Definition
Asymmetric Information
Refers to situation where buyers and sellers don't have the same access to information.
- When talking about competitive markets, it is assumed that there is complete information in the market.
- However, this is rarely the case, since there is always two types of asymmetric information in the market:
- Adverse Selection.
- Moral Hazard.
In this section, you should just focus on understanding the concept of asymmetric information. The effects it has on markets and the responses stakeholders develop to prevent it will be explored in the next section.
Adverse Selection
Definition
Adverse selection
When one of the sides has more knowledge about the quality of the product sold than the other.
- A transaction has two sides:
- The buyer.
- The seller.
- In real-life, in most transactions, two scenarios often occur:
- The seller has more information about the product than the buyer.
- The buyer has more information about the product than the seller.
Scenarios when the seller has more information
- The seller of the product oftentimes a lot of times has information about the quality of the product.
- Often, this information is hidden because, if revealed to the buyer, it may cause the buyer to not buy the product.
- This often results in an under-allocation of resources:
- Consumers reduce their spending to protect themselves from the lack of information.
- This lowers overall demand, leading to less production and inefficient resource allocation in the market.
Examples of this type of adverse selection include:
- Second hand markets for cars.
- Since the car has been used before, the chance of it having a certain defect is higher.
- Therefore the seller might hide the fact that the car has a defect to be able to sell the car for a higher price
- Real estate
- The seller of the house knows if the building may have any structural problems.
- For that reason, it may try to hide this information from the buyer to not decrease the value of the house.
Scenario when the buyer has more information
- There are occasions where the buyer of the good/service may have more information than the seller.
- Similarly, sometimes the buyer may be better off hiding this information.
- This often results in an under-allocation of resources:
- Producers reduce their production of the goos/service to protect themselves from the lack of information.
- This leads to less production and inefficient resource allocation in the market.
Example of scenarios where the buyer has more information than the seller:
- Insurance:
- The buyer knows their own health risk, while the insurance company doesn’t.
- As a result, high-risk individuals may pay the same premium as low-risk ones, causing the insurer to spend more on them than they received.
- Job market (employee effort):
- The buyer (employer) does not fully know the level of effort or productivity the employee will exert once hired.
- The employee, on the other hand, knows their own work ethic and intentions.
- This can lead to inefficiencies, such as employers offering lower wages to account for potential underperformance, potentially discouraging high-effort workers.
Moral Hazard
Definition
Moral Hazard
A situation where one part takes a risk but is not responsible for covering all of the costs because they are being covered by the other party.
- Moral hazard occurs when one party takes on more risks because they do not bear the full consequences of their actions.
- It arises when there is asymmetric information, where one party has more information about their behaviour or intentions than the other party.
- This often results in an under-allocation of resources:
- Producers, anticipating higher costs caused by the risky behaviour of individuals, may reduce their production of the good/service or raise prices significantly.
- This discourages potential buyers from purchasing the good/service, leading to fewer resources being allocated to the market.
- Consequently, the market fails to provide adequate coverage, reflecting an inefficient allocation of resources.
Examples of moral hazards where someone doesn't face the costs of their actions are:
- Car insurance:
- A person who purchases comprehensive car insurance might start driving recklessly, knowing that any damages from an accident will be covered by the insurer.
- This increases the risk for the insurance company, while the driver doesn't face the direct financial consequences.
- Unemployment benefits:
- If a state provides unemployment benefits, an unemployed person may not be quick in trying to find a job as he can get financial benefits without working.
- This increases the costs of the state, while the unemployed does not face these generated costs.
