Asymmetric Information

The Neo Classical Theory of the firm and the study of markets assume that
consumers and producers have complete information about the economic variables that are
relevant for the choices they face. Problems raised by differences in information are not
analysed. In the real world, however, buyers and sellers are not perfectly informed about the
quality of goods being sold in the market. If the information about quality is not costly, then the
prices of the goods will simply adust to reflect the quality differences. !ut if information about
quality is costly to obtain, then it is no longer likely that buyers and sellers have the same
information about the goods involved in transaction. "ne obvious e#ample for such costly
information is the labour market $ it is very difficult for a firm to determine how productive its
employees are.
%symmetric Information is the characteristic of many business situations. &requently,
the seller of a product knows more about its quality than the buyer does. 'orkers usually know
their own skills and abilities better than their employers. !usiness (anagers know their
management capabilities better than owners.
The implications of %symmetric Information about product quality were first analysed
by George Akerlof in a classic paper )The Market for Lemons Quality Uncertainty and the
Market Mechanism. %kerlof*s analysis goes far beyond the market for used cars. The market
for insurance, financial credit and even employment are also characteri+ed by %symmetric
quality information.
%symmetric Information e#plains many institutional arrangements in our society. It
helps us to understand why automobile companies offer warranties on parts and service for new
cars, why firms and employees sign contracts that include incentives and rewards, why the
shareholders of corporations need to monitor the behaviour of the firm*s manager.
The Market for Lemons
'hen sellers of a product have better information about its quality than buyers have, it
leads to market failure. This can be e#plained by considering the market for used cars. -sed cars,
even though the car is brand new, sell far less than new cars, because there is asymmetric
information about their quality. The seller of a used car knows much more about its quality than
its prospective buyer. % used car could be a good car .plum/ or a bad car .lemon/. The very fact
that the car is for sale indicates that it may indeed be a lemon and the prospective buyer of a used
car will always be suspicious of its quality.
0uppose two kinds of used cars are available1 high2quality cars .plums/ and low2quality cars
.lemons/. %lso suppose that both buyers and sellers which cars belong to which category. There
are thus two markets as illustrated in the following figure.
3
In the figure 04 5 64 are the supply curve and demand curve for high2quality cars.
0imilarly, 07 5 67 are the supply curves and demand curves for low2quality cars. 08 is at a
higher level than 07 because owners of higher2quality cars are more reluctant to part with them
and must receive a higher price to do so. 0imilarly, 68 is higher than 67 because buyers are
willing to pay more to get high2quality cars. %s the figure show, the market price for high2quality
cars is 9s.3:::: and for low2quality cars is 9s.;::: and ;:::: cars of each type are sold. In
reality, the seller of a used car knows more about its quality than the buyer does. If sellers know
about qualities which the buyers do not, and if the buyers e#pect the cars to be of medium
quality, then the dd curve 67 shifts upward to 6( while 68 shifts downward to 6( position in the
figure, and only <;::: high2quality cars are sold while =;::: low2quality cars will be sold. %s
consumers reali+e that most of the cars sold .=;:::/ are low2quality cars, their dd shifts. The
new demand curve is 67(, which means that on average, cars are of low to medium quality.
8owever, mi# of cars shifts further to low2quality cars. 0hifting continues until only low2quality
cars are sold. %t that point, market price would be too low to bring forth any high2quality cars for
sale. %t final equilibrium, fraction of high2quality cars will be smaller than it would be if
consumers could identify quality before making the purchase.
Thus when sellers of products have better information about product quality than buyers, a
lemons market may develop in which low2quality goods drive out high2quality goods.
%symmetric Information can result in market failure. There is an e#ternality between sellers of
good cars and bad cars, when an individual decides to try to sell a bad car, he affects the
purchaser*s perception of the quality of the average car on the market. This lowers the price that
they are willing to pay for the average car and thus hurts the people who are trying to sell good
cars. It is this e#ternality that creates market failure.The very act of offering to sell something
sends a signal to the prospective buyer about its quality. If too many low2quality items are
offered for sale, it makes it difficult for owners of high2quality items to sell their products.
