Pearson Edexcel International Advanced Level Economics: Imperfect information, moral hazard, bubbles (YEC11)

This study guide is aligned to the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (YEC11), Issue 2, June 2018. It covers section 1.3.5 Market failure, items 4 to 6: imperfect market information, moral hazard, and speculation and market bubbles. The specification labels Units 1 and 2 as International AS (IAS) and Units 3 and 4 as the extra International A2 (IA2) content. This is Unit 1 content, so it is IAS and also part of the full IAL. Externalities and public goods (items 1 to 3) are taught on separate pages.

All countries, firms and figures below are invented for practice. Do not quote them as real data.

Related pages: the Edexcel economics hub, the printable checklist, the revision notes, the practice set, the wider Unit 1 guide and our free 10-minute diagnostics.

What you must be able to do

Item	Content
4 a, b	Symmetric and asymmetric information; why information gaps matter
4 c	Misallocation from imperfect information in healthcare, education, pensions and insurance
5 a	How moral hazard occurs
5 b	Its impact on consumers, producers, workers and governments in insurance and banking
6 a	How market bubbles arise
6 b	Their impact on the same four groups in housing and stocks and shares

Market failure means the market delivers a quantity above or below the level that is best for society. Each topic below ends in that test: does the market quantity differ from the best quantity, and why?

4 Imperfect market information

Symmetric and asymmetric information

Information is symmetric when buyer and seller know the same things about the product. It is asymmetric when one side knows more. A doctor knows more about a treatment than the patient. A borrower knows more about their own plans than the lender.

An information gap is any shortfall in what a decision maker knows: about quality, price, risk, long-run benefits or alternatives. Gaps matter because rational choices need accurate information. Where people misjudge costs or benefits, they choose a quantity different from the socially optimal one.

A simple sketch in words: draw a demand curve based on perceived benefits. Where people underestimate true benefits, it sits to the left of the true marginal social benefit curve. The market equilibrium quantity is then smaller than the socially optimal quantity, and the gap between them is a welfare loss.

Healthcare

Patients rarely judge diagnosis or treatment themselves. Providers can recommend more treatment than is needed, which is overconsumption. Patients also underestimate long-run risks, so they under-consume preventive care.

Worked example (illustrative). A health check costs 50. Without it, the chance of needing late treatment costing 2,000 is 10%.

• True expected cost of skipping: 0.10 × 2,000 = 200, which exceeds 50.
• Perceived risk is 1%: 0.01 × 2,000 = 20, which is below 50.

The person skips the check. It would save 150 in expected cost, so too little is consumed.

Education

Students and families often cannot see the quality of a course in advance, and they guess future earnings. Underestimating the benefit leads to underinvestment.

Worked example (illustrative). A degree costs 120,000 in fees and forgone earnings. A student expects a pay premium of 3,000 a year for 30 years (90,000 in total). The true premium is 9,000 a year (270,000). Undiscounted for simplicity:

• Perceived net: 90,000 − 120,000 = −30,000, so the student does not enrol.
• True net: 270,000 − 120,000 = +150,000.

A gain of 150,000 is lost. The gap also has a wider dimension: society loses the output of a more skilled worker.

Pensions

Pensions involve long horizons, complex products and a payoff decades away. People underestimate how much they need and delay saving.

Worked example (illustrative). Saving 1,800 a year at a steady 3% a year:

• For 35 years: 1,800 × (1.03³⁵ − 1)/0.03 = 108,831.75.
• For 25 years: 1,800 × (1.03²⁵ − 1)/0.03 = 65,626.68.

Starting ten years later cuts the pot by 43,205.07, though total contributions fall only from 63,000 to 45,000. Because many people do not see this, they under-save and later rely on the state. Information gaps also allow sellers to market complex products that buyers cannot compare, which can lead to unsuitable purchases.

Insurance

Insurers cannot see each customer’s true risk. If they charge one average premium, low-risk customers get poor value and some leave, which worsens the risk mix. This is a well-known consequence of asymmetric information (many textbooks call it adverse selection, a term the specification does not use).

Worked example (illustrative). Of 1,000 drivers in Country A, 800 are low-risk (expected claims 200 a year) and 200 are high-risk (expected claims 1,000).

• Average cost: (800 × 200 + 200 × 1,000)/1,000 = 360.
• A low-risk driver values cover at 300, so at a premium of 360 they leave.
• Only 200 high-risk drivers stay, and the break-even premium rises to 1,000.

Insured drivers fall from 1,000 to 200. Cover for low-risk drivers is worth 300 and costs 200, so each lost policy wastes 100 of potential gain: 800 × 100 = 80,000. Too little insurance is traded.

5 Moral hazard

How moral hazard occurs

Moral hazard arises when a person, protected from the consequences of risk, takes more risk than they otherwise would, because someone else bears part of the cost. Information is asymmetric after the deal: the insurer or lender cannot observe behaviour. It requires protection (an insurance policy, a guarantee, a bailout) plus unobservable behaviour.

