Asymmetric information occurs when one person or group in a deal has more or better information than the other. This imbalance often leads to unfair or inefficient market results.
Essentially, one side knows something important that the other does not. This is a common issue in many parts of the economy.
Key Characteristics:
- The person with less information faces adverse selection before the deal.
- The person with less information faces moral hazard after the deal.
- It can lead to market failure because resources are not used effectively.
Types of Asymmetric Information:
- Hidden characteristics (adverse selection): One party has secret knowledge about a product or service before the deal happens. For example, a car seller knows if a vehicle is broken, but the buyer does not.
- Hidden actions (moral hazard): One party changes their behavior after the deal. For example, a person with insurance might take fewer safety precautions because they are covered.
- Hidden intentions: One party may fail to follow through on their promises because their true plans were never known.
Common Examples:
- Insurance: The insurance company does not know the true risk level of the customer.
- Used Cars: The seller knows more about the vehicle’s condition than the buyer.
- Employment: An employer finds it difficult to monitor the exact amount of effort a worker puts into their job.
Solutions:
- Signalling: The informed party proves their quality (e.g., offering a product warranty).
- Screening: The uninformed party creates contracts to help reveal the truth (e.g., insurance deductibles).
- Government Intervention: Rules that require companies to share information or hold licenses.
- Reputation: Businesses work to build a good name to show they are trustworthy.