Adverse Selection
%n inevitable result of the %symmetric Information is Adverse Selection. %dverse
0election can destroy the market for the commodity. %n outstanding e#ample of %dverse
0election is the Insurance Industry. Insurance markets frequently involve %symmetric
Information because the insuring party has better information about the risk involved than the
<
insurance company. This leads to %dverse 0election in which poorer risks choose to insure and
good risks do not. This can be e#plained through an e#ample. %n insurance company that wants
to offer insurance for bicycle theft offers the product after a careful market survey of the
incidence of bicycle theft. 0uppose the incidence of the theft varies widely across communities.
In some areas there is a high probability for a bicycle to be stolen and in some areas thefts are
quite rare. If the insurance company decides to offer the insurance based on the average theft
rate, the company is likely to become bankrupt quickly. This is because, at the average rate, only
people with high incidence of theft will want the insurance and hence, insurance claims will
mostly be made by consumers living in the high2risk areas. 9ates based on the average
probability of thefts will be a misleading indication of the actual e#perience of claims filed with
the insurance company. The insurance company will not get an biased selection of
customers*rather they will get an Adverse Selection. In order to break even, the insurance
company must base their rates on the )worst case forecasts and customers with low .but not
negligible/ risks, will be unwilling to purchase the resulting high2priced insurance.
Adverse Selection is a matter of serious concern in Health Insurance, people who buy health
insurance know much more about their general health than any insurance company can hope to
know, even if it insists on medical e#amination. %s a result, there is adverse selection, unhealthy
people are more likely to want health insurance. 8ence, the proportion of unhealthy people in the
pool of insured people increases. This forces the price of insurance to rise, hence more healthy
people, reali+ing their low risks, opt not to be insured. This further increases the proportion of
unhealthy people and this in turn, increases the price of insurance higher and higher until all the
people who want to buy the insurance are unhealthy, thus selling insurance becomes
unprofitable. It is because of %symmetric Information and %dverse 0election that people over >;
yrs. have difficulty in buying (edical Insurance at almost any price. %s price level rises, people
who insure themselves are increasingly certain that they will need the insurance and no insurance
sales may take place at any price. There is a severe problem of %dverse 0election at that age
.over >? yrs/.
In health insurance, insurance companies cannot base their rates on the average
incidence of health problems of the population. They can only base their rates on the average
incidence of health problems in the group of potential purchasers. !ut the people who want to
purchase health insurance are the most are the ones who are likely to need it the most and thus
the rates must reflect this disparity. In such a situation it is possible that every one can be made
better off by requiring the purchase of insurance that reflects the average risk in population. The
high risk people are better off because they can purchase insurance at rates that are lower than
the actual risk they face and the low risk people can purchase insurance that is more favourable
to them than the insurance offered if only high risk people purchased it.
%dverse selection is an instance of market failure, there is an e#ternality between high
risk insurers and low risk insurers . This creates a role for the government. It provides an
argument in favour of medicare or related form of government health insurance for the elderly.
!y providing insurance for all people over >;, the government eliminates adverse selection .The
rates $premium2 must reflect the disparity between high risk and low risk people. In fact there
are social institutions that help to solve this market inefficiency that results from e#ternality
between high risk and low risk people. @mployers offer health plans to their employees as part of
A
the package of fringe benefits. The insurance company can base its rate on the averages over the
set of employees and is assured that all employees must participate in the program, thus
eliminating adverse selection.
%symmetric information is also present in many other markets like1 retail traders. a
store knows more about the quality of its products than the buyer/, dealers of rare stamps, coins,
books and paintings .are they real or counterfeitB/. In all these cases the seller knows more about
the quality of the product than the buyer. -nless the seller can provide information to the buyer
about the product quality, low quality goods and services will drive out the high quality ones and
there will be market failure. 0tandardisation and establishing reputation for the product quality
can help to overcome such problems of adverse selection.