Insurance

Worked example (illustrative). A van insurer prices on a 4% annual claim chance and an average claim of 5,000. With full cover, owners take less care and the chance rises to 6%.

• Premium charged: 0.04 × 5,000 = 200.
• Actual expected claim: 0.06 × 5,000 = 300. Loss of 100 per policy.
• Across 10,000 policies: 1,000,000 a year.
• Premium needed to break even: 300, a 50% rise.

If the insurer adds an excess of 1,000, the owner bears part of any loss. Suppose the claim chance settles at 4.5% and payouts fall to 4,000: 0.045 × 4,000 = 180, below the original 200. Excesses restore incentives.

Impact on each group

• Consumers: careful customers pay higher premiums; cover may be restricted or withdrawn.
• Producers (insurers): unexpected claims, plus monitoring and administration costs; some insurers withdraw from risky markets.
• Workers: employees of firms with generous cover may take fewer precautions at work, and staff at insurers may face job cuts after heavy losses.
• Governments: may pay for risks the market will not insure, raising public spending and taxes.

Banking

Banks borrow from depositors and lend. If depositors or the state will cover losses, a bank gains the upside of risky lending but does not bear the full downside.

Worked example (illustrative). A bank lends 1,000, with equity of 40.

• Safe option: certain return of 5%, so +50.
• Risky option: 60% chance of +120, 40% chance of −60.
• Social expected return of the risky option: 0.6 × 120 + 0.4 × (−60) = 48, below 50.
• Bank’s expected profit, if losses beyond its equity are covered by the state: 0.6 × 120 + 0.4 × (−40) = 56, above 50.

The bank chooses the risky option, though it is worse for society. The state covers 20 in the bad outcome: expected cost 0.4 × 20 = 8, and 56 − 8 = 48.

Impact on each group

• Consumers: depositors may monitor banks less if their savings are guaranteed; borrowers face credit that expands and then contracts.
• Producers: firms enjoy easy credit, then a credit shortage after losses.
• Workers: bonuses linked to short-term profit reward risk. Job losses follow a bank failure or credit squeeze.
• Governments: carry bailout and guarantee costs, raise debt or taxes, and must then regulate (covered on the government intervention pages).

6 Speculation and market bubbles

How bubbles arise

Speculation is buying an asset mainly to sell it later at a higher price, not for the income it provides. A bubble is a sustained rise in an asset price well above its fundamental value, driven by expectations of further rises.

The chain: some good news or low borrowing costs lift price, early buyers profit, others see the gains and copy them (herd behaviour), demand for resale grows, and cheap credit lets more people buy. Higher prices raise expectations, which raise demand again. The price detaches from underlying value. A bubble bursts when confidence breaks: a few sell, prices dip, loss-making buyers must sell, and expectations reverse. The same positive feedback works downward.

Housing

Worked example (illustrative). A price index starts at 100 and climbs to 180, a rise of 80%. A later fall of 30% gives 180 × 0.7 = 126. Yet to return to 100 from 180 would need a fall of 44.4%.

Rents show fundamentals. A house worth 200,000 rents for 10,000 a year, a 5% yield. At an index of 180 the price is 360,000, and the yield falls to 10,000/360,000 = 2.78%. Prices have run ahead of rental value.

Negative equity. A buyer pays 250,000 with a 10% deposit (25,000), borrowing 225,000. Prices fall 30%: value 175,000. Equity is 175,000 − 225,000 = −50,000.

• Consumers: buyers near the peak face negative equity, owners feel richer then poorer (changing spending), and first-time buyers are priced out.
• Producers: builders expand, then face unsold stock; firms linked to housing lose.
• Workers: construction jobs rise then fall; mobility falls if people cannot sell.
• Governments: tax revenues rise in the boom and fall in the bust, welfare costs rise, and banks’ mortgage losses may need support.

Stocks and shares

A share priced at 120 with earnings per share (EPS) of 10 has a price-earnings ratio of 12. If the price reaches 400 with EPS at 10, the ratio is 40. Even if EPS rises to 12, the ratio is 33.3. Buying at 400 and seeing 150 means a loss of (150 − 400)/400 = −62.5%.

• Consumers: savers whose pension funds hold shares lose; investors who bought late lose most.
• Producers: firms raise cheap funds during the boom, perhaps over-investing, and find funds scarce after the crash.
• Workers: lower pension values, redundancies as firms cut back.
• Governments: capital gains tax receipts rise then fall, and growth and confidence weaken.

Evaluation. A bubble is hard to spot in real time, since prices may reflect fundamentals that have genuinely improved. Some speculation helps by revealing information and adding liquidity. The cost of a burst depends on how much borrowing funded it: debt-fuelled bubbles do more harm.

Common errors

• Describing moral hazard as dishonesty. It is a response to incentives.
• Mixing up information before the deal (hidden risk) and behaviour after it (moral hazard).
• Giving a stock-market impact for housing, or vice versa.
• Describing effects on only one of the four groups.
• Claiming a bubble is certain. Use “may” and justify with fundamentals.

Exam technique is covered on the exam preparation page.

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.