What is asymmetric information?
In a perfect market both sides know everything about the good. In real life information is incomplete: finding out costs time and money (checking a car, reading a contract, hiring an expert). These costs are called transaction costs.
Information is asymmetric when one party has an information advantage over the other:
- Seller knows more than buyer (used cars, houses, online goods).
- Buyer knows more than seller (insurance: the customer knows his own health and habits).
- Agent knows more than principal (a manager knows how hard she works).
The party that knows less is afraid of a bad deal, so it offers less or refuses. That can make a market smaller or break it. In the 3D, the tall pillars are what the seller knows and the grey covers hide it from the buyer.
Adverse selection: hidden quality before the deal
Adverse selection happens when the hidden information is about quality or type and the "wrong" ones choose to take part.
- Buyer cannot tell good from bad, so offers the average value.
- Owners of good goods get less than they are worth, so they leave.
- The average quality of what remains is lower, so the offer falls.
- More good ones leave. The market may shrink or vanish.
With 12 cars worth 1 to 12 (average 6.5), the offer of 6.5 pushes out cars 7 to 12; the new average is 3.5, which pushes out 4 to 6, and so on. The economist George Akerlof called such a market a "market for lemons" (lemon = a bad car).
Other examples: people who are ill buy more health insurance than healthy people; risky borrowers apply for loans at high interest.
Moral hazard: hidden action after the deal
Moral hazard happens when someone changes behaviour after the deal because another person bears the cost, and that behaviour cannot be seen.
- Fully insured house owner: less careful with fire and theft.
- Bank that expects a rescue: takes bigger risks.
- Employee with a fixed salary and no supervision: works less.
In the 3D, as cover goes from 0% to 100% the green care bar falls and the red risk bar rises. The insurer sees a rise in claims but not the carelessness that caused it, so it raises premiums for everyone.
Firms: sources of finance, principal and agent
Choosing finance
A manager knows her project better than a lender does. The lender fears risky borrowers, so it charges higher interest, asks for collateral (an asset it can take if the loan is not repaid) or refuses. A firm may therefore prefer own funds (retained profit), where nobody needs to be convinced, or share capital, where owners judge the firm themselves. Outside finance is easier for firms with a good record and plenty of information.
Principal and agent
The principal (owner, shareholder) hires an agent (manager, worker) to act for her. The agent knows his effort and may have goals of his own, but the principal cannot watch everything. This is the principal-agent problem.
Role of supervisors
A supervisor (a manager, an auditor, a board of directors) watches or checks the agent, reduces hidden action and reports to the principal. Supervision costs money, so the principal balances its cost against the gain.
Ways to limit adverse selection and moral hazard
Against hidden quality (adverse selection)
- Get information: inspections, medical check-ups, credit scores, ratings, labels.
- Signalling by the informed side: a warranty, a certificate, a brand with a reputation. A seller of a good car can afford to offer a warranty; a seller of a bad one cannot.
- Screening by the uninformed side: forms, tests, different contracts for different types.
Against hidden action (moral hazard)
- Share the risk: an excess or deductible (the insured pays the first part), partial cover, a no-claim bonus.
- Incentive contracts: commission, bonus, profit-sharing, share options so the agent gains when the principal gains.
- Monitoring by supervisors and audits.
- Collateral: the borrower loses something too if the project fails, so takes more care.
No fix is free or perfect, so some asymmetric information always remains.
Key formulas and definitions
- Offer under hidden quality = average value of the goods the buyer thinks are on sale
- Seller sells only if offer ≥ own value of the good
- Expected loss = probability of loss × size of loss
- Owner's expected loss with an excess = probability × (loss the owner still pays)
- Information is worth buying if expected loss avoided > cost of getting it (transaction cost)
Worked examples
1. Easy. Twelve used cars are worth 1, 2, …, 12 thousand. The buyer cannot tell them apart. What average value will the buyer offer, and which owners will sell?
Average = (1 + 2 + … + 12) ÷ 12 = 78 ÷ 12 = 6.5 thousand. An owner sells only if the offer is at least the car's value, so only cars worth 1 to 6 are sold. Cars worth 7 to 12 are taken off the market.
2. Medium. Continue the example. After the first round, what offer does the buyer make next, and how does the market end?
Cars worth 1 to 6 are left: average = 21 ÷ 6 = 3.5. At 3.5, cars 4, 5 and 6 leave. Left: 1, 2, 3 with average 2. At 2, car 3 leaves. Left: 1, 2 with average 1.5. At 1.5, car 2 leaves. Only the worst car (worth 1) remains. The market has collapsed to the worst quality: adverse selection.
3. Medium. A buyer may pay a mechanic 2,000 to check a car. One in ten cars has a hidden fault costing 50,000 to repair. Is the check worth it?
Expected loss without a check = 0.1 × 50,000 = 5,000. The check costs 2,000, which is less than the 5,000 loss it avoids, so it is worth it. (This shows that information has a price, a transaction cost, and people buy it when the gain is bigger.)
4. Medium. A house worth 100,000 has a 2% fire chance if the owner is careful and 6% if careless. Without insurance the owner is careful. Find the insurer's expected cost for full cover in both cases.
Careful: 0.02 × 100,000 = 2,000. Careless: 0.06 × 100,000 = 6,000. With full cover the owner no longer bears any loss and may become careless, so the insurer's cost can be 6,000 instead of 2,000. That is moral hazard.
5. Hard. In the same house example the insurer adds an excess of 20,000 (the owner pays the first 20,000 of any loss). What is the owner's expected loss if careful and if careless? Does the excess help?
Careful: 0.02 × 20,000 = 400. Careless: 0.06 × 20,000 = 1,200. The owner still loses something in a fire and carelessness costs the owner 800 more in expectation, so there is a reason to take care. The insurer also pays less per fire (80,000, not 100,000). The excess limits moral hazard.
6. Hard. A shop owner pays a manager a fixed 30,000 a month. If the manager works hard, monthly sales are 400,000, if not 200,000. The owner cannot see effort. Suggest a contract and explain.
With a fixed salary the manager earns 30,000 either way, so he has no reason to work hard: moral hazard. Offer a lower fixed pay of 20,000 plus 5% commission on sales. Hard work gives 20,000 + 20,000 = 40,000, while lazy work gives 20,000 + 10,000 = 30,000. Now effort pays 10,000 more, so the manager's interest matches the owner's. The owner also gains because sales rise by 200,000.
Common mistakes
- Mixing up the two. Adverse selection is hidden information about type or quality BEFORE the deal. Moral hazard is hidden behaviour AFTER the deal.
- Saying the seller is always the better informed one. In insurance the buyer knows more; in a firm the agent knows more.
- Thinking the buyer simply refuses all bad cars. The real problem is that the buyer cannot tell, so good cars suffer too.
- Thinking insurance causes carelessness in everyone. Moral hazard is a tendency, not a certainty, and fixes such as an excess keep it small.