Moral Hazard1 (oral ha+ard refers to a situation in which the individual taking the insurance
can determine the value of probability of a loss occurring. If those taking the policy can set
pC3,an insurance company will not offer a policy against theft. Intuitively
Individuals are in effect trying to e#change an insurance premium for a new bicycle, or car for
which the insurance cover is sought. If the bicycle owners who buy bicycle insurance do not
bother to lock their cycle or use a flimsy lock, the bicycle is much more likely to stolen than if
they use a secure lock. 0imilarly in health insurance the consumers are less likely to need the
insurance if they take actions associated with a healthy lifestyle. %lternatively the insuree will
visit the doctor more often than he would if his coverage was limited. If the insurance company
can monitor the insuree*s behaviour it can charge higher fees for those who make more claims.
!ut if the company cannot monitor behaviour, it may find its payment to be larger than e#pected.
'ith moral ha+ard, the insurance companies may be forced to increase their premium or even to
refuse to sell insurance at all. Thus when the insuring party takes less and less care to avoid
losses, there is a case of moral ha+ard and this occurs because the insurer cannot monitor the
behaviour of the insured. Thus there is a trade off, too little insurance means that people bear a
lot of risks and too much insurance means that people will take inadequate care. If the amount of
care is observable then there is no problem. The insurance company can base its rates on the
amount of care taken .In real life it is common for insurance companies to give different rates to
businesses that have a fire sprinkler system in their building or to charge smokers different rates
than non2smokers for health insurance. Thus the insurance company discriminates among users.
8owever when insurance companies cannot monitor all the relevant actions of the insured, there
is the inevitable trade off.
In general insurance companies do not want to offer complete insurance to
consumers. They will always want the consumers to face part of the risk. That is why most
insurance policies include as )deductibleD, a sum that the insured party has to pay in any claim.
!y making consumers pay part of the claim insurance companies can make sure that the
consumer always has an incentive to take some amount of care.
Moral Hazard and Adverse selection
(oral ha+ard refers to situations where one side of the market cannot observe the actions of the
other. It is there fore also referred to as a hidden action problem. %dverse selection refers to
situations where one side of the market can not observe the type or quality of the goods on the
other side of the market. &or this reason it is therefore referred to as the hidden information
problem. @quilibrium in a market involving hidden action typically involves some form of
rationing $firms would like to provide more than they do but they are unwilling to do since it
E
will change the incentives of the consumer. @quilibrium in a market involving hidden
information will result in too little trade taking place because of e#ternality between the good
and the bad types of goods. The equilibrium will be inefficient relative to equilibrium with full
information. Fovernment intervention cannot remove inefficiency that arises due to hidden
action problem unless it prescribes particular level of care and sets criminal punishments for
those who did not take due care. !ut government to some e#tent can correct for hidden
information by making health insurance compulsory for all people. 8owever the cost of
government intervention should be minimum. %s stated already there are private solutions to the
problem of hidden information $ provision of health insurance as a fringe benefit by employers
to the employees.
Signaling
0ignalling refers to the fact that when adverse selection or moral ha+ard is present, some agents
will want to invest in signals that will differentiate them from other agents. In the case of the
market for used for used cars, for e#ample, the owners of the good used cars have an incentive to
try to convey to the potential buyer the fact that they have a good car. They would like to choose
actions that signal the quality of their car to those who might buy it. &or e#ample, the owner of
the good used car might give a !arranty. This would promise to pay the purchaser some agreed
upon amount if the car turned out to be a lemon. "wners of good used cars can afford to offer
such a warranty while the owners of lemons cannot afford this. 0ignalling helps the market to
perform better.
(arket signalling is therefore a mechanism through which sellers and buyers deal
with the problem of asymmetric information. The concept of market signaling was developed by
(ichael 0pence who showed that in some markets sellers send buyers signals that convey
information about a product*s quality. 0uch signals can be easily observed in labour market.In
the labour market education can be a useful signal. 0uppose there are two types of workers2able
and unable .The able workers have a marginal product of a"
and the unable workers have a
marginal product of a#anda" G a#. It is also assumed that fraction Hb* of the workers is able and H32
b* are unable. &or simplicity a linear production is assumed so that total amount produced by 7"
able workers and 7#
unable workers is1 a#7#Ia"7". If worker quality was observable firms would
ust offer a wage of w"Ca" to able workers and w#Ca#
to unable workers, i.e., each worker would
be paid according to his marginal product and there will be an efficient equilibrium !ut if firms
can not observe the marginal product the firm can not distinguish the type of workers, the best
the firm can do is to offer average wage, which is1 wC .32 b/ a# Iba". This will result in an
equilibrium output and profit for the firm as under observable conditions .%s long as able and
unable workers agree to work at this wage rate there is no problem of adverse selection.
