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Learn what happens when one party in a transaction has more information than the other, leading to market imbalances.
Why does a brand-new car lose 10% of its value the moment you drive it off the lot, even if it's still in perfect condition?
In a perfect market, everyone has the same facts. However, in the real world, we often face asymmetric information—where one party knows more than the other. This isn't just a minor inconvenience; it can cause markets to collapse entirely. When sellers know more about a product's quality than buyers, or when a person buying insurance knows more about their health than the company, the 'wrong' people might end up trading. This leads to market failure, where the price mechanism fails to allocate resources efficiently. We categorize these problems into two main types: what happens before a deal is signed, and what happens after.
Quick Check
If a buyer cannot distinguish quality, why does the 'average' price lead to a market failure?
Answer
Because owners of high-quality goods will refuse to sell at the average price, leaving only low-quality goods in the market.
Adverse Selection occurs before the transaction. It is a 'hidden attributes' problem where the uninformed party ends up dealing with the people they'd least like to trade with (e.g., only sick people buying health insurance). Moral Hazard, however, occurs after the transaction. It is a 'hidden action' problem. Once a person is insured or under contract, they may change their behavior because they no longer bear the full cost of their risks. For example, someone with theft insurance might become less careful about locking their doors because the insurance company will pay if the car is stolen.
An insurance company calculates that a 'safe' driver has a 1% chance of a crash, while a 'risky' driver has a 10% chance. 1. If the company charges a premium based on the average risk (), only the 'risky' drivers find the deal attractive. 2. This is Adverse Selection. 3. If a safe driver buys the insurance and then starts speeding because they feel 'protected,' that is Moral Hazard.
Quick Check
Is a person driving recklessly because they have full auto insurance an example of adverse selection or moral hazard?
Answer
Moral hazard, because the behavior changed after the contract was signed.
Markets develop tools to fight information gaps. Signaling is an action taken by the informed party to prove their quality. To be effective, a signal must be costly—otherwise, everyone would do it. A college degree is a signal to employers that a student is hardworking. Screening is an action taken by the uninformed party to uncover information. An insurance company might screen applicants by requiring a medical exam or offering a high-deductible plan to identify low-risk individuals who are confident they won't crash.
Which concept explains why healthy people might opt out of insurance, driving up premiums for everyone else?
A used car warranty offered by a seller is an example of:
Moral hazard refers to the tendency of people to take more risks when they are shielded from the consequences.
Review Tomorrow
In 24 hours, try to explain the difference between 'hidden attributes' and 'hidden actions' to a friend.
Practice Activity
Look at a job posting online. Identify which requirements are 'signals' the employer is looking for and which parts of the application process are 'screening' tools.