How do information gaps and the merit and demerit distinction cause markets to misallocate resources?
1.3 Information failure: imperfect and asymmetric information, moral hazard and adverse selection, and merit and demerit goods leading to under-consumption or over-consumption.
An OCR H460 answer to information failure, covering imperfect and asymmetric information, adverse selection and moral hazard, and how merit goods are under-consumed and demerit goods over-consumed because individuals misjudge their true costs and benefits.
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What this dot point is asking
OCR wants you to explain information failure (imperfect and asymmetric information), to describe adverse selection and moral hazard, and to explain why merit goods are under-consumed and demerit goods over-consumed, recognising that the merit and demerit label rests on a value judgement.
Information failure
Imperfect information is a general lack of full information affecting all parties (few of us know the true long-term effect of our diet). Asymmetric information is more specific: one party to a transaction has more or better information than the other, which can be exploited.
Adverse selection and moral hazard
These problems are why insurers screen and price by risk, why lenders demand collateral, and why governments regulate disclosure (food labelling, financial product information).
Merit and demerit goods
On a diagram, a merit good has marginal private benefit below the marginal social benefit that fully informed individuals would perceive, so the market consumes too little. A demerit good has the reverse. The merit and demerit classification rests on a value judgement about what consumption "should" be, so it is normative, which is why these labels are sometimes disputed.
Examples in context
- Pensions. UK auto-enrolment (from 2012) tackled the information gap and present bias behind under-saving, raising workplace pension participation from around 55 per cent to over 88 per cent of eligible employees.
- Health screening. People under-use free NHS health checks because they underestimate the benefit of early detection, a classic merit-good information failure.
- Used cars and insurance. The lemons problem and moral hazard are the textbook illustrations of asymmetric information and why warranties and risk-based premiums exist.
Try this
Q1. Distinguish between adverse selection and moral hazard. [4 marks]
- Cue. Adverse selection: before the transaction, worst risks or lowest quality dominate; moral hazard: after, the protected party takes more risk.
Q2. Explain why a merit good is under-consumed in a free market. [4 marks]
- Cue. Information failure or present bias means individuals undervalue long-term private and external benefits, so they consume less than the optimum.
Exam-style practice questions
Practice questions written in the style of OCR exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
OCR H460/01 20205 marksExplain, using an example, how asymmetric information can lead to market failure.Show worked answer →
A short structured question. Define asymmetric information as a situation where one party to a transaction has more or better information than the other.
Develop a chain of reasoning with an example. Used cars: sellers know the quality of their car but buyers cannot tell good cars from bad. Buyers offer only an average price, so owners of good cars withdraw them, leaving mainly bad cars (the lemons problem, a form of adverse selection). The market unravels and welfare falls. Alternatively, insurance: once insured, people take more risk (moral hazard), raising costs.
Markers reward a clear definition, a named mechanism (adverse selection or moral hazard), and a worked example showing the misallocation.
OCR H460/01 202312 marksAssess the view that information failure is the main reason merit goods are under-consumed in a free market.Show worked answer →
A levels-of-response question. Knowledge and application: define a merit good (under-consumed because individuals undervalue its long-term private and external benefits) and information failure (imperfect information about those benefits). Apply to pensions or health checks, where present bias and poor information cause under-saving and under-use. Draw MPB below MSB with under-consumption.
Analysis: explain how better information or nudges (auto-enrolment, health campaigns) raise consumption toward the optimum.
Evaluation: weigh information failure against positive externalities (the external benefits the individual ignores even with full information) and affordability or access. Conclude that information failure is a major but not the sole cause; the merit-good label also rests on a normative value judgement. A supported judgement reaches the top level.
Related dot points
- 1.3 Externalities: positive and negative externalities of production and consumption, the divergence of private and social costs and benefits, the welfare loss, and the social optimum.
An OCR H460 answer to externalities, covering positive and negative externalities of production and consumption, the divergence of private and social costs and benefits, the welfare loss triangle, and how the social optimum differs from the free-market outcome.
- 1.3 Public goods: the characteristics of non-rivalry and non-excludability, the free-rider problem, quasi-public goods, and why public goods cause complete market failure.
An OCR H460 answer to public goods, covering the defining characteristics of non-rivalry and non-excludability, the free-rider problem, quasi-public goods, and why pure public goods cause complete market failure and are funded by the state.
- 1.3 Government failure: the causes of government failure including distorted price signals, unintended consequences, information gaps and administrative costs, and the case for and against intervention.
An OCR H460 answer to government failure, covering why intervention to correct market failure can leave society worse off, through distorted price signals, unintended consequences such as black markets, government information gaps and excessive administrative costs.
- 1.3 Methods of intervention: indirect taxes and subsidies, the incidence of tax and elasticity, maximum and minimum prices, tradable pollution permits, regulation, state provision and information provision.
An OCR H460 answer to government intervention methods, covering indirect taxes and subsidies, the incidence of an indirect tax and how elasticity splits the burden, maximum and minimum prices, tradable pollution permits, regulation, state provision and information provision.
Sources & how we know this
- OCR A Level Economics (H460) Specification — OCR (2023)