Edexcel IAL Economics: Imperfect information, moral hazard, bubbles (YEC11) – Revision Notes

These notes condense section 1.3.5 Market failure, items 4 to 6, of the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (YEC11), Issue 2, June 2018. This is Unit 1 content, labelled IAS and also part of the full IAL. For full explanations and longer worked examples, use the study guide. Test yourself with the practice set.

Other links: Edexcel economics hub, printable checklist and free 10-minute diagnostics. All figures below are invented.

Core definitions

Term	Meaning
Market failure	The market quantity is above or below the level that is best for society
Symmetric information	Buyer and seller know the same about the product
Asymmetric information	One side knows more than the other
Information gap	A shortfall in what a decision maker knows, such as quality, price, risk or long-run benefit
Moral hazard	Taking more risk because someone else bears some of the cost
Speculation	Buying an asset mainly to sell later at a higher price
Market bubble	A sustained rise in price well above fundamental value, driven by expectations of further rises

Item 4: imperfect information

Why it causes misallocation. Decisions rest on perceived costs and benefits. If perceptions are wrong, the market quantity is not the socially optimal quantity. Describe it in words: perceived marginal benefit sits below (or above) true marginal social benefit, so the equilibrium quantity is too low (or too high), and there is a welfare loss.

Context	Typical information gap	Likely result
Healthcare	Patients cannot judge diagnosis; they underestimate long-run risk	Too little prevention; possible overtreatment
Education	Quality and future pay are uncertain	Underinvestment in courses
Pensions	Long horizon, complex products, delay	Under-saving; unsuitable purchases
Insurance	Insurer cannot see each customer’s risk	Premiums rise; low-risk customers leave; too little cover

Method for a misallocation answer

1. Name who lacks information and what they do not know.
2. Say what choice they make as a result.
3. State the direction: too much or too little compared with the optimum.
4. Give the consequence for individuals and society.

Reminders (illustrative).

• Health check costs 90. Late treatment costs 3,000, with a true chance of 5%. True expected cost: 0.05 × 3,000 = 150. A person who believes the chance is 1% sees 30, below 90, so skips the check. The 60 difference between true expected cost and the check price is lost.
• An insurance pool: 400 low-risk (expected claims 150) and 100 high-risk (900). Average cost: (400 × 150 + 100 × 900)/500 = 300. If low-risk people value cover at 220, they leave at 300. Each lost policy wastes 220 − 150 = 70; 400 × 70 = 28,000.
• Education: perceived pay premium 2,000 a year for 25 years (50,000) against a cost of 70,000, so the student declines. True premium 6,000 a year (150,000), so a gain of 80,000 is missed.
• Pensions: saving 2,400 a year at 4%. Thirty years gives 134,603.85. Twenty years gives 71,467.39. Delay costs 63,136.46, while contributions differ by only 24,000.

Item 5: moral hazard

How it occurs. Protection plus unobservable behaviour. After a contract, one side takes more risk because they do not bear all the cost, and the other side cannot see it.

Do not confuse. Information gap before the deal (the insurer cannot see risk type) is different from changed behaviour after the deal (moral hazard).

Setting	The protection	The behaviour	Who pays
Insurance	Cover for losses	Less care	Insurer, then other customers
Banking	Deposit guarantee or expected rescue	Riskier lending	Depositors, taxpayers

Four groups (insurance and banking)

Group	Insurance	Banking
Consumers	Higher premiums; limits on cover	Credit boom then squeeze; weaker monitoring by depositors
Producers	Higher claims and monitoring costs	Cheap credit, then credit shortage
Workers	Less care at work; job cuts at weak insurers	Bonuses reward risk; job losses if banks fail
Governments	Pay for uninsured risks	Bailout costs, higher debt or taxes, tighter regulation

Reminders (illustrative).

• Household contents insurer assumes a 2% claim chance and an average claim of 4,000: expected claim 80. After cover, behaviour lifts the chance to 3%: 120. Premium must rise 50% to break even.
• An excess of 500 might lead to a 2.5% chance with payouts of 3,500: 0.025 × 3,500 = 87.5. Excess, no-claims discounts and monitoring all restore incentives.
• Bank test: risky lending returns +80 with probability 0.7 and −50 with probability 0.3: expected 0.7 × 80 + 0.3 × (−50) = 41. With losses capped at 30 for the bank because the state covers the rest: 0.7 × 80 + 0.3 × (−30) = 47. The state absorbs expected cost 0.3 × 20 = 6, and 47 − 6 = 41. The bank gains from risk the economy does not.