8owever if workers can distinguish among themselves through signals such as education then a
new equilibrium will emerge. 7et e
3
be the amount of education attained by unable workers and
e
<
be the education level of able workers. Total cost of education for the able workers is c
<
e
<
and
that of unable education is c
3
e
3
. The costs include not only the money cost of attending the
school but also the opportunity cost. It is assumed that c
<
Jc
3
and that education does not alter
marginal productivity. "nly value of education is a signal. 0uppose firms decide that anyone
with a education level of eK or more is a able person and is offered a higher wage rate w
<
and
anyone with an education level less than eK is an unable person and is offered a lower wage rate
;
w
3
.Therefore education allows workers to get a better paying ob. The benefit to the worker is the
increase in wages a
<
2a
#
. The cost to the unable worker is c
3
eK and the cost to the able worker is
c
<
eK. &or the unable worker benefits are less than cost if .w
<
2w
3
/ J c
3
eK. !ecause c
3
Gc
<
, unable
workers will choose an education level of +ero. &or the able workers, benefits e#ceed cost. i.e.,
.w
<
2w
3
/G c
<
eK.This pattern of wages result in an equilibrium in which each able workers chooses
education level eK and each unable worker chooses +ero education level. The differences in the
cost of acquiring education for the two groups of workers, serves as a signal of the different
productivities at equilibrium. %ble workers want to acquire education not because it makes them
more productive but ust because it distinguishes them from unable workers. The equilibrium
output is the same both in the presence and absence of signals, thus making signals a social waste
Lan inefficiency arising because of an e#ternality. If both able and unable workers were paid
their average product, the wage of able workers would be depressed because of the presence of
unable workers. Thus the able workers will have an incentive to invest in signal that will
distinguish them from unable workers and also pay them more than what unable workers are
paid.
AS$MM%T&I' I()*&MATI*( I( LA+*,& MA&-%T A(. &*L% *)
I('%(TI/%S1 0&I('I0AL 1 AG%(T 0&*+L%M
%symmetric information in labour market implies that it is impossible to measure
efforts of labour directly. %symmetric information makes it costly for the owners of the firms to
monitor the efforts of the labourer. @mployees have better information than employers. This
asymmetry creates a principal2agent problem. %n agency relationship e#ists whenever there is
an employment relationship in which one person*s welfare depends on what another person does.
The agent is the person who acts and the principal is the party whom the action affects.
%symmetry in labour markets leads to principal agent problem. In the labour market, workers are
agents and owner is the principal. 'hen owner*s interest and worker*s interest conflict then
incentives can be designed to induce agents to aim for the goals that owners set. Marious
incentive schemes are available1
!onus arrangements by which the owners offer the workers a higher wage rate for higher
effort.
% profit sharing payment arrangement where the worker gets a share in the profit for
higher profits. % profit sharing payment arrangement may achieve the identical outcome
as a bonus payment scheme. 0uch incentives encourage the workers to perform
productively.
The workers may have incentives to shirk work at market clearing wage rate 34 in the
following figure.
>
%s an incentive not to shirk a firm must offer worker higher wage rate. %t this higher wage rate,
workers who are fired for shirking work will have to face a decrease in wages if they get hired by
another firm at 3
4
. If the difference in wage rate is large enough, workers will be induced to be
productive and the firm will not have a problem with shirking. If all firms face shirking they will
offer a wage rate greater than 34, say 3
e,
and 3
e
is the efficiency wage rate. The wage rate at
which no shirking takes place is the efficiency wage rate. %t 3
e
, which is greater than 3
4
the
demand for labour will be less than market clearing quantity and there is unemployment. This
means that the workers fired for shirking will face a spell of unemployment before earning we at
another firm.
