Q***: Outline how a company can reduce the problems derived from adverse

selection and moral hazard in economic situation of asymmetric information.

1. Introduction
This question is related to the problems associated to asymmetric information, namely,
adverse selection and moral hazard. To answer this issue, the following plan will be
followed: Part 2 analyses the theory behind asymmetric information, Part 3 shows how
they can be minimised, Part 4 shows an example to reduce imperfect information, and
the last part presents concluding comments.

2. Asymmetric information
Asymmetric information models assume that one party has more information than the
other in a transaction. This leads to the following 2 problems:

t-1: t t+1:
Adverse Moral
selection hazard

 Adverse selection: The ignorant part lacks information while negotiating an

agreed contract. Adverse selection typically refers to a situation where the seller
knows more about the quality of the good than the buyer, and it is a particular
example of how asymmetric information leads to a market imperfection. The
following conditions must be given so that adverse selection takes place:
 The buyer has difficulties in determining the quality of the product (cars,
electronic devices, etc.).
 The seller has a good knowledge about the quality of the product.
 Moral hazard: It occurs when the party with more information about its actions
has a tendency to behave inappropriately from the perspective of the party with
less information. These conditions must be given to have moral hazard:
 One of the parties can take unilaterally action without being observed.
 The informed party benefits from the unobserved action, and the other
party is harm.
3. How to reduce adverse selection and moral hazard
There are several ways to reduce the problems associated with asymmetric information.
Here, one of each will be analysed in depth: a) changing the payoffs, and b) signalling:

Regarding the first one, incentives can be created in such a way that the interest of the
principal and the agent are better aligned. The objective of a new payoff is to give the
same incentives to behave as with complete information. Applying asymmetric
information to corporate governance, several incentives can be created. It consists of
pricing managers’ tasks and rewarding them by each unit of task performed, and it is
called individual price-rate system. The drawback is that the system does not encourage
cooperation between workers since it focuses excessively on individual performance
rather than the firm as a whole. In addition, it is excessively focused in short-term rather
than in the long-run success of the organisation. Because of the various disadvantages, it
was proposed to pay individual bonuses in shares, so that managers worked in favour of
the company, instead of his own benefit, and in the long-run rather than in the short-run.
This is the best way to align the interest of the owner of the company and the manager.

The solution to avoid adverse selection is that the principal gathers more information in
order to reduce the information asymmetry. This may consists of feedback at different
stages, additional meetings with the managers, increase the accountability and
transparency of the managers, and any other signalling consisting in making the less
informed party easier to determine the hidden characteristic.

4. Critique
Before the crisis, bonuses were widely used to reward managers. However, these
bonuses were only assessing the work performed by the manager, not his performance
in the organisation as a whole. In addition, it was only focused in getting short-term
profits. This issue led managers to take risky decisions that could make a lot of money
in the short-run, but being harmful in the long-run for the company. There are many
cases in the late 90s such as Enron, but also in the commencement of the financial crisis
with many investment banks (Leman Brothers, etc.).
5. Conclusion comments
To sum up, moral hazard and adverse selection are the consequences of asymmetric
information, which can create several issues, but that they also have solutions. There is
an example of many companies that went to bankruptcy because of severe asymmetric
information.