IB DP Economics: Public goods and asymmetric information

This guide follows the IB Diploma Programme Economics guide (first assessment 2022, published February 2020), the course examined from the 2022 session onwards. It covers sub-topic 2.9, market failure through public goods, which is taught at SL and HL, and sub-topic 2.10, market failure through asymmetric information, which is HL only. Every HL-only section below is marked.

Also in this unit: the revision notes and the practice set. Course links: the IB DP Economics hub, the printable checklist, the 10-minute diagnostics, and the neighbouring units on the role of government and externalities.

Every place, firm and figure below is made up. Money is counted in veldors, the currency of fictional Veldoria.

What the guide lists

Section	What you must be able to do	Level
2.9 Public goods	Explain non-rivalrous and non-excludable, and the free rider problem	SL and HL
2.9 Government response	Evaluate direct provision and contracting out to the private sector	SL and HL
2.10 Asymmetric information	Explain adverse selection and moral hazard	HL only
2.10 Responses	Evaluate government responses (legislation and regulation, provision of information) and private responses (signalling and screening)	HL only

The guide sets the first row of each pair at analysis level and the second at evaluation level. It lists no diagrams or calculations for either sub-topic; the figures below make the ideas concrete. Questions on 2.10 appear only on HL papers, as the SL papers exclude HL-only topics.

2.9 Public goods

The two defining features

A public good has two features at once.

• Non-rivalrous. Using it leaves just as much for everyone else. Once the good exists, the cost of serving one more user is zero or close to it.
• Non-excludable. The producer cannot stop people who have not paid from using it, or can do so only at a prohibitive cost.

A private good is rival and excludable. A ticketed concert seat is both: only one person occupies it, and the venue can turn away anyone without a ticket.

Test a good with two questions: can non-payers be stopped, and does your use leave less for me? A signal from a hilltop mast that any radio can receive is non-excludable and non-rivalrous. So is a sea wall defending a whole bay: you cannot defend one house and leave its neighbour dry.

A good is not a public good because the government provides it. A place in a state-run classroom is still rival and excludable. The classification depends on the two features, not on who pays. A public good is also not a free good: a free good has no opportunity cost, while a public good costs real resources.

Why the market under-provides: the free rider problem

A free rider uses a good and pays nothing towards it. If a good is non-excludable, each consumer can reason that it will be there whether or not they contribute, so each prefers to let others pay. If enough people reason this way, revenue falls short of cost and the good is not provided, though people value it.

Because the good is non-rivalrous, the efficient price of use is zero, since an extra user imposes no extra cost, and no private firm can survive charging zero. The market failure is a missing market: the good is not supplied, or too little is supplied, though society would gain.

Worked example: the river-gauge network

The town of Marsh Hollow in Veldoria has 120 households. A river-gauge network would cost 2,400 veldors. Each household values the network at 30 veldors.

1. Total benefit = 120 × 30 = 3,600 veldors.
2. Net benefit to society = 3,600 − 2,400 = 1,200 veldors, so the network is worth building.
3. A private firm asks for voluntary payments of 20 veldors per household, an equal share of cost (2,400 ÷ 120 = 20). Suppose only 20 households pay. Revenue = 20 × 20 = 400 veldors.
4. Shortfall = 2,400 − 400 = 2,000 veldors, so the network is not built.

Each of the 100 free riders gives up a net benefit of 30 − 20 = 10 veldors. Free riding is rational for each household alone and leaves the group worse off: the whole 1,200 veldors of net benefit is lost.

Government responses

The guide names two responses, and both are to be evaluated.

Direct provision. The government funds the good from taxation and supplies it through its own agencies. Tax collection solves the free rider problem because payment is compulsory.

Strengths: the good is provided when the market would not provide it, and it is free at the point of use, which suits a good whose extra user costs nothing. Limitations: the government does not know households’ true valuations, because people have a reason to understate them, so it may provide too much or too little. The opportunity cost is the other uses of the tax revenue. Public agencies may face weaker pressure to control costs.

Contracting out to the private sector. The government still funds the good, but a private firm builds or runs it, chosen by tender.

Strengths: competition between bidders can lower cost, and specialist firms bring expertise. Limitations: writing, monitoring and enforcing the contract costs money. A winning firm may cut quality to protect its margin, particularly where quality is hard to specify. With few bidders, competitive pressure is weak.

Worked example: the tender. Veldoria’s council plans street lighting for 80 households. The council’s own estimate is 1,500 veldors, and each household values lighting at 25 veldors. Three firms bid: 1,620, 1,380 and 1,560 veldors.

1. Lowest bid = 1,380 veldors.
2. Saving against the council’s estimate = 1,500 − 1,380 = 120 veldors.
3. Tax per household = 1,380 ÷ 80 = 17.25 veldors.
4. Net gain per household = 25 − 17.25 = 7.75 veldors.

The saving is real only if quality matches what the council would have supplied. Evaluation would ask what the contract specifies and who inspects the lights.

Judging the responses

Both responses use taxation, so they differ in who produces the good, not who pays. The deciding factors are how easily quality can be written into a contract and how many credible bidders exist. Neither approach is always better.

