Asymmetric Information: Adverse Selection and Moral Hazard | UGC NET Economics – Notes

Introduction

• In a perfect competitive market structure, one of the key assumptions defining the market is that of complete and symmetric information among the parties involved in the transaction. That is, we assumed no seller knows more about a product’s characteristics than a buyer, and no buyer knows more about the product’s costs than a seller. Such an assumption is unrealistic due to the fact that in real life, one party to a transaction often has more information than another about the characteristics of the good or service to be traded. This condition is referred to as that of asymmetric information.

• For instance, the seller of a product usually knows more about the quality of the good than the buyer; workers usually know more about their abilities than the potential employers; in the market for second-hand cars, sellers have more information regarding the true status of the car than the buyer; in the financial market, the creditor has relatively lesser information about the default risk of the debtor than the debtor himself; and in the health insurance market, the insurance company has lesser information about the health status of the individual than the individual himself. These are some of the common examples of the presence of asymmetrical information.

• As per the first welfare theorem of Economics, perfect competition leads to a Pareto efficient allocation of resources. A key assumption for the theorem to hold is that all the information related to the trade in the market should be equally observed by all the agents involved. When such assumption fails to hold, that is, when information is asymmetric with one agent possessing more information related to the trade than other agent(s), prices are distorted and we do not get a Pareto efficient allocation of resources. This is referred to as the situation of market failure.

Asymmetric Information

• The concept of asymmetric information was first analysed by George Akerlof in his 1970 paper titled The Market for “Lemons”: Quality Uncertainty and the Market Mechanism. He considered an example of the automobile market. Asymmetric information exists, when amongst different parties in the trade, unequal information set persists. That is, if we assume there are buyers and sellers in the market, then under asymmetric information, one agent will have greater (or lesser) information than the other.

• For example, in the market for second-hand cars, also called the market for lemons, sellers of the second-hand cars have more information about the real value of the car than the buyer. This information asymmetry gives the seller an incentive to sell goods of less than the average market quality. The average quality of goods in the market will then reduce as will the market size. Moreover, buyer possessing lesser information, often is discouraged to go in trade, as he wants to reduce the risk of buying a damaged car, called a ‘lemon’. Thus the presence of asymmetric information, may result in no trade taking place at all.

• In another example, in the market for health insurance, buyer of insurance has more information about his/her status of health than the insurance company selling such policies. More such examples exist in the real world. The existence and persistence of asymmetrical information cannot be denied and due to it, many markets fail to trade. This simply means, that due to lack of symmetry in information between the parties, they are unable to construct tradable price in the market and without tradable price, trade cannot take place. This way asymmetrical information leads to market failure.

• To correct for the market failure resulting from asymmetrical information, one way out is when such asymmetries in information can be nullified, in other words when more equal distribution of information is possible.

  • For instance, in markets for second-hand cars, some certification or quality accreditation with some years of guarantee from an organisation can help spread information about the true real value of the second-hand car amongst buyers and sellers.

  • In the market for health insurance, a thorough medical check-up can reveal true status of the buyers’ health.

  • In the financial market for credit, borrowers borrowing-score can help reveal the actual default rate of the borrower.