In the figure 67 is the demand curve and 07 is the supply curve of labour. The inter section of 67
with 07 sets the market wage rate at wKand lull employment results. .7K/. 'ith shirking $ that
arises because employers cannot monitor workers performance2 individual firms are willing to
pay more than wK to induce workers to be more productive. This wage rate is shown by the no
shirking constraint curve .N0C/. The curve shows the minimum wage workers need to earn in
order not to shirk for each level of unemployment. The figure shows that greater the level of
unemployment smaller the difference between we and wK. This is because with higher levels of
unemployment, people who shirk will have to face long periods of unemployment and therefore
do not need much inducement to be productive. @quilibrium wage rate is N0C cuts 67 and is
given as we. &irm will not pay less than we because of shirking. It must be noted that N0C curve
will not cross supply curve for labour because there will always be some unemployment in
equilibrium. Incentive chosen ensure that the utility the workers get from this ob must be atleast
as great as the utility he could get elsewhere. In terms of his efforts the incentive should be such
that the utility to the workers from choosing an effort eK, must be greater than the utility of any
other choice of effort.
Incentive could be in the form of residual profit. i.e., the worker gets all the output
that remains after paying a fi#ed sum to the owner..rent/ This is called as a rent
scheme.
Incentive should be a wage labour scheme in which the owner pays the worker a
constant wage per unit of effort along with a lump sum -. The constant sum - is
=
chosen ust to make the worker indifferent between working for him and working
elsewhere. 'age labour requires observation of effort. If owners cannot observe
the amount of input, then it will be impossible to implement this incentive
scheme.
Incentive could be a )take it or leave it schemeD. In this scheme owner pays the
worker a certain sum (K if he puts in @K efforts and +ero otherwise. (K is
determined by participation constraint, i.e., (? is a sum that will retain the
workers in the present ob giving him a utility level that is at least as great as
utility he could get elsewhere.
Incentive scheme could be based on share cropping scheme in which the worker
and the owners each get some fi#ed percentage of output. 'orker and the owner
share the risk of output fluctuation and worker need not bear all the risk. 'orker
has an incentive to be productive. This scheme is infle#ible if owner cannot
monitor the effort. 9esidual profit and the take it or leave it incentive scheme
e#pose the worker to much risk. 0hare cropping is a compromise between the two
e#tremes. It gives worker some incentive to produce without burdening him all
the risk
?
Discuss the reasons why asymmetric
information can be a source of market failure.
Use examples to illustrate your answers.
By Andrew Sweeting
November 1998
Introduction
This essay is concerned with the issue of information in microeconomics, particularly where information is
a factor in the failure of individual marets in an economy! "conomic information and its importance in
microeconomics is initially discussed, and continues with defining asymmetric information, which is a
factor that can lead to a maret failure!
#n the analysis of asymmetric information in marets, e$ ante and e$ post asymmetries information are
discussed in relation to maret transactions! "$ ante asymmetric information can be e$plained through
Adverse Selection in relation to %uality of goods in the product maret, and e$ post asymmetric
information can be e$plained through Moral Hazard in insurance marets! Strategies to correct maret
failure&s' caused by these information asymmetries is addressed for each e$ample discussed!
The e$position of these two types of asymmetric information problems leads to the discussion of
principal-agent problems, particularly in relation to efficiency wage theory, which have been developed to
analyse maret failures! (abour maret failure e$plained through the efficiency wage theory has been
used to e$plain involuntary unemployment!
Economics of Information
)"conomics is concerned with the efficient use of limited productive resources for the purpose of attaining
the ma$imum satisfaction of our material wants)&*acson and +c,onnell,198-,p!.', which involves
economic agents undertaing transactions that utili/e these resources to meet and satisfy their wants! By
way of analysing these maret transactions, economist have developed microeconomic models, such as
perfect competition, to e$plain the interactions in individual marets! +uch of this analysis has been
undertaen on the critical assumption of economic agents having full information about the goods or
services being bought or sold, and full information about each other! These assumptions describe a
maret where there is perfect information&Stiglit/,199.'!
