Information Failure

For markets to allocate resources efficiently, decision-makers require complete, accurate, and accessible information. If all buyers and sellers in a market had the same knowledge about prices, product quality, and future market conditions, then choices could be made rationally and resources would be directed to their most valued uses. In practice, however, there are many markets in which information is incomplete, unavailable, or unevenly distributed between participants. This problem is called information failure, and it is a key source of market failure. Information failure occurs when market participants lack sufficient, accurate, or complete information to make optimal decisions, resulting in inefficient resource allocation and, consequently, market failure.

When consumers lack accurate information, they may purchase products that do not give them the benefits they expect, or they may fail to consume goods and services that could have brought them large benefits. On the producer side, firms may not be able to judge consumer demand correctly if they cannot observe willingness to pay or assess how demand is likely to change in the future. In both cases, resources are misallocated, because decisions are not based on the full social costs and benefits of consumption and production.

Information failure itself is subdivided into several types, including asymmetric information, adverse selection, moral hazard, as well as merit and demerit goods and public and quasi-public goods.

A particular type of information failure is called asymmetric information. This occurs when one party in a transaction has better or more complete information than the other. In such situations, the informed party can exploit the less informed party, and the outcome is unlikely to match the socially optimal allocation of resources. Asymmetric information can occur in many markets, from healthcare and education to insurance and second-hand goods. Each case shows how serious misallocations can arise when knowledge is unevenly shared.

Healthcare

Healthcare provides a clear example of information failure caused by asymmetry between doctors and patients. Suppose a patient visits a dentist for a routine check-up. The dentist advises that a filling must be replaced. The patient, however, has experienced no pain and has no way of verifying whether the treatment is actually necessary. Because the dentist possesses much greater knowledge of medical conditions than the patient, the dentist can recommend treatment that may not be strictly required. The patient must either accept the advice or face the cost and difficulty of obtaining a second opinion.

In this situation, the dentist has an incentive to increase revenue by recommending additional treatment, while the patient cannot easily challenge the advice. This imbalance creates an inefficient outcome: patients may pay for services that provide little or no additional health benefit. The Office of Fair Trading has criticised some private dentists for this practice. The fundamental cause is that dentists have far better information about the true medical situation than patients. This gap in knowledge produces misallocation, as consumers pay for services that do not match their real needs.

The same issue arises in other areas of healthcare. Doctors may withhold or fail to disclose treatment prices until after services have been carried out. Patients cannot compare prices across providers if this information is hidden. Without transparency, patients are unable to make informed choices, and the market outcome diverges from efficiency. The presence of asymmetric information in healthcare demonstrates how information failure can prevent consumers from obtaining the best treatment at the lowest possible cost, while simultaneously allowing providers to earn excess profits.

Education

Education provides another example of market failure linked to information problems. In education, the asymmetry exists between teachers, inspectors, or government planners on the one hand, and students or parents on the other. Education authorities have more information about which subjects and skills are valuable in the long term. Students, however, may not fully appreciate the importance of compulsory subjects such as mathematics and statistics when they first encounter them. They may regard these topics as excessively difficult or irrelevant, and only later in their lives will they recognise their usefulness.

For example, economics students at university often realise in their second or third year that mathematics and statistics are critical to understanding complex models, even though they might have resisted studying these subjects earlier. By the time they make this discovery, it is often too late to go back and change their earlier choices. This lag in understanding illustrates the information failure: students lacked sufficient knowledge at the moment when their educational decisions mattered most.

How might policymakers address this failure? One response is to ensure that the curriculum compels students to take certain key subjects, even if they would not have chosen them voluntarily. By mandating such study, government authorities are using their superior knowledge of long-term needs to correct the students’ underestimation of benefits. Another approach is to provide better information to students and parents about the long-term returns to education, so that they can make decisions that align more closely with social benefits.

