phone). Part of the risk is shifted back to the person whose actions the insurer cannot observe, so less excess risk is taken.

MediumQ5. A gym offers a 12-month contract at $40 a month. Many members go only a few times. Which behavioural ideas explain this? Show worked answer

Bounded self-control: people sign up intending to exercise but give in to the short-term temptation to skip.
Present bias / overconfidence: when signing, they overestimate how often their future self will go.
Default bias: the contract continues unless cancelled, so many keep paying.
Total commitment: $ 12 \times 40 = \$480 $ a year, which can be far more than paying per visit.

ExamQ6. Evaluate the use of nudges by governments to improve economic decision-making. [10 marks] Show worked answer

Knowledge (up to 2): define a nudge and choice architecture; explain that rational choice assumes perfect information and self-interest, while behavioural economics identifies bounded rationality, bounded self-control and biases.
Application and analysis (up to 4): pension auto-enrolment uses default bias to raise saving, correcting bounded self-control and present bias; opt-out organ donation (Wales 2015, England 2020) switches the default; social-norm letters raise tax payment. These change behaviour at low cost while keeping freedom of choice.
Evaluation (up to 4): nudges are cheap and preserve choice, but effects may be small or temporary; they can be seen as manipulative or paternalistic; policymakers have biases too; firms can use the same tools against consumers; for serious market failures (e.g. pollution) taxes or regulation may be needed alongside nudges. Judgement: nudges are most effective where the problem is a predictable bias and the “better” choice is widely agreed, as with pension saving, and least effective where incentives or incomes are the real cause.

Check yourself

1. After buying full phone insurance, Sam stops using a case. This is an example of:

Sam’s behaviour changes after the deal because the insurer bears the cost: moral hazard.

2. Which of these is a nudge?

Only the default changes; every option stays available at the same price.

3. A shop shows “Was $300, now $180” to make $180 seem cheap. Which bias is this?

The $300 acts as an anchor that shapes how the $180 price is judged.

Your score: 0 out of 3

The short version

Asymmetric information is a market failure: one side knows more than the other.
Adverse selection (before the deal) can drive good products and low-risk customers out; moral hazard (after the deal) leads to too much risk-taking.
Warranties, regulation, licensing, deposits and excesses, screening and reputation all reduce information problems.
Behavioural economics replaces the fully rational consumer with bounded rationality, bounded self-control and bounded selfishness, plus biases such as anchoring, availability, framing, loss aversion and default bias.
Nudges redesign choice architecture (auto-enrolment, opt-out organ donation); they are cheap and keep choice, but can be weak, temporary or paternalistic.