Question

Name and describe two potential market failures resulting from asymmetric information.

Answer 1

Asymmetric information means that some individuals have more information than the others, implying that there is no perfect information between the individuals. This results in market failure where market is not Pareto efficient. Asymmetric information can lead to imperfect competition where price charged is more than marginal cist and lack if competition gives the firm some control over price. Consider a natural monopoly where average cost falls over a large range of output. The price charged is less than the average cost and there is continous loss. In such situation government has to intervene. Secondly, in case of externalities, the actions of one agent affects the other agents and they create a cost or benefit for others but donot compensate for the same. Externalities cause divergence of social costs from private costs, and of social benefits from private benefits and the perfect competition will not achieve Pareto optimality.