The key point is that private decisions about education tend to underestimate its future benefits. The perceived marginal private benefit of education is lower than the true marginal social benefit. As a result, too little education is demanded compared with the socially optimal quantity. This underconsumption mirrors the logic of a positive consumption externality, but it originates from lack of knowledge rather than from the non-internalisation of spillovers. It shows how closely linked externalities and information failure can be.

Second-hand Cars

Another famous case of asymmetric information is the market for second-hand cars. The economist George Akerlof analysed this problem in his well-known paper on the "market for lemons." In the used car market, sellers have far more information than buyers about the quality of vehicles. A seller knows whether a car has a history of breakdowns or defects, but a buyer cannot easily verify this information.

This imbalance creates a severe problem. Because buyers cannot tell whether a car is high quality or a "lemon" (a defective car), they are only willing to pay a price that reflects the average quality of cars on the market. Sellers of good-quality cars, who know their cars are worth more, will not accept this low average price and will withdraw from the market. As a result, the share of lemons in the market increases, driving down the average quality further and further. The eventual outcome may be that only poor-quality cars are traded.

This demonstrates how asymmetric information can cause a market to collapse entirely. Potential gains from trade are destroyed because buyers cannot trust sellers. The used car example is powerful because it shows how the absence of reliable information can remove high-quality products from the market, leaving only poor-quality ones. This is an extreme form of market failure, where resources are wasted and consumer welfare declines sharply.

Pensions

Pensions provide another case where lack of information leads to inefficient outcomes. Planning for retirement requires individuals to make complex decisions about saving and investment, often decades in advance. Most people lack the financial expertise to assess how much they should save, what kind of pension product to buy, or how future inflation and interest rates will affect their wealth.

Asymmetric information in this market arises because pension providers and financial institutions know much more about investment products than ordinary savers. Individuals face uncertainty about their future health, longevity, and income needs. Because these factors are complex and difficult to predict, many people under-save or choose inappropriate pension schemes. Some fail to join pension schemes altogether, assuming they will manage in the future, only to find themselves in poverty during old age.

In this case, information failure undermines individual welfare and creates social problems. When too many people are inadequately prepared for retirement, the government must intervene through public pensions or social security. The root cause of this failure is that individuals cannot access or process the complex information required to make efficient decisions about their future financial security.

Adverse Selection and Moral Hazard

Adverse selection is a market situation where asymmetric information results in a party taking advantage of undisclosed information to benefit more from a contract or trade. For example, in the insurance market, adverse selection is a situation in which a person at risk is more likely to take out insurance. Insurance involves contracts where one party transfers risk to another. For this to work efficiently, insurers need accurate information about the riskiness of individuals. However, in many cases, the insured individuals have more information about their own behaviour and health than the insurer.

This asymmetry leads to two major problems. The first is adverse selection. This occurs when people who are most likely to make claims are also the most likely to buy insurance. For example, individuals with poor health may be especially keen to purchase health insurance, while healthy people opt out. The insurer cannot perfectly distinguish high-risk from low-risk customers, so the pool of insured individuals contains disproportionately high-risk clients. Premiums must rise, and as they do, even more healthy people drop out of the market, worsening the imbalance. The final result may be that only the highest-risk individuals remain, causing the insurance market to shrink or collapse.

The second problem is moral hazard. Moral hazard is a situation where one party takes on more risk because another party will bear the cost of that risk. For example, using the insurance market analogy, it would arise when an individual who is insured changes their behaviour because they are protected from the consequences of risk. For example, a driver with comprehensive car insurance may take less care when parking, or someone with health insurance may take fewer precautions with diet or exercise. Because the cost of risky behaviour is shifted to the insurer, individuals engage in more of it. Insurers may respond by raising premiums, but this further distorts the market and reduces efficiency.

Both adverse selection and moral hazard show how asymmetric information damages the efficiency of insurance markets. In the first case, high-risk individuals disproportionately buy insurance, undermining the stability of the market. In the second case, insured individuals behave more recklessly because they know they are covered. In both cases, resources are misallocated because premiums and coverage no longer reflect true risks. This leads to higher costs and inefficiency for society as a whole.