Item 6: speculation and bubbles

How a bubble builds

1. A trigger: good news or low borrowing costs lifts price.
2. Early buyers profit and are noticed.
3. Herd behaviour and expectations of further rises add demand for resale.
4. Easy credit lets more buyers in.
5. Price detaches from fundamental value, for example rent for housing or earnings for shares.
6. Confidence breaks, sales rise, loss-making holders are forced to sell, and prices fall quickly.

Percentage arithmetic. A rise of 50% takes an index from 100 to 150. A 40% fall then gives 150 × 0.6 = 90, which is 10% below the start. After a 40% fall, a rise of 1/0.6 − 1 = 66.7% is needed to recover.

Housing (illustrative). Price-to-rent ratio: 300,000/12,000 = 25. If price reaches 540,000, ratio is 45, and rental yield falls from 4% to 2.22%. A buyer pays 240,000 with a 10% deposit (24,000) and a loan of 216,000. After a 25% fall, value is 180,000, so equity is 180,000 − 216,000 = −36,000.

Shares (illustrative). Price 300 with earnings per share of 15 gives a price-earnings ratio of 20. At price 90 the ratio is 6. Buying at 300 and selling at 90 is a loss of 70%.

Group	Housing	Shares
Consumers	Negative equity; wealth effect on spending; first-time buyers priced out	Savings and pensions fall; late buyers lose most
Producers	Construction boom then unsold stock	Cheap funds then scarce funds; over-investment
Workers	Construction jobs rise then fall; limited mobility	Lower pension values; redundancies
Governments	Tax receipts rise then fall; welfare and bank support costs	Gains tax receipts swing; weaker growth and confidence

Evaluation points. Bubbles are hard to identify in real time. Some price rises reflect real improvements. Speculation can add information and liquidity. Harm depends on how far debt financed the boom. Effects differ by group and time.

Quick self-test

1. State the difference between symmetric and asymmetric information.
2. Explain why imperfect information can cause too little consumption of a good.
3. A health check costs 90, late treatment costs 3,000, and the true chance is 5%. Calculate the true expected cost without the check.
4. In the insurance pool above, what is the average cost per customer if 400 customers cost 150 and 100 cost 900?
5. Define moral hazard.
6. Why does an excess reduce moral hazard?
7. A claim chance moves from 2% to 3% with an average claim of 4,000. Calculate the percentage rise in expected claims.
8. Give one way moral hazard in banking affects a government.
9. An index rises from 100 to 150, then falls 40%. State its final value.
10. Give one effect of a housing bubble bursting on workers.

Answers

1. Symmetric: both sides know the same. Asymmetric: one knows more.
2. Consumers underestimate benefits or overestimate costs, so the market quantity is below the optimum.
3. 0.05 × 3,000 = 150.
4. (400 × 150 + 100 × 900)/500 = 300.
5. Taking more risk because another party bears part of the cost.
6. The insured bears part of any loss, so care pays.
7. 80 to 120 is a 50% rise.
8. It may have to fund bailouts or guarantees, which raises debt or taxes.
10. Construction job losses, or reduced mobility if homes cannot be sold.

Where marks are usually lost

• Naming moral hazard but not saying who bears the cost.
• Using the pre-deal information gap as if it were moral hazard.
• Covering only consumers when four groups are asked for.
• Describing a housing effect when asked about stocks and shares.
• Not saying whether too much or too little is consumed.
• Defining a bubble without mentioning fundamental value or expectations.
• Calculating a percentage fall from the wrong base.
• Listing effects without a chain of reasoning, and evaluating without a conclusion.

Official syllabus

Source: Pearson Education Limited, Edexcel International Advanced Subsidiary/Advanced Level in Economics (specification, Issue 2, June 2018; first teaching September 2018), section 1.3.5 Market failure, items 4 to 6.