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Level

This whole subtopic is higher level. Nothing in it is on an SL paper.

Educerie · IB Diploma · Economics

Unit 2 Microeconomics · 2.10 Market failure — asymmetric information

Level
HL only, the whole subtopic. Every line is higher level extension material, so no section is marked separately. SL students are not examined on any of it.
Themes (key concepts)
efficiency, intervention, economic well-being. This sits on the syllabus as a market failure, so an answer that never mentions efficiency has missed the point.
The question this unit answers
when are markets unable to satisfy important economic objectives, and does government intervention help?
Where it is examined
Paper 1, part (a) to explain the market failure and part (b) to evaluate a response; Paper 2, on an extract with a hidden fact in it; Paper 3, under a policy question. The syllabus names no diagram here, which changes how you write.

What you must be able to do

You must be able toLevelWhat it looks like in the exam
Explain what asymmetric information is and why it causes market failureHL only"Explain how asymmetric information may lead to market failure" (10 marks)
Explain adverse selection, with an exampleHL onlyPart of that explanation, or a 4-mark Paper 2 question
Explain moral hazard, with an exampleHL onlyThe same, usually asked beside adverse selection so the two can be told apart
Explain the government responses: legislation and regulation, provision of informationHL only"Explain one government response to…" (4 marks)
Explain the private responses: signalling and screeningHL only"Distinguish between signalling and screening" (4 marks)
Evaluate how well those responses workHL onlyPaper 1 part (b), 15 marks

Before you start

You need market failure from earlier in this unit: a market fails when it allocates resources in a way that does not maximise social surplus, leaving a welfare loss. You also need allocative efficiency, price equal to marginal cost. Asymmetric information breaks it without touching costs, because it stops the price carrying honest information.

1The idea in one paragraph

A market only works if the price tells the truth, and the price of a used car can only say what that car is worth if both sides know what it is like. When one side knows something the other cannot check, the price is set on the wrong information, the wrong quantity is traded, and sometimes the wrong people trade at all. That is asymmetric information: two forms of it on the syllabus, adverse selection and moral hazard, and four responses, two from government and two from the market itself.

2What asymmetric information is

Asymmetric information exists when one party to a transaction has more, or better, information than the other, and the other cannot cheaply check it.

Asymmetric means unequal, not absent: one side in the dark while the other holds a torch. And cheaply matters, because a fact you could only find by stripping the engine is, in practice, hidden. Information runs either way, and Figure 1 shows both; say which way it runs in your example.

Figure 1 · Asymmetric information runs in one direction Figure 1 · Asymmetric information runs in one direction One side of the deal knows something the other side cannot check before paying. The seller knows more A second-hand phone. The seller has lived with the battery and knows it dies by lunchtime. The buyer sees only a clean screen. The buyer knows more A health insurance policy. The buyer knows about the cough that has lasted eight months. The insurer sees only an age and a postcode. Either way, the price cannot do its job, because it is set on the wrong information. Asymmetric information is not a lack of information. It is unequal information.
Figure 1 · Asymmetric information runs in one direction

This is a market failure because the price stops doing its job. If buyers cannot tell a sound phone from a worn one, they will not pay the sound phone's price, so sound phones are not supplied. Too little of the good thing is made and too much of the bad: allocative inefficiency, and the surplus lost is a welfare loss. That sentence turns a story about phones into an economics answer.

3Adverse selection

Adverse selection happens before the deal is agreed. One side knows a fact about quality, or about its own riskiness, and that hidden fact decides who is willing to trade at the going price. The people who agree are the ones the other side least wants.

Take second-hand phones. Half are sound and worth 280 to a buyer; half have a failing battery and are worth 120. A buyer who cannot tell them apart offers near the average, 200. Figure 2 follows that offer through.

Figure 2 · Adverse selection: the good phones leave first Figure 2 · Adverse selection: the good phones leave first Sellers know whether their phone is sound. Buyers cannot tell. Buyers will only pay a price for an average phone, say 200. Owners of sound phones are worth 280 and refuse to sell. They leave the market. Only the weaker phones are left, so average quality falls. Buyers work this out and cut their offer again. The market shrinks. Trades that would have made both sides better off never happen. The wrong sellers are selected into the market, so the market allocates too few resources to it.
Figure 2 · Adverse selection: the good phones leave first

The owner of a sound phone will not sell for 200 what is worth 280 to them, so they keep it. The owner of a weak phone gladly takes 200 for something worth 120. The stock on offer gets worse, buyers notice, the offer falls again. Trades that would have made both sides better off never happen, and that lost surplus is the welfare loss.

Insurance runs the same way with the roles swapped: whoever knows they are ill is keenest to buy, the insurer prices for the average, healthy people stay out, the remaining pool is sicker, so the premium rises again. The word adverse carries the idea. The selection of who ends up in the market goes against the uninformed side.

4Moral hazard

Moral hazard happens after the deal is agreed. One side takes an action the other cannot observe, and takes it differently because it no longer carries the full cost of that action.

Nobody has to be dishonest, which is why the name misleads. If a cost stops landing on whoever causes it, less care is taken. Figure 3 follows a bicycle policy.

