Here is a question and answer from the financial sector topic within the A-level Economics syllabus.
Explain how asymmetric information in the banking system may lead to market failure.
Model answer guidance (full model answer here)
To answer this question, you will need to define the term “asymmetric information” and “market failure”. You will then want to show the chain of reasoning as to why asymmetric information can lead to a lack of social welfare.
Asymmetric information - a type of information failure where one party involved in an economic transaction knows more than the other e.g. a used car dealer and a buyer - the used car dealer knows more about the history of the car than the buyer - this can cause market failure
Market failure - when the free market fails to allocate resources efficiently - meaning it fails to maximise social welfare on its own
How asymmetric information can cause market failure in the banking system
Banks often don’t know about the history of their customers (are they risky to lend to or not)
This leads to poor choices - misallocation of financial resources
Could mean loans are lent to riskier individuals (sub-prime)
Could lead to higher levels of defaults
Could lead to a lack of liquidity within the banking system
This can cause systemic failure (failure of the banking system)
This can cause mass panic - banks are at the heart of the economy
Economic recession - lack of social welfare - the market has failed
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