Merit Goods

A merit good is a good that society believes will be under-consumed if left entirely to the free market because consumers do not realize/anticipate the full benefits of consumption. The defining feature of a merit good is that individuals do not fully recognise or appreciate the benefits of consuming it. This can be because of limited information, short-term thinking, or lack of understanding about long-term outcomes. As a result, the private demand for the good falls short of the level that would maximise social welfare.

In economic terms, the marginal private benefit (MPB) curve, which reflects the willingness of individual consumers to pay, lies below the marginal social benefit (MSB) curve, which represents the full benefit to society. The divergence between MPB and MSB means that the free market equilibrium quantity is less than the socially optimal quantity. Merit goods are therefore systematically under-consumed, which creates a welfare loss for society.

The reason merit goods are linked to information failure is that individuals often underestimate the long-term returns or the external benefits that others gain from their consumption. By contrast, government or policymakers are thought to be in a better position to evaluate these benefits, since they have access to broader information about the impact of education, healthcare, or cultural institutions on society as a whole. This is why governments frequently intervene to increase consumption of merit goods, either by providing them directly, subsidising them, or making their consumption compulsory.

Why Merit Goods Are Undervalued

The undervaluation of merit goods comes from the gap between perceived benefits and actual benefits. Individuals, acting on the basis of private information, decide how much of a good to consume by comparing their private benefit with the cost. If the perceived private benefit is lower than the true social benefit, they will demand too little.

For example, a student may see only the immediate cost and effort of attending school and undervalue the long-term gain of higher earnings and broader opportunities. A patient may see only the inconvenience of vaccinations without recognising the collective benefit of herd immunity. In both cases, individuals base decisions on narrow private perspectives, while ignoring the wider social impact.

This divergence means that the demand curve in the free market, which is based on MPB, lies below the socially optimal demand curve represented by MSB. The result is that equilibrium consumption in the free market is at Q rather than Q*, where Q* represents the quantity that would equate MSB with marginal cost. Society as a whole is worse off, because some beneficial consumption that could have produced gains exceeding costs never takes place.

Education as a Merit Good

Education is one of the most widely discussed examples of a merit good. In the UK, attendance at school is compulsory until the age of 16. The reason for this is that government believes education has benefits that exceed those perceived by individuals. Students may see only the immediate effort and sacrifice required to attend school, while failing to appreciate the significant future gains.

From a private perspective, education increases individual productivity, raises lifetime earnings, and improves employment opportunities. From a social perspective, education provides additional benefits in the form of technological progress, civic engagement, lower crime, and higher overall economic growth. The divergence between MPB and MSB is therefore very large. Because students and parents often underestimate the full return to education, they demand too little when left to their own decisions.

The diagram for education as a merit good shows the supply curve, labelled MC = MSC, an MPB demand curve, and a higher MSB curve above it. The free market equilibrium is at quantity Q, where MPB intersects MC. The socially optimal equilibrium is at Q*, where MSB intersects MC. The shaded triangle between Q and Q* represents the welfare loss caused by underconsumption. Society misses out on the gains that could have been achieved if more people had been educated.

Government corrects this problem in two main ways. First, it makes education compulsory up to a certain age. Second, it provides education free at the point of use, funded by taxation. These measures ensure that consumption of education reaches closer to Q*, the socially optimal level, rather than being stuck at Q. In addition, governments may subsidise higher education, recognising that the social benefits of an educated workforce extend far beyond the private benefits enjoyed by individuals.

Other Merit Goods

Although education and healthcare are the most prominent examples, other merit goods exist. Museums, libraries, and galleries are often subsidised or provided free because governments believe they generate cultural and social benefits that exceed the private benefits perceived by individual visitors. Without intervention, fewer people would consume these services, and society would be deprived of their positive externalities.

