Cambridge Syllabus Notes

Efficiency and Market Failure – Imperfect Information

1. Syllabus Context (Cambridge AS/A‑Level Economics)

Imperfect information is a form of market failure. It links the introductory ideas of scarcity, choice and the role of government (AS 1.1‑1.6) to the detailed study of the price system (AS 2.1‑2.5) and to both micro‑ and macro‑government intervention (AS 3.1‑3.3, 5.1‑5.4). Understanding information problems helps students explain:

Why some markets do not reach the efficient equilibrium (AO1).
How government can improve efficiency, equity and redistribution (AO2).
Potential government failure and the limits of policy (AO3).

2. What Is Imperfect Information?

Imperfect information occurs when buyers and/or sellers do not have full, accurate and symmetric knowledge about a product, its price, quality, or the consequences of consumption. This breaches the perfect‑information assumption that underpins the model of perfect competition.

3. Types of Information Problems

Adverse Selection – Private information exists before a contract is concluded, causing high‑risk agents to dominate the market (e.g., sick people buying health insurance).
Moral Hazard – Behaviour changes after a contract is signed because one party is insulated from the consequences (e.g., insured drivers taking more risks).
Information Asymmetry – A generic term for any imbalance where one side knows more than the other; includes signalling (seller sends a credible signal) and screening (buyer induces the seller to reveal information).

4. How Imperfect Information Leads to Market Failure

Shift in the demand or supply curve – When buyers cannot assess quality, willingness to pay falls, shifting demand leftward (or supply rightward if sellers cannot price correctly).
Quantity traded falls below the socially optimal level (Q_i < Q*).
Dead‑weight loss (DWL) – The welfare loss is the area between marginal benefit (demand) and marginal cost (supply) from Q_i to Q*:
$$\text{DWL}= \int_{Q_i}^{Q^*}\big(P_{MB}-P_{MC}\big)\,dQ$$
Change in price elasticity – With less information, consumers become more price‑sensitive, flattening the demand curve and reducing producers’ total revenue.

Suggested Diagram (exam revision)

Draw a standard upward‑sloping supply curve S. Plot two demand curves:

D₁ – perfect information (intersects S at the socially optimal point (Q*, P*)).
D₂ – imperfect information (intersects S at (Q_i, P_i)).

Shade the triangle between the two demand curves and the supply curve – this is the DWL caused by imperfect information.

5. Other Major Market‑Failure Types (A‑Level requirement)

Failure	Key Feature	Typical Diagrammatic Representation
Externalities (positive & negative)	Marginal private cost/benefit ≠ marginal social cost/benefit.	Supply (or demand) curve shifted to reflect external cost/benefit; DWL between MSC and MPB (or MCB and MPB).
Public Goods	Non‑rivalry and non‑excludability → market under‑provides.	Supply curve lies above demand at the socially optimal quantity; DWL shown as the area between them.
Merit & Demerit Goods (AS 1.6)	Goods whose private marginal benefit differs from the socially optimal marginal benefit.	Demand curve shifted up (merit) or down (demerit) relative to private demand.
X‑inefficiency	Firms operate above the lowest possible average cost due to weak competition.	Supply curve lies above the long‑run marginal cost curve.
Imperfect Information	Information asymmetry, adverse selection, moral hazard.	Demand (or supply) shift and resulting DWL as described above.

6. Real‑World Illustrations of Imperfect Information

Used‑car market – “lemons” problem (adverse selection): Sellers know the car’s condition; buyers cannot, leading to a market dominated by low‑quality cars.
Health insurance (adverse selection & moral hazard): Healthy people drop out, raising premiums; once insured, people over‑use medical services.
Financial markets (information asymmetry): Insider knowledge misprices assets; regulatory responses include mandatory disclosure and insider‑trading bans.
Energy‑efficiency appliances (information asymmetry): Consumers cannot easily compare long‑run running costs; energy‑labelling schemes reduce the gap.
Online marketplaces (signalling & screening): Seller ratings and guarantees act as signals of quality.

7. Government Intervention – Micro‑economic Objectives

Cambridge expects students to link each policy tool to the three government objectives (efficiency, equity, redistribution) and to recognise possible government failure.

Intervention	Mechanism (how it works)	Primary Government Objective(s)	Potential Government Failure
Mandatory disclosure (e.g., nutrition labelling)	Legal requirement to provide specified information to consumers.	Efficiency – reduces information asymmetry; Equity – helps low‑income consumers make better choices.	Compliance costs; information overload; weak enforcement.
Certification & labelling (e.g., CE mark, organic logo)	Third‑party verification that a product meets defined standards.	Efficiency – signals quality; Equity – protects vulnerable buyers.	False certification; “green‑washing”; market for certifications.
Subsidies for information‑producing activities (testing, inspections)	Financial support to reduce the cost of acquiring reliable information.	Efficiency – encourages acquisition of accurate data; Equity – makes safety checks affordable.	Fiscal burden; risk of over‑subsidisation and waste.
Taxes on demerit goods (e.g., tobacco duty)	Raises price to reflect hidden social costs and to discourage consumption.	Efficiency – internalises negative externalities; Redistribution – revenue can fund health services.	Regressive impact; possible black‑market activity.
Subsidies for merit goods (e.g., education grants)	Reduces price to encourage consumption of socially beneficial goods.	Efficiency – corrects under‑consumption; Equity – improves access for low‑income groups.	Fiscal cost; risk of over‑consumption or waste.
Price controls (e.g., caps on insurance premiums)	Directly limits the maximum price that can be charged.	Equity – protects low‑income consumers; Redistribution of risk.	Price distortion; reduced supply; reduced incentives for innovation.
Taxes / subsidies that target externalities (e.g., carbon tax)	Aligns private marginal cost with social marginal cost.	Efficiency – internalises external costs; Equity – can be recycled as rebates.	Administrative complexity; potential for evasion.
Public provision of goods/services (e.g., NHS, school meals)	Government directly supplies the good where the private market fails.	Equity – universal access; Efficiency – guarantees minimum quality.	Bureaucratic inefficiency; crowding‑out of private sector.
Regulation of market behaviour (e.g., caps on claim payouts)	Sets legal standards or limits to protect consumers.	Equity – protects vulnerable groups; Redistribution of risk.	Regulatory capture; reduced market dynamism.

