Information failure does not need a third-party spillover.
Information failure can make choices diverge from those people would make with accurate information. Buyers may underestimate a long-term private cost or benefit, so perceived marginal values differ from actual values. Explain the information gap and the resulting quantity error. This differs from an externality, where an effect on third parties is left out even if the buyer understands their own interests.
- Perceived values
- Perceived benefit or cost is what people believe they will gain or lose. Inaccurate information can make that assessment wrong, even when nobody outside the transaction is affected.
- Actual values
- Compare the chosen quantity with what accurate information would support. Overstating a benefit can lead to too much consumption; understating it can lead to too little.
- Separate cause
- An information failure concerns a mistaken decision about benefits or costs. An externality concerns an unpriced effect on others. One market can have both, but one does not prove the other.
Two directions of mistaken choice
Overstated benefit or understated cost
A mistaken private assessment can produce too much consumption relative to the informed outcome.
Understated benefit or overstated cost
A mistaken assessment can produce too little. Reliable evidence and understandable education can move perceived values closer to actual ones.
Merit and demerit labels
Merit and demerit labels describe arguments that a good is consumed too little or too much. Explain the underlying information error, externality or both; the label alone does not establish the cause or the diagram.
Information diagram
Separate perceived MPB from actual MPB when using a benefit example, and state whether actual private benefit equals social benefit. Do not add a third-party benefit without evidence.
Worked example: An overstated benefit
Buyers believe a product provides benefits described by perceived MPB = 16 - 0.1 Q. Reliable evidence gives actual MPB = 12 - 0.1 Q. MPC = $4 per unit and there are no external effects.
- Using the perceived benefit, 16 - 0.1Q = 4 gives 12 = 0.1Q, so buyers choose Q = 120 in this model.
- With accurate information, 12 - 0.1Q = 4 gives 8 = 0.1Q, so Q = 80. Between 80 and 120, actual benefit is below cost.
- Correcting the claim can reduce perceived willingness to pay towards the actual benefit relationship and reduce overconsumption.
- The loss arises from inaccurate private information, not harm to third parties. A tax that changes price without fixing the false claim addresses a different channel.
Watch out for this
An information failure is just another name for an externality.
One concerns mistaken information in a private decision; the other concerns an unpriced effect on others. Both can occur in one market, but identify them separately.
Check your understanding
A buyer underestimates the benefit of preventive maintenance to their own machine. No one else is affected. What is the stated problem?
- Information failure about a private benefit.
- A positive externality simply because maintenance is useful.
- A public good because information is involved.