2.10 Asymmetric information (HL only)

Asymmetric information exists when one side of a deal holds more relevant knowledge than the other. Markets can then fail even when both sides would gain from trade. The guide names two problems.

Adverse selection (HL only)

Adverse selection arises before the deal, when sellers (or buyers) hold hidden knowledge about quality or risk. The uninformed side can only judge the average, so the market attracts the worse cases.

Worked example: used pianos in Tessara. In the fictional market of Tessara, half of all used pianos are in good condition and half are poor. Sellers know which they have; buyers cannot tell. The valuations are:

	Good piano	Poor piano
Buyer’s value	900	400
Seller’s value	800	300

1. A buyer who cannot tell the difference values a random piano at 0.5 × 900 + 0.5 × 400 = 650 veldors.
2. No buyer will pay more than 650.
3. A good piano’s seller needs at least 800 veldors, so those sellers withdraw.
4. Only poor pianos remain, and buyers who work this out pay at most 400.
5. The gain from trade lost on each good piano = 900 − 800 = 100 veldors.

Good sellers return only if the share g of good pianos is high enough. A buyer’s expected value is 400 + 500g, which must reach 800. So 400 + 500g ≥ 800, which gives g ≥ 0.8. With only half of the pianos good, the trade in good pianos collapses.

Moral hazard (HL only)

Moral hazard arises after the deal, when behaviour shifts because someone else carries the risk. Fully insured people have less reason to take care.

Worked example: fire insurance. A shop owner in Veldoria faces a possible fire loss of 20,000 veldors. Spending 300 veldors a year on sprinkler maintenance cuts the probability of fire from 10% to 4%.

1. Uninsured, without maintenance: expected loss = 0.10 × 20,000 = 2,000 veldors.
2. Uninsured, with maintenance: 300 + 0.04 × 20,000 = 1,100 veldors. The owner maintains.
3. Fully insured, the owner’s expected loss is zero either way, so spending 300 veldors is a pure cost. The owner does not maintain.
4. The insurer’s expected payout rises from 0.04 × 20,000 = 800 veldors to 0.10 × 20,000 = 2,000 veldors.
5. The saving from maintenance forgone = 2,000 − 1,100 = 900 veldors.

The contract causes the change, and the insurer cannot easily watch maintenance. A cheap action that cuts expected loss by more than it costs is no longer taken.

Responses (HL only)

Government responses.

• Legislation and regulation. Examples include requiring sellers to disclose known defects, setting minimum standards, licensing professionals, and making some insurance compulsory. Strengths: they bind all sellers. Limitations: enforcement is costly, rules lag behind practice, and strict standards can raise prices or shut out small sellers.
• Provision of information. The government can publish inspection results, safety ratings or registers. Strengths: it cheaply narrows the information gap. Limitations: information may be misread or go out of date, and costs money to collect.

Private responses.

• Signalling. The informed party does something that reveals quality, such as offering a warranty or showing a qualification. A signal works only if low-quality sellers find it too costly to copy.
• Screening. The uninformed party designs a test that makes the informed party reveal itself, for example an application form, a medical check, or a menu of contracts.

Worked example: a warranty signal. In Tessara, a seller offers a 12-month warranty and asks 850 veldors. The expected cost of honouring it is 30 veldors for a good piano and 520 veldors for a poor one. Buyers will pay 850 for a warranted piano and 400 for an unwarranted one.

• Good seller: 850 − 30 = 820 veldors, which beats the seller’s value of 800, so offering the warranty pays.
• Poor seller copying the signal: 850 − 520 = 330 veldors, which is below the 400 available without a warranty, so copying does not pay.
• Buyers can trust the warranty, and a buyer who values a good piano at 900 keeps 50 veldors of surplus.

Worked example: a screening menu. An insurer cannot tell who is high risk. The chance of a 10,000-veldor loss is 5% for low-risk customers and 20% for high-risk customers. It offers policy X (premium 2,100, no excess) and policy Y (premium 700, the customer pays the first 8,000 of any loss).

Customer	Expected cost on X	Expected cost on Y
High risk	2,100	700 + 0.20 × 8,000 = 2,300
Low risk	2,100	700 + 0.05 × 8,000 = 1,100

High-risk customers choose X; low-risk customers choose Y. The choice reveals the type. The insurer still profits: 2,100 − 0.20 × 10,000 = 100 on X, and 700 − 0.05 × 2,000 = 600 on Y.

Evaluation in the exam papers

In the guide, part (b) of Paper 1 carries 15 marks including evaluation, and part (g) of Paper 2 carries 15 marks for synthesis and evaluation. HL Paper 3 is a 60-mark policy paper. Paper 1 allows no calculator; Papers 2 and 3 do, and a four-function model suffices. As advice, not mark-scheme rules: support each point with a reason, weigh strengths against limitations, and end with a judgement tied to the context.

Common errors

• Treating “non-rivalrous” and “non-excludable” as the same property.
• Claiming free riders do not value the good. They value it and still do not pay.
• Mixing up adverse selection (before the deal, hidden quality or risk) and moral hazard (after the deal, hidden behaviour).
• Describing a signal as something the buyer does. The informed party signals; the uninformed party screens.

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.