N
Stigler&1901' states that )information is a valuable resource1 nowledge is power)&p!21.', and information
can determine actions such as where purchasers buy higher %uality goods at lower prices in their
allocation of scare resources&money', or where 3overnments regulation of the environment can be more
efficient if they have the good scientific information! Therefore information can be seen as a valuable
economic factor, especially in the allocation of scare economic resources, and the level of uncertainty that
can ultimately determine utility levels&Nicholson,1998'!
4ith microeconomic assumptions of perfect information in economic models, economists do not
represent real world situations! e!g! households do not now the price of a particular good at every store
that sells it, or firms do not now the actual productivity of every 5ob applicant for a vacant position!
Therefore there is imperfect information in individual marets, for reasons such as accurate information
being too costly, or impossible to obtain, for important decision characteristics! The lac of information in
a maret transaction may be only one sided, or be evident to both parties&Stiglit/,199.'&6arian,1997'!
Asymmetric Information
8efinition
Asymmetric information is a situation in which economic agents involved in a transaction have different
information, as when the a private motorcycle seller has more detailed information about the its %uality
than the prospective purchaser, or an employee will now more about their ability than their employer!
#nformation that is distributed asymmetrically between economic agents can be categori/ed as e$ ante,
pre9contractual of the transaction, or e$ post, post9contractual of the transaction, that will influence
economic behaviour and operation of the maret&Stiglit/,199.'!
These two forms of asymmetric information, e$ ante 9Adverse Selection9 and e$ post 9Moral Hazard9 are
foundations in the e$planation of insurance maret theory and therefore much of informational asymmetry
e$planations involve e$amples relating to insurance marets and their inefficiencies:failures!
Adverse Selection
Adverse selection is a situation where one party in a transaction nows something about its own
characteristic that the other party does not now! Adverse selection is often referred to as a hidden
information problem in a maret, where for e$ample sellers may now more about a product than a
customer&"strin and (aidler,199-'!
#nformation asymmetry and adverse selection was first pioneered by 3eorge Aerlof in his article )The
+aret for (emons1 ;uality <ncertainty and the +aret +echanism), which e$amined the marets for
used motor vehicles, insurance, credit and employment! Aerlof e$plores adverse selection by the use of
asymmetric %uality information about the purchase of used motor vehicles to show maret failure! The
following e$ample loos at adverse selection in the insurance maret&"strin and (aidler,199-'!
3:
Example: Motor Vehicle Market(!alit"#
Aerlof&19=7' posed a %uestion as to why there is such a large price difference in new motor vehicle and
those that have 5ust left the showroom! Aerlof developed the concept of asymmetric information about
the motor vehicles %uality because the sellers nows more about the motor vehicle than the buyer!
Buyers with a lac of nowledge about the motor vehicle would as the %uestion, why is it for sale> 9 is it a
)lemon)> Therefore all prospective buyers would be suspicious of the %uality of used motor vehicles and
infer %uality from pricing policies of sellers&?indyc and @ubinfeld,1989'!
AerlofAs model is developed on the simplified basis that there are two types of used motor vehicles
available, high %uality or low %uality, with sellers nowing the %uality, and buyers cannot distinguish the
%uality! A simplified numerical e$ample e$plains the results of %uality differences1
4e assume that the seller of a low %uality motor vehicle will sell for B-77, the seller of a high
%uality motor vehicle will sell for B1277, and buyers will be willing to pay B=77 for a low %uality
motor vehicle and B1-77 for a high %uality motor vehicle! Buyers will have to estimate how much
a motor vehicle is worth, and we assume the probability of obtaining a high or low %uality motor
vehicle is e%ual! #f a buyer will pay the e$pected value of a motor vehicle, then they would be
willing to pay 7!-C=77D7!-C1-77E$1100!
The only seller willing to sell would be that of the low %uality motor vehicles
&$500F$%%&&FB1277'! Therefore only low %uality motor vehicles would be offered for sale and
buyers would e$pect to get a low %uality motor vehicle and no high %uality motor vehicles would
be sold! +aret failure will occur because selling a low %uality motor vehicle affects the buyers
perceptions of the %uality of all motor vehicles, the price they are willing to pay, and affects the
sale of all good %uality motor vehicles&6arian,1997'!
