Question

(a) Define and explain asymmetric information outlining its two sources.

(b) Governments sometimes intervene in insurance markets. Explain in detail two reasons why they might intervene and outline the rationale and justification for doing so.

 

Answer 1

a. The concept of Asymmetric Information revolves around a situation in which each party to a transaction has disproportionate knowledge, where one party has better information than the other. That type of asymmetry produces a transaction imbalance. There are two types of asymmetric information – adverse selection and moral hazard.

Adverse selection defines situations in which either buyers or sellers have knowledge not available to the other party. When these two groups are told to different degrees in these cases, that creates asymmetric knowledge The problem with asymmetric information occurs before the transaction takes place / pre-contractual problems where one party has more information than another. Drivers of used cars have more knowledge than they share when selling their vehicles. Cover-seekers are more likely to require cover, so the decision-maker typically has a limited range.

We need to generate cheaper information (in the financial sector-information needs to be published by companies). Companies are expected to meet common accounting rules, the involvement of rating agencies, information disclosure, collateral requirements and net worth criteria. For example, blogging, which can be considered a new source of cheap information, has reduced the role of insider information by preventing people in power from depriving the general public of financial information.

Moral hazard is a situation where a party is more likely to take risks, because the risk-taking party does not bear the costs that may result. This asymmetric knowledge problem arises after transaction. For example, a person with auto theft insurance can be less vigilant about locking their car because the negative consequences of vehicle theft are now (partially) the insurance company's liability. Another example may be people receiving welfare insurance; they may be less likely to obtain jobs than in a case in which they have had no insurance.

b. Governments intervene to combat inefficiency in economies. Assets are ideally distributed to those that need them in the quantities they need in an optimally productive economy. This is not the case in competitive markets; some may have too much of a resource while others may not have enough. Inefficiency can take several varying forms. The government attempts to combat these inequities by regulating, taxing and subsidizing them. When they interfere in the economy, most governments have some combination of four distinct goals. In an fragmented unregulated market, cartels and other types of organizations may exert monopoly control, boost entry costs and restrict infrastructure growth. Without control, without consequence, companies may create negative externalities. All of this leads to limited capital, stifled competition and decreased trade and its associated advantages. Those problems can be resolved directly through government action by regulation.

Financial firms make their own investment decisions in a competitive market economy, without government intervention. The need for stabilization in the financial system is based on the notion that a financial institution's failure can undermine stability and public confidence in the financial sector as a whole through contagion effects.
This is why policymakers are setting minimum financial soundness requirements for businesses that offer financial goods or services. Such requirements are intended to reduce the risk of damage to customers and the general public if the financial performance of a business is weak and to preserve a fair degree of public confidence in the industry as a whole.

It is important that the institution leaves the industry in an orderly manner when a failure occurs, and that the interests of investors and policyholders are protected.
Regulation of government is an important instrument for achieving those goals.
Regulation also helps to ensure shareholders and not customers and taxpayers bear the risk of loss. It requires the system of management to be more transparent and to take greater consideration while making investment decisions.