This raises an important point about merit goods. Identifying them involves a value judgement by policymakers. Deciding that a good is a merit good means believing that society benefits more from its consumption than individuals would recognise privately. Some critics argue that this approach is paternalistic, since it assumes government knows better than individuals. Others argue that it is justified, because individuals often act on short-term preferences while ignoring long-term welfare.

Economically, however, the logic is clear: wherever MSB exceeds MPB, the free market will produce underconsumption. The shaded welfare loss triangle on the diagram represents the missed opportunities for society. By subsidising or providing merit goods directly, government policy seeks to reduce this welfare loss and bring consumption closer to the optimal level.

Demerit Goods

A demerit good is defined as a good is likely to be overconsumed because the consumers do not anticipate the lack of benefits from consumption. The essence of the concept lies in information failure. Individuals make consumption decisions based on their own perceived private benefits, but they do not take account of the true costs to themselves or to society. The result is that their willingness to pay overstates the real value of the good, and demand is excessive relative to what is socially optimal.

From an analytical perspective, this means that the marginal private benefit (MPB) curve lies above the marginal social benefit (MSB) curve. The gap between these two curves represents the extent to which consumers overvalue the good because of misperceptions, addiction, or lack of awareness of long-term harm. The supply curve is labelled MC = MSC, because producers’ private costs are assumed to be equal to the costs to society. Market equilibrium occurs where MPB intersects MC, but the socially optimal equilibrium occurs where MSB intersects MC, at a lower quantity.

Diagram of a Demerit Good

The diagram shows that in the free market equilibrium, the good is consumed at quantity Q1 and price P1. At this point, individuals are making decisions based on MPB, the benefits they think they are gaining. However, because the true social benefit is lower, represented by the MSB curve, the socially optimal equilibrium is at Q*, where MSB intersects MC. The shaded triangle between Q1 and Q* represents the welfare loss from overconsumption. Each unit consumed between Q* and Q1 generates more social cost than social benefit.

Drugs as a Demerit Goods

An explicit example is the consumption of hard drugs. Individuals who choose to consume drugs perceive immediate private benefits such as pleasure or relief from stress. Their willingness to pay reflects these perceived gains. This is why the MPB curve is relatively high. However, the true benefits are far lower when judged from society’s perspective because drug use creates severe negative consequences including health deterioration, the risk of addiction, reduced workplace productivity, and costs imposed on families and communities. These harms mean that the MSB curve lies below the MPB curve.

In a free market where cocaine consumption were unrestricted, the market equilibrium would be at Q1, where MPB intersects MC. At this point, the level of consumption is determined entirely by what individuals think the good is worth to them. But the socially optimal outcome, which considers the real costs and reduced benefits, is at Q*, where MSB intersects MC. At this lower level of consumption, the net social benefit would be maximised.

The shaded welfare loss triangle between Q* and Q1 shows the scale of inefficiency. Every unit of cocaine consumed beyond Q* produces more social cost than social benefit. For example, a single additional purchase may provide the user with short-lived enjoyment, but it also creates healthcare costs, risks of dependency, and potential social disruption that outweigh any benefit. The overconsumption of cocaine is therefore a textbook example of market failure caused by information failure and misperceived benefits.

Why This Is Market Failure

Demerit goods illustrate market failure because private decision-making does not align with what is best for society. Consumers act on distorted perceptions of benefit, so the market equilibrium quantity diverges from the socially optimal quantity. The welfare loss triangle quantifies the extent of this misallocation.

Public Goods

Markets often fail to provide certain goods and services even though society values them highly. These are known as public goods. A public good is defined by three main characteristics: non-excludability, non-rivalry, and non-rejectability.

Non-excludability is a situation in which it is not possible to provide a product to one person without allowing others to consume it as well.

Non-rivalry is a situation in which one person's consumption of a good does not prevent others from consuming it as well.

Non-rejectability is a situation in which an individual cannot avoid consuming a good.