4here there is an absence of full information,, or a high cost of obtaining all the information re%uired, low
%uality goods will drive high %uality goods out of the maret, or even collapse the maret&"strin and
(aidler,199-'! Solutions that are available to correct maret failure in relation to %uality asymmetries are1
o @eputation 9 Gigh %uality product sellers can build a reputation to differentiate the high
%uality products!
o Standardi/ation 9 To help with the problem of building a reputation, sellers may
standardi/e the high %uality service:good! e!g! +c8onalds or HI, around the world!
o 3uarantees and 4arranties 9Gigher %uality products can overcome asymmetric
information problems by signalling product %uality through an e$tensive warranty or
guarantee&?indyc and @ubinfeld,1989'!
Example: 'ns!rance Market((ooled#
33
4ith insurance, any potential buyer faces different probabilities of an insurable event occurring, some at
least under his control! Therefore an assumption can be made that individuals are either )o* +isk or a
High +isk of the insured event happening, but they are not individually identifiable by the insurer! 3eneral
assumptions are1
o Gigh ris individuals are most liely to claim on insurance and will be enthusiastic to
purchase full insurance!
o (ow ris individuals are unliely to claim insurance and are therefore willing to purchase
insurance at a discounted rate&Stiglit/,199.'!
#nsurers in the maret offer an insurance contract at a premium set at the average probability of a claim
where it e%uals the premium income! i!e! a pooled premium, ensuring average losses from claims are
e%ual to the premiums collected! As premiums rise, low ris individuals will not be willing to buy insurance
so losses will occur to the insurer and hence maret failure will occur&@ees,1989'!
The adverse selection problem is that the potential insurer buyer has hidden information from the insurer
before a contract is entered into, and the insurer could not afford to offer full insurance to low ris
individuals because it would incur a loss&@ees,1989'!
Solutions to adverse selection in the insurance maret include1
o Trying to obtain critical information before insurance is provided! e!g! pre9inspection
before fire insurance is provided!
o Jffer full insurance at a high premium and partial insurance at lower premium to help
identify individuals into their respective ris groups!
+oral Ga/ard
+oral Ga/ard are )situations where one side of the maret canAt observe the actions of the otherK, andL is
sometimes Kreferred to asL a hidden action problem)&6arian,1997,p!-89'! The results of moral ha/ard are
an increased probability of undesired outcomes for one party and the maret, post contractual! A basic
e$ample of moral ha/ard is motor vehicle owners driving more reclessly if their motor vehicle is fully
insured&3ibson,199='!
Example: Home , -ontents 'ns!rance
4hen individuals are insured, they will pay less care ensuring that the undesired outcome does not occur!
e!g! a householder may tae less care in locing up their house when they have house and contents
insurance! This moral ha/ard problem can cause maret failure, failure to reach maret efficiency in the
insurance maret, because individuals incentives are altered by not having to worry about their post
3<
contractual actions in regards to the insured event! #nsurers may not offer Gome M ,ontents insurance
where moral ha/ard problems are strong, or specify certain conditions for the insured! e!g! fit window
locs to the house&Stiglit/,199.'&"strin and (aidler,199-'!
Solutions to moral ha/ard in the insurance maret are1
The use of deductibles&e$cess' and co9payments, depending on whether moral ha/ard increases
the ris or increases the si/e of the loss!
3overnment intervention through ta$ation or subsidies to ensure an incentive to reduce the ris or
improve the care taen by individuals&3ibson,199='!
Example: .overnment Health 'ns!rance(Medicare#
3ibson&199=' introduces the problem of moral ha/ard to a 3overnments operation of universal health
care such as +edicare! +edicare is compulsory payments&)a ta$)' to fund the public heath system! +oral
ha/ard could lead to individuals taing less care of their health then if they had to pay all costs from their
actions! ?ublic health costs will probably then increase under this scenario!
