2.4 - Asymmetric Information

What is asymmetric information?

A situation where one party in a transaction has more or better information than the other.

What is adverse selection?

When one party has hidden knowledge before a transaction, leading to the selection of undesirable outcomes (e.g. unhealthy people buying health insurance).

What is moral hazard?

When one party takes more risks because they don't bear the full consequences of those risks (e.g. insured drivers driving carelessly).

What is signalling?

Actions taken by the informed party to reveal their private information (e.g. education credentials).

What is screening?

Actions taken by the less informed party to learn more about the other party (e.g. health exams before insurance approval).

How can asymmetric information cause market failure?

It leads to suboptimal market outcomes as decisions are made on incomplete or misleading data, reducing efficiency.

Give an example of adverse selection in the real world.

In used car markets, sellers know more about car quality, so buyers assume all cars are bad (market for 'lemons').

Give an example of moral hazard in the real world.

A bank takes excessive risk knowing it may be bailed out by the government.

How can legislation reduce asymmetric information?

Laws requiring full disclosure or labelling can reduce information gaps.

How can regulation help fix asymmetric information?

Governments can enforce minimum standards (e.g. for food safety or vehicle safety).

How can provision of information help reduce asymmetric information?

Governments can publish statistics or health warnings to inform consumers.

How can signalling address asymmetric information?

Informed parties voluntarily reveal info (e.g. degrees or warranties) to reduce uncertainty.

How can screening address asymmetric information?

Uninformed parties demand extra proof or conduct assessments (e.g. reference checks, background verification).