For example, city lights - one cannot be prevented from consuming light emitted once provided (non-excludability), there's no limit to the amount of light that one individual can consume, and it doesn't prevent others from receiving the same light (non-rivalry), and if walking along a pavement, one cannot choose not to receive light (non-rejectability).

These features mean that once the good is provided, it is available to everyone regardless of whether they have paid for it, and one person’s use does not reduce the amount available for others. Because private firms cannot capture enough revenue from selling such goods, they have no incentive to provide them, and as a result, public goods are systematically under-provided or not provided at all in a free market.

Private versus Public Goods

Before defining public goods more carefully, it helps to contrast them with private goods. A private good is excludable and rivalrous. This means that a producer can prevent someone from using it unless they pay, and consumption by one person reduces the quantity available for others. For example, a loaf of bread is a private good. A baker can exclude people who do not pay by refusing to sell them the bread, and once a loaf is eaten by one consumer, it cannot be consumed by another.

Public goods are very different. They are non-excludable. Once they are supplied, it is impossible or very costly to prevent people from consuming them. They are also non-rivalrous. One person’s use of the good does not reduce the amount available to others. A simple example is a lighthouse. Once it is built and operating, ships at sea cannot be excluded from benefiting from its light, and one ship’s use of the light does not diminish its usefulness to other ships. Because no one can be prevented from consuming the good and because everyone can benefit at the same time, private firms find it impossible to charge directly for its use.

This means that if a good has the features of a public good, the market mechanism fails. No private firm can supply it profitably, because there is no way to guarantee payment. Left entirely to the free market, such goods would be absent despite the fact that they provide great value to society.

The Free Rider Problem

The free rider problem arises when people can benefit from a good without contributing to its cost. If no one can be excluded from consumption once the good is provided, many individuals have an incentive to withhold payment in the hope that others will pay for it instead. Since everyone thinks this way, the outcome is that too few people are willing to contribute, and the good is not provided at all.

Consider national defence. Every citizen benefits equally from being protected from invasion, but if defence were left to private subscription, many people would choose not to pay, reasoning that they will still be protected if others pay. As more people refuse to pay, total revenue falls short of what is needed to provide defence in the first place. The same logic applies to flood barriers or lighthouses. Because no one can be excluded and everyone benefits regardless of contribution, the free rider problem ensures that markets will fail to supply the good.

The result is a clear case of market failure. Even though the marginal social benefit of public goods is high, no private firm can recover the cost of producing them. The free rider problem prevents voluntary contributions from covering the cost. This explains why governments must intervene to provide public goods directly out of taxation.

Quasi-Public Goods

Some goods display characteristics of both public and private goods. These are called quasi-public goods. They are partly excludable and partly rivalrous, but not completely. For example, roads are often described as quasi-public goods. In normal circumstances, one person’s use of a road does not reduce the ability of others to use it, so roads are largely non-rivalrous. However, once traffic congestion sets in, additional users reduce the quality of use for others, making the good rivalrous. Similarly, while it is often difficult to exclude people from using a road, tolls can be introduced to restrict access, making it excludable.

Because quasi-public goods have mixed characteristics, they are sometimes provided privately and sometimes publicly. The extent to which government must intervene depends on whether exclusion is practical and whether rivalry arises at certain levels of consumption.

Public Goods Provision

Given the characteristics of public goods and the free rider problem, private firms cannot supply them efficiently. Governments therefore play a crucial role in ensuring provision. Funding comes from taxation, which ensures that all citizens contribute to the cost, whether they would have chosen to pay voluntarily or not. The use of taxation overcomes the free rider problem, because exclusion is no longer relevant: everyone pays through compulsory contributions.

Examples of public goods provided by governments include national defence, policing, flood defences, street lighting, and many aspects of environmental protection. In each case, the combination of non-excludability and non-rivalry means that without state intervention, the good would be severely under-provided. By providing these goods, governments reduce welfare loss and move society closer to the socially optimal allocation of resources.