ASYMMETRIC

INFORMATION AND
MARKETS
 Complete Information And
Asymmetric Information
• Uptil now all discussion regarding managerial decision
making assumed complete information for all
stakeholders.

• However, there are situations in which more information

is available with one party as compared to the other
party involved in a business transaction/deal.

• This leads to breakdown of normal functioning of market

and instead leads to a problem known as adverse
selection.
 ASYMMETRIC INFORMATION AND
THE MARKET FOR LEMONS
• One party to a transaction (i.e. buyer or seller) often has
less information than the other party with regard to the
quality of the product or service – asymmetric
information.

• Market for lemons such as used cars – sellers of used

cars know exactly the quality of the cars they are selling
but prospective buyers do not.

• As a result, the market price for used cars will depend on

the quality of the average used car available for sale.
 ASYMMETRIC INFORMATION AND
THE MARKET FOR LEMONS

• The owners of lemons would then tend to

receive a higher price than their cars are
worth while owners of high quality used
cars would tend to get a lower price than
their cars are worth.
 The Market for Used Cars
• With asymmetric information:
– Low quality goods drive high quality goods out
of the market – adverse selection
– The market has failed to produce