The following article is an excerpt from my latest book, “Real World Economics: Detailed Examples For IB Diploma“, now available for purchase at Amazon’s books store.
The book is also a complementary resource for my students – contact me to enquire about my lessons on Economics.
Case 1: The seller knows more than the buyers
Example:
The car market (new and used) in the USA: Cars are complex machineries, with potential issues and hazards that buyers may not be aware of at the time of purchase. Aside from the risks of purchasing a problematic car, high-quality used cars may also be adversely eliminated from the market.
Government response: Legislation and regulation
The National Highway Traffic Safety Administration (NHTSA) requires that all new vehicles sold comply with the Federal Motor Vehicle Safety Standards (FMVSS). These specify mandatory minimum safety requirements for the design, construction, performance and durability of vehicles, as well as regulated automobile safety-related components, systems and design features.
By forcing new-car sellers to certify their cars as FMVSS-compliant, the true state of the vehicle sold would converge with the buyer’s expectations for safety.
The effectiveness of the FMVSS can be indirectly determined by the lack of similar certifications for used cars. For example, in 2024, substandard airbags in used cars have killed at least 3 people in the USA. These airbags were installed as non-manufacturer replacements, and would not have passed the FMVSS tests.
On the other hand, the FMVSS standards can unwittingly pose additional barriers to entries for vehicle manufacturers attempting to sell vehicles in the USA, as they are not one-to-one with UN regulations (World Forum for Harmonization of Vehicle Regulations).
Government response: Provision of information
The Federal Trade Commission (FTC) requires that used cars sold in the USA must display the “Buyers Guide” which is a structured form filled out by the seller and contains information such as the problems to look out for, and details of the major mechanical and electronic systems of the car.
However, even the Buyers Guide does not give the complete information about the true state of the used car, due to its onerous nature and the principle that used cars can be assumed to have potential problems due to wear-and-tear amongst other reasons.
Tellingly, the FTC recommends that the buyer pays for an independent mechanic to conduct a mechanical inspection of a used car for a more thorough assessment, suggesting limitations to how much standardizations on the provision of information can be imposed on the used car seller, to avoid excessive government interventions in the market that may lead to higher prices on used cars.
Private response: Signaling
Used car sellers in the USA often sell a category of used cars known as Certified Pre-Owned (CPO) cars. These cars are sold at a higher price, but have been certified by the dealer to the specification of the car manufacturer. Further assurance is frequently provided with extended warranty and the vehicle’s history report at no additional cost.
The effectiveness of signaling as a way to allow buyers to willingly pay higher prices and eliminating a “missing market” of high-quality used cars, depends on the trust that buyers have in the certification process.
Although there is indeed risk that car sellers may certify used cars in less-than-truthful ways, given that the certification process is neither mandated nor with strict guidelines, it is assumed that used car sellers with good reputation will have an incentive in ensuring that the expectations of buyers are aligned with the true state of the used car.
Private responses: Screening
Buyers can “screen” the seller’s products by gathering more information about the seller and the product. A common way to do so in the used market, is by word of mouth from other satisfied buyers, or independent survey platforms such as Trustpilot.
On the other hand, the amount of information available about the seller tends to beget more sales, and thus more buyers’ information. This eventually leads to barriers to entry for new sellers and the monopolization of the market by established players.
It is also not uncommon for sellers to manipulate the screening information by participating in the process undercover, or paying people to provide more desirable about the used car. The awareness of such a problem, can be seen in polls suggesting that globally, more than 80% of people worry about the extent of online disinformation.
Case 2: The buyer knows more than the sellers
Example:
The healthcare insurance market in Singapore: Individuals generally know about their true state of health, more than the insurance providers. Healthy individuals then tend to be under-insured through adverse selections.
Government response: Direct provisioning for the market
Singapore’s MediShield Life is a basic health insurance scheme that provides Singapore Citizens and Permanent Residents with universal and lifelong protection against large healthcare bills, regardless of age or health condition.
A common concern with government-provisioned markets is the potentially large expenditure on taxpayers. A trade-off is therefore inevitable between the government expenditure and the extent to which the government is willing to pay.
An individual’s MediShield Life premium is paid from a special account called the Medisave, which is topped-up from the individual’s income, and supplemented with government top-ups from time to time, and MediShield premium subsidies.
To ensure the sustainability of this insurance scheme, there is a claim limit of $150k per annum for the individual. In 2024, it was reported that up to 2 in 10 hospitalization bills exceeded the MediShield Life’s coverage despite government subsidies, illustrating the potential high costs of healthcare that the government must either pay substantially more for, or risk insufficient insurance coverage. This was also on top of various restrictions such as individuals being unable to opt for higher-end hospitalization care to control costs.
Private response: Screening
Health questionnaires are a common way for healthcare insurance providers, not just in Singapore, to gather more information about the buyer’s true state of health, to close the asymmetric information gap.
There is a strong incentive for the individual to under-declare potential health issues as the insurance premium is directly related to the estimated healthcare requirements. This is despite Singapore laws permitting the insurer to nullify its insuring obligation to an individual if he or she was found to have failed to declare the true state of health in good faith.
JC Econs 101 