8. Linking Imperfect Information to the Macro‑economy

Aggregate demand (AD) – Uncertainty about future income, employment or product quality depresses consumer confidence, shifting AD leftward.
Inflation expectations – If households doubt the credibility of monetary policy because of opaque communication, they embed higher inflation expectations into wage‑price setting.
Fiscal‑policy effectiveness – Information gaps about the informal sector or the true size of a tax base can lead to mis‑estimation of multiplier effects.
Monetary‑policy transmission – Banks’ assessment of borrowers’ creditworthiness (information asymmetry) influences how quickly interest‑rate changes affect lending and investment.
Data reliability – Incomplete or delayed macro data creates policy lags and can undermine credibility, reducing the impact of both fiscal and monetary actions.

Macro‑government Intervention and Information Problems

Both fiscal and monetary authorities rely on accurate data. Incomplete or delayed information can cause:

Policy lags – decisions based on outdated figures.
Credibility issues – markets may doubt announced targets, reducing policy impact.
Misallocation of resources – e.g., stimulus directed to sectors that are already over‑invested.

9. Evaluation – When Is Intervention Justified?

Cost‑Benefit Test – Compare the estimated welfare loss from imperfect information with the total cost of the policy (administrative, compliance, fiscal). Intervention is welfare‑enhancing when Benefit > Cost.
Equity Considerations – Even a small net efficiency gain may be justified if the policy protects low‑income or vulnerable groups.
Risk of Government Failure – Over‑regulation, rent‑seeking, or creating new information gaps can outweigh the benefits. Discuss:
- Regulatory capture.
- Administrative complexity and bureaucratic delay.
- Unintended market distortions (e.g., reduced competition, black‑markets).
Dynamic Effects – Some policies (e.g., certification schemes) may generate long‑run benefits by encouraging innovation, improving overall market transparency, and reducing future information costs.

Illustrative Evaluation (Health‑Insurance Market)

Estimated DWL from adverse selection: £200 million per year.
Mandatory risk‑adjusted premiums + a public information campaign cost £45 million and cut the DWL by 80 %.
Net welfare gain ≈ £115 million, plus improved equity for high‑risk groups – strong case for intervention.

10. Summary Points (AO‑2 / AO‑3 Ready)

Imperfect information breaches the perfect‑competition assumption, causing market failure and a dead‑weight loss.
Key channels: adverse selection (pre‑contract) and moral hazard (post‑contract); signalling and screening are important micro‑tools.
Welfare loss is illustrated by a left‑ward shift of demand (or right‑ward shift of supply) and a resulting DWL triangle; formula provided.
Government can improve information flow (mandatory disclosure, labelling, certification), subsidise information generation, or directly provide the good/service.
All micro‑intervention tools required by the syllabus – taxes, subsidies, price controls, direct provision, regulation – should be linked to efficiency, equity, redistribution and possible government failure.
Information problems also affect macro‑variables (AD, expectations) and the effectiveness of fiscal and monetary policy.
Evaluation requires a cost‑benefit analysis, equity judgement, awareness of dynamic effects and the risk of government failure.

11. Syllabus Mapping – Where This Sub‑topic Fits

Syllabus Block	Relevant Content in These Notes
1 Basic Economic Ideas (1.1‑1.6)	Definition of market failure; link to merit & demerit goods and public goods.
2 Price System & Microeconomics (2.1‑2.5)	Demand‑curve shift, elasticity change, DWL formula, diagram description.
3 Government Micro‑intervention (3.1‑3.3)	Comprehensive table of all required tools, mechanisms, objectives and government‑failure risks.
4 Macroeconomics (4.1‑4.6)	Impact of information asymmetry on AD, inflation expectations, fiscal and monetary transmission.
5 Government Macro‑intervention (5.1‑5.4)	Discussion of data reliability, policy lags and credibility issues.
7 Efficiency & Market Failure (A‑Level)	Comparison of imperfect information with other failures (externalities, public goods, X‑inefficiency, merit/demerit goods).

12. Suggested Exam Practice Questions

Define adverse selection and explain, with a diagram, how it can lead to a dead‑weight loss in the used‑car market.
Evaluate the effectiveness of mandatory nutritional labelling as a policy to correct imperfect information, referring to the three government objectives and possible government failure.
Discuss how information asymmetry can affect aggregate demand and the transmission of monetary policy.
Compare and contrast the ways in which taxes, subsidies and price controls can be used to address market failures arising from imperfect information and externalities.
Explain why public provision of a good may be preferred to regulation when information problems are severe, using a real‑world example.

imperfect information