To reduce moral ha/ard and any rising health costs, 3overnments may introduce ta$es or subsidies, such
as increasing the ta$ on cigarettes, or introduce co9payments for the public health system! These two
options may reverse the maret failure, but if private health insurance e$ists to cover co9payments, then
moral ha/ard will still contribute to maret failure and health budget problems&3ibson,199='!
Principle-Agent Problem and Asymmetric Information
?rincipal agent problems are )any situation in which one party&the principal' needs to delegate actions to
another party&the agent', and thus wishes to provide the agent with incentives to wor hard and mae
decisions about the ris that reflect the interest of the principal)&Stiglit/,199.,p!A12'! e!g! the property
owner and the real estate agent managing it on the owners behalf! ?roblems may occur because
principals cannot monitor every action that the agent undertaes, agents will therefore have better
information, and the collection of this information by the principal may also be costly, if at all possible! As
defined at the start of this essay, this principal relationship demonstrates the characteristics of
as"mmetric information being prevalent&?indyc and @ubinfeld,1989'!
The principal9agent problem and asymmetric information can be shown in a number of marets such as
the owners&shareholders' and managers of publicly listed companies, or owners&citi/ens' and managers
of publicly owned organi/ations! Solutions to the problem of the principal9agent problem usually
incorporate incentives to the agent of some sort! Jne of the recent attentions has been the utili/ation the
problem of asymmetric information in the labour maret! #n particular, one of the ma5or issues in
economics, that of unemployment, and the failure of the labour maret to clear, has been addresses
through efficienc" *age theor"&Gillier,199='!
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"fficiency wage theory has several variants, but the common thread is that the %uality of worers in a firm
is dependent on the wages paid in such a way that reducing the wage would reduce the %uality of the
worers and the profits of the firm! Therefore the firm will not cut wages even it was possible to do so on
the current worers, or hire from unemployed worers! Therefore the wage may not fall to its maret
clearing level! The reason for this result is because of the asymmetric information available to firms about
worers productivity, both in an adverse selection and moral ha/ard form&Gillier,199='!
Adverse selection problems are based on the inability for employers to distinguish between type of
worers&as seen previously in relation to %uality' and that good %uality worers will be less willing to tae
low paid 5obs that bad %uality worers! Therefore firms will have an incentive to pay higher wages to
attract the good %uality worers, but good %uality worers may choose to remain unemployed because if a
5ob is low paid it may send a signal about their low %uality&Gillier,199='!
+oral ha/ard problems are referred to as the shirking model in the principal9agent theory, where in the
simple model, assumptions of a perfectly competitive maret, employees are e%ually productive, and are
paid the same wage! 4orers can either wor and be productive, or be non9productive and NshirA!
Because asymmetric information is present, worers may therefore not lose their 5obs for shiring&?indyc
and @ubinfeld,1989'!
?indyc and @ubinfeld&1989'!provide an e$ample of the effect of efficiency wages in the history of Iord
+otor ,ompany! By paying an efficiency wage of B- in 191O, rather than the average maret rate of B2 to
B. per day, Genry Iord attracted better worers and gained greater profits! ?roductivity was estimated at
a -1P increase, absenteeism halved and discharges had reduced&signs of shiring'! These incentives
helped overcome the asymmetric information for the Iord +otor ,ompany with its labour maret
principal9agent problem!
Conclusion
Asymmetric information is a problem that economists should always consider in the analysis of marets,
as it tends to create maret failures in product marets where low %uality products drive out good %uality
products, insurance marets where low ris groups do tae out insurance and high ris groups do, and
other marets where principals do not receiving productivity:return from agents! ,omple$ity of the items
being traded will usually ensure there is asymmetric information in the particular product maret!
Therefore it is not 5ust the uncertainty economic agents face, but the distribution of the information
between agents that can influence their actions in the maret!
The e$istence of asymmetric information e$plains why manufacturers offer warranties&mandatory and
optional', incentive and reward contracts are offered to employees, and that shareholders need to monitor
behaviour of firms managers to ensure return on their capital! These strategies try to alleviate the effect of
adverse selection and moral ha/ard problems from informational asymmetries, where costs to capture
these information deficiencies are too e$pensive or impossible!
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