Unit 2: Higher Level (2.10 - 2.12)

Asymmetric information

Refers to a situation where one party possesses more information or better information than the other party (sellers having more information than buyers or vice versa), when making a transaction.

Adverse selection

Refers to a situation where the party with more information takes advantage of the imbalance of information, before a contract is written or a transaction occurs.

Examples of adverse selection

• Insurance buyers possessing more information than health insurance providers
  e.g., by concealing their smoking habits.

• Car sellers possessing more information than car buyers in the market for used cars
  e.g., by concealing car defects.

Moral Hazard

It refers to the situation where one party changes their behaviour as they become incentivized to take risks, knowing they are insured against the costs involved.

Government responses to asymmetric information 

Legislation, regulation, and direct provision of information.

Legislation

Laws enacted by the lawmakers of a country.

Regulation

Refers to the monitoring of industries by government agencies, or by the industry itself. It involves the enforcement of the legislation of a country.

Direct provision of information

The use of mass media in order to reduce the magnitude of asymmetry in the information that the consumer has. Examples include health campaigns, publish of studies (profeco) etc. It is cheaper, and empowers the consumer to take a decision, but it still has an opportunity cost and might be less effective than other measures.

Private responses to asymmetrical information

Signalling and screening

Signalling

The idea that one party (the agent) credibly conveys some information about itself to another party (the principal). Reduces uncertainty and promotes trust

Screening

Refers to the ability of a party to obtain information of the other party prior to defining. It helps filter out false information and only retaining the truth.