Figure 3 · Moral hazard: the contract changes the behaviour Figure 3 · Moral hazard: the contract changes the behaviour Before the policy: you carry the cost of a stolen bicycle, so you buy the heavy lock and use it. You insure the bicycle for its full value. The cost of a theft now falls on the insurer, not on you. You leave it unlocked outside the shop, just this once, and then most days. Thefts rise. Premiums rise for every careful cyclist too. The insurer cannot watch you lock the bike, so the price of the policy cannot reflect how you behave.
Figure 3 · Moral hazard: the contract changes the behaviour

The same mechanism appears wherever one party acts for another and cannot be watched: a firm insured against fire spends less on sprinklers, a tenant who does not pay the water bill runs the tap longer. The failure is the same in kind. Insurers must charge a premium covering the extra risk, so careful people pay more than their behaviour warrants and some drop out. Too little insurance is bought, and resources go on thefts that care would have prevented.

5Telling the two apart

Examiners ask for both in one question because students swap them. One question sorts it, and Figure 4 draws it out.

Hidden fact before the deal is adverse selection. Hidden action after the deal is moral hazard.

Figure 4 · Which one is it? Ask when the problem happens Figure 4 · Which one is it? Ask when the problem happens One side knows more than the other. before the deal after the deal Adverse selection The hidden fact exists before anyone signs. It decides who agrees to the deal at all, and the wrong people are selected in. Ill buyers queue for insurance. Good cars stay home. Moral hazard The hidden action happens after signing. One side no longer carries the cost of its own choices, so those choices change. The insured bike is left unlocked. Hidden facts before the deal, hidden actions after it. Answer that question first, every time.
Figure 4 · Which one is it? Ask when the problem happens

Test it on a sentence. "Only people who already smoke buy the smoking-related cover." Before the deal: adverse selection. "Once covered, they smoke more." After: moral hazard. One market gives you both, and naming both and separating them cleanly is what the question wants.

6Government responses

The guide lists two. They are different things, so name the one you mean.

Legislation and regulation. The hidden fact is made illegal to hide, or the poor option illegal to sell: compulsory disclosure of a car's accident history, licensing, minimum safety standards, penalties for a false claim. Regulation works on the rules of the deal.

Provision of information. The government publishes what the buyer cannot see: hygiene grades in a restaurant window, a register of written-off vehicles, energy labels, school inspection reports. Provision works on the information itself, and leaves the choice with the buyer.

Both push the same way: the buyer can price the good properly, good sellers are no longer driven out, and the quantity traded moves back towards the allocatively efficient one.

7Private responses: signalling and screening

Markets do not sit still while information stays unequal, because both sides lose money from it. The guide names two market-made responses, and the difference is who moves.

Signalling is the informed side proving what it knows. The proof only works if a seller with a bad product could not afford to copy it: a three-year warranty is cheap on a sound phone and ruinous on a failing one. A qualification, an inspection certificate and heavy brand spending are signals for the same reason.

Screening is the uninformed side drawing the information out: a health questionnaire, or a large excess at a low premium offered beside no excess at a high premium, so the choice reveals the risk. A no-claims discount rewards a record you cannot fake; an employer sets a test; a buyer takes a test drive.

Figure 5 · The four responses the guide lists Figure 5 · The four responses the guide lists Government responses Private responses Legislation and regulation Make the hidden fact illegal to hide. Licensing, minimum standards, compulsory disclosure, a cooling-off period, penalties for a false claim about a product. Provision of information Publish what the buyer cannot see. Hygiene grades in the window, a public register of written-off cars, energy labels, published school inspection reports. Signalling The side that knows proves it. A two-year warranty, an independent inspection certificate, a qualification, money spent building a brand. Screening The side that does not know digs. A health questionnaire, a no-claims discount, an excess on the policy, a test drive, an interview. Government works on the information itself. Private responses work on who has a reason to reveal it.
Figure 5 · The four responses the guide lists

Figure 6 is the one to keep in your head, because swapping the two is a standing loss of marks.

Figure 6 · Signalling and screening: who makes the move Figure 6 · Signalling and screening: who makes the move Informed side knows the hidden fact Uninformed side cannot check it signal Informed side knows the hidden fact Uninformed side cannot check it screen Signalling: the seller pays for a warranty a bad seller could not afford. Screening: the insurer offers two policies and watches which you pick. The shaded box is the side that acts. Get that the wrong way round and the mark is gone.
Figure 6 · Signalling and screening: who makes the move

8How well do the responses work?

Part (b) marks are won here, so hold a judgement rather than a list.

Regulation is strong where the hidden fact is dangerous and easy to define, such as a hygiene standard. It costs money to monitor, it can be written by the industry it regulates, and a firm can obey a rule to the letter while the buyer learns nothing.

Provision of information is cheap and leaves choice intact, which is why governments reach for it first. It assumes people read and understand what is published, and a long disclosure hides a fact as well as silence does.

Signalling and screening need no government spending, but both use resources that produce nothing: the warranty administration, the questionnaire, the extra year of study taken to prove ability rather than gain it. Screening can also be blunt, refusing a whole group because that group's average is risky, which raises equity as well as efficiency.

None of the four removes the problem, and which is best depends on how large the harm is, how cheaply the information can be published, and whether buyers can act on it.

9Where marks are lost

Treating asymmetric information as no information. It is unequal information. Say who knows and who does not, in that order, in your first sentence.

Swapping adverse selection and moral hazard. Run the before-and-after test from section 5 before writing anything.

Thinking moral hazard means immoral behaviour. It is about who carries the cost of an action.

Getting signalling and screening the wrong way round. The informed party signals; the uninformed party screens.

Drawing a supply and demand diagram out of habit. The syllabus names no diagram here, and one you never refer to earns nothing.

Stopping at the story. A broken phone is not yet economics. Finish the chain: wrong information, wrong quantity traded, allocative inefficiency, welfare loss.

Listing responses without judging them. That line is assessed at AO3, so four responses described and none weighed cannot reach the top band.

10Write it right

Nothing to draw here, so the marks sit in the shape of the writing.

  1. Define asymmetric information: one party knows more and the other cannot check it.
  2. Name the market and who holds the hidden information.
  3. Name which form it is, and justify that by saying whether the problem sits before or after the agreement.
  4. Trace the consequence to the quantity traded, then use the words the question is marked against: allocative inefficiency, welfare loss, market failure.
  5. For a response, name it from the syllabus list, say what it changes, then how well it works.
  6. In part (b), judge, and say what it depends on. "It depends on" plus a condition beats a second example.

11Try it

Marks in brackets. Answers and marker's notes are at the end. Do them before you look.

Q1. Define the term moral hazard. 2 marks

Q2. Using an example, distinguish between adverse selection and moral hazard. 4 marks

Q3. Explain how signalling and screening differ as responses to asymmetric information. 4 marks

Q4. Evaluate the view that providing information is the most effective government response to asymmetric information. 15 marks

12In one breath

One side of a deal knows something the other cannot check, so the price is set on the wrong information and the market trades the wrong quantity: allocative inefficiency and a welfare loss. Adverse selection comes before the deal and decides who agrees to trade at all, so good cars and healthy customers leave. Moral hazard comes after, when someone stops carrying the cost of their own actions and takes less care. Governments respond with legislation and regulation, changing the rules, and with provision of information, changing what buyers know. Markets respond by themselves: signalling, the informed side proving its quality, and screening, the uninformed side drawing the truth out. All four help, none finishes the job, and which works best depends on the market.

Answers

Q1. Moral hazard is the tendency of one party to change its behaviour, taking more risk or less care, after a transaction has been agreed, because it no longer carries the full cost of that behaviour and the other party cannot observe the action. one mark for behaviour changing after the agreement, one for the reason, that the cost has been transferred or the action cannot be observed. "Acting immorally" scores 0.

Q2. Adverse selection happens before an agreement: a hidden fact decides who is willing to trade at the going price. An insurer who cannot tell a healthy applicant from an ill one charges an average premium; ill applicants buy, healthy ones stay out, so the insured pool is worse than average. Moral hazard happens after the agreement, when the insured party changes behaviour: once covered, the same person may skip the check-ups that would catch a problem early, because the insurer pays for the treatment. 1 for adverse selection placed before the agreement, 1 for moral hazard placed after it, 1 for a correct example of each. Two correct definitions with no example is capped at 2.

Q3. Signalling is done by the party that holds the information: a costly, credible action that proves quality, such as a manufacturer offering a long warranty that would be too expensive to honour on a poor product. Screening is done by the party that lacks it: a test or a choice that makes the other side reveal what it knows, such as an insurer offering a large excess at a low premium beside no excess at a high premium, and reading the applicant's risk from which is taken. 1 for signalling as the informed party's action, 1 for screening as the uninformed party's action, 1 for a valid example of each. Reversing the two parties scores 0 for that half, however good the example.

Q4. A plan, because part (b) is marked against level descriptors rather than a list of points. Define asymmetric information and say why it causes allocative inefficiency. Explain provision of information with one example carried through: hygiene grades in restaurant windows let buyers tell a clean kitchen from a dirty one, so clean kitchens are no longer undercut and their sales rise towards the efficient level. Weigh it: cheap next to enforcement and it leaves choice intact, but it works only if people read and understand it, and it does nothing about moral hazard, where the problem is a hidden action. Compare one alternative, such as regulation, which forbids the harmful option outright but costs more and removes choice. Judge conditionally: provision of information is strongest where the hidden fact is easy to publish and buyers can act on it, weakest where the problem is a hidden action or the harm is too severe to allow a wrong choice. no per-mark ticks; the band turns on whether the economics is explained rather than asserted, whether the example is carried through, whether alternatives are compared rather than listed, and whether the judgement says what it depends on.

Educerie · written from the published IB Diploma Programme Economics guide, first assessment 2022, section 2.10 Market failure—asymmetric information. Original text, examples and questions. Diagrams drawn by Educerie. Last reviewed 10 September 2026.

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