IB DP Economics: Public goods and asymmetric information – Revision Notes

These notes follow the IB Diploma Programme Economics guide (first assessment 2022, published February 2020), the course examined from the 2022 session onwards. They condense sub-topic 2.9, public goods (SL and HL), and sub-topic 2.10, asymmetric information (HL only). For full explanations, read the study guide, then test yourself with the practice set.

Course links: the IB DP Economics hub, the printable checklist and the 10-minute diagnostics. Related units: the role of government and externalities. Every name and figure in the examples is made up.

Definitions to know cold

Term	Meaning	Level
Public good	A good that is both non-rivalrous and non-excludable	SL and HL
Non-rivalrous	Use by one person leaves the amount for others unchanged; an extra user adds no cost	SL and HL
Non-excludable	Non-payers cannot be stopped from using the good, or only at prohibitive cost	SL and HL
Free rider	A person who uses a good but pays nothing towards it	SL and HL
Direct provision	The government funds and supplies the good itself	SL and HL
Contracting out	The government funds the good; a private firm supplies it under contract	SL and HL
Asymmetric information	One side of a deal holds more relevant knowledge than the other	HL only
Adverse selection	Hidden quality or risk before the deal drives out better cases	HL only
Moral hazard	Behaviour shifts after the deal because another party carries the risk	HL only
Signalling	The informed party reveals its quality by a costly action	HL only
Screening	The uninformed party sets a test that makes the informed party reveal its type	HL only

2.9 Public goods: the chain of reasoning

1. The good is non-excludable, so a producer cannot charge for it.
2. Each person gains by letting others pay: the free rider problem.
3. Revenue falls below cost, so private firms do not supply it.
4. The good is missing or under-supplied, although the benefit to society exceeds the cost. This is market failure.

Write the four links in order. Skipping a link, usually the free rider step, loses the reasoning.

Spotting a public good

Ask two questions in this order.

Question	If yes	If no
Can the producer stop non-payers?	Excludable (private-good side)	Non-excludable
Does your use reduce mine?	Rivalrous (private-good side)	Non-rivalrous

Both answers must fall on the public side. A concert seat fails both tests. A sea wall that defends a whole bay passes both.

Do not confuse

• Public good versus good provided by the government. A state-run classroom place is rival and excludable.
• Public good versus free good. A free good has no opportunity cost; a public good costs resources.
• Non-rivalrous versus non-excludable. They are two separate features, and a public good needs both.

The numbers in miniature

A fictional town has 120 households. A river-gauge network costs 2,400 veldors, and each household values it at 30 veldors.

• Total benefit = 120 × 30 = 3,600 veldors; net benefit = 3,600 − 2,400 = 1,200 veldors.
• Equal share = 2,400 ÷ 120 = 20 veldors each.
• If only 20 households pay: revenue = 400 veldors, shortfall = 2,000 veldors, not built.

Method: total benefit, then net benefit, then revenue against cost.

Government responses (evaluate both)

	Direct provision	Contracting out
Who pays	Taxpayers	Taxpayers
Who produces	Government agency	Private firm chosen by tender
Strengths	Provided despite free riding; free at the point of use; no profit motive to cut quality	Competition between bidders can lower cost; expertise
Limitations	Valuations unknown, so quantity may be wrong; opportunity cost of tax revenue; weaker cost pressure	Contract costs to write and monitor; quality may be cut; few bidders weaken competition

Tender reminder: with a council estimate of 1,500 veldors and a lowest bid of 1,380, the saving is 120 veldors. For 80 households the tax per household is 1,380 ÷ 80 = 17.25 veldors.

Both responses use compulsory taxation to remove free riding. They differ in who produces the good. A judgement should rest on how easily quality can be specified and how many bidders there are.

2.10 Asymmetric information (HL only)

Adverse selection versus moral hazard

	Adverse selection	Moral hazard
Timing	Before the deal	After the deal
Hidden	Quality or risk type	Behaviour or effort
Result	Better sellers or customers leave; the market shrinks toward the worse cases	Risk-taking rises or care falls
Example	Used goods, where buyers cannot judge quality	An insured shop owner who stops maintaining equipment

Adverse selection in numbers (HL only)

Fictional piano market. Half the pianos are good. Buyers value good at 900 and poor at 400. Sellers value good at 800 and poor at 300.

• Average value to an uninformed buyer = 0.5 × 900 + 0.5 × 400 = 650.
• Good sellers need 800, so they withdraw.
• Gain from trade lost per good piano = 900 − 800 = 100.
• Share of good pianos needed to keep good sellers: 400 + 500g ≥ 800, so g ≥ 0.8.

Moral hazard in numbers (HL only)

Fire loss 20,000 veldors. Maintenance costs 300 and cuts the fire probability from 0.10 to 0.04.

Situation	Owner’s expected cost, no maintenance	Owner’s expected cost, maintenance
Uninsured	0.10 × 20,000 = 2,000	300 + 0.04 × 20,000 = 1,100
Fully insured	0	300

Uninsured owners maintain. Insured owners do not. The insurer’s expected payout rises from 800 to 2,000.

Partial cover (an excess) restores incentives. With an excess of 8,000 the owner’s expected cost is 0.10 × 8,000 = 800 without maintenance and 300 + 0.04 × 8,000 = 620 with it, so the owner maintains again.

Responses (HL only)

Type	Tool	Example	Main limitation
Government	Legislation and regulation	Compulsory disclosure of defects; licensing	Enforcement cost; rules lag behind practice
Government	Provision of information	Published inspection results	May be misread or out of date
Private	Signalling (informed party acts)	Warranty, qualification	Works only if low-quality sellers cannot afford to copy
Private	Screening (uninformed party designs test)	Menu of insurance contracts; application checks	Test must make types choose differently

Warranty reminder: price 850; cost of honouring 30 for a good piano and 520 for a poor one. Good seller nets 820, which beats its value of 800. A poor seller copying nets 330, which is below the 400 available without a warranty. The signal separates the types.

Screening reminder: insurer offers X (premium 2,100, no excess) and Y (premium 700, excess 8,000). With loss probabilities of 20% (high risk) and 5% (low risk) on a 10,000 loss, high risk prefer X (2,100 against 2,300) and low risk prefer Y (1,100 against 2,100).

Method boxes

Evaluating a government response

1. State what it does and the market failure it targets.
2. Give one strength with a reason.
3. Give one limitation with a reason, such as cost, enforcement, quality or information.
4. Judge which factors decide success in the context given.

Explaining adverse selection (HL only)

1. Say who holds the hidden information.
2. Show the buyer pays only an average value.
3. Show good sellers leave.
4. State the result: a smaller market of lower average quality.

Exam facts from the guide

• Paper 1: 1 hour 15 minutes, extended response, 25 marks, with part (a) at 10 marks and part (b) at 15. Calculators are not permitted.
• Paper 2: 1 hour 45 minutes, data response, 40 marks. Calculators are allowed.
• HL Paper 3: 1 hour 45 minutes, policy paper, 60 marks. Calculators are allowed.
• SL papers exclude HL-only topics, so 2.10 is examined only at HL.
• The guide sets public goods at analysis level and the government response to them at evaluation level.

Quick self-test

1. Name the two features that together define a public good.
2. Explain why a private firm is unlikely to supply a non-excludable good.
3. A good costs 900 veldors and 50 households each value it at 24 veldors. Find the net benefit to society.
4. Explain why a state-run primary school is not a public good.
5. Name one strength and one limitation of contracting out.
6. (HL only) Distinguish adverse selection from moral hazard.
7. (HL only) Buyers value a good item at 500 and a poor item at 200. Sellers value them at 420 and 150. Half of the items are good. Show that good sellers withdraw.
8. (HL only) Find the share of good items needed for good sellers to stay, using the figures in question 7.
9. (HL only) State one government response and one private response to asymmetric information.
10. (HL only) Explain why a signal must be costly for low-quality sellers to copy.

Answers

1. Non-rivalrous and non-excludable.
2. It cannot charge, because non-payers cannot be excluded. Each person prefers to free ride, so revenue falls below cost.
3. Total benefit = 50 × 24 = 1,200; net benefit = 1,200 − 900 = 300 veldors.
4. A school place is rival and excludable, so it fails both tests. The government pays, but payment does not decide classification.
5. Strength: competitive bidding can lower cost. Limitation: quality may be cut and the contract costs money to monitor.
6. Adverse selection arises before the deal from hidden quality or risk. Moral hazard arises after the deal from hidden behaviour.
7. Average value = 0.5 × 500 + 0.5 × 200 = 350. This is below 420, so good sellers withdraw.
8. 200 + 300g ≥ 420, so g ≥ 220 ÷ 300 = 11/15, about 0.733.
9. Government: disclosure legislation, or published inspection results. Private: a warranty (signalling), or a menu of contracts (screening).
10. If low-quality sellers could copy the signal cheaply, every seller would send it and buyers would learn nothing from it.

Where marks are usually lost

• Naming only one feature of a public good.
• Calling any state-funded service a public good.
• Jumping from non-excludable to under-provision without the free rider step.
• Giving a list of government actions with no judgement.
• Writing that contracting out is cheaper without asking about quality or monitoring.
• Mixing up the timing of adverse selection and moral hazard.
• Showing only the final answer in a calculation when the command term asks for the working.
• Using a hidden-action example, such as careless driving, for adverse selection.

Official syllabus

IB Diploma Programme Economics guide, first assessment 2022, published by the International Baccalaureate Organization, February 2020. Sub-topics 2.9 and 2.10 (HL only) of Unit 2: Microeconomics.