Asymmetric information
When one side of a transaction knows more than the other, markets can malfunction or even disappear.
Asymmetric information
Asymmetric information exists when one party to a transaction knows more than the other. Sellers of used cars know more about their cars than buyers; people buying insurance know more about their own risks than insurers; workers know more about their effort than employers.
Adverse selection
Adverse selection happens before a transaction, when hidden characteristics mean the wrong people are more likely to trade. In George Akerlof's 'market for lemons', buyers who cannot tell good used cars from bad offer only an average price; owners of good cars withdraw, quality falls, and the market can shrink toward only 'lemons'.
Adverse selection in insurance
If insurers cannot tell high-risk from low-risk customers, they charge an average premium. Low-risk people may find it too expensive and drop out, leaving a riskier pool and pushing premiums up further: a 'death spiral'. Mandatory or group insurance reduces this by keeping low-risk people in the pool.
Moral hazard
Moral hazard arises after a transaction, when one party changes behaviour because it does not bear the full consequences. Insured drivers might drive less carefully; banks expecting bailouts might take bigger risks. Deductibles, co-payments, and regulation make people share some of the cost, preserving their incentive to be careful.
The principal-agent problem
A principal (such as a shareholder or employer) hires an agent (a manager or worker) whose actions are hard to observe. The agent may pursue their own interests. Performance pay, stock options, monitoring, and reputation help align incentives, though they can create new distortions.
Signalling
Informed parties can send costly signals to reveal their quality. Michael Spence argued that education partly signals ability to employers. Warranties signal a seller's confidence in a product. For a signal to work, it must be cheaper for high-quality types to send than for low-quality ones.
Screening
Uninformed parties can screen to sort people. Insurers offer a menu of policies: high-deductible plans attract low-risk customers, comprehensive plans attract high-risk ones. Employers use probation periods and tests; lenders check credit histories.
Worked example
Half the used cars on a market are good (worth 10,000 dollars to buyers) and half are lemons (worth 4,000). Buyers who cannot tell offer about 7,000. Good-car owners who value their cars at 8,000 refuse to sell, so only lemons remain and buyers soon offer only 4,000. Vehicle history reports and warranties help restore trade in good cars.
Key takeaways
Asymmetric information means one side knows more. Adverse selection, from hidden characteristics, drives good-quality participants out, as in the market for lemons and insurance death spirals. Moral hazard, from hidden actions, reduces care after a deal. Principal-agent problems require incentives. Signalling and screening help reveal hidden information.
Flashcard
One side knows more than the other
Check your understanding
After buying full insurance on his phone, Leo stops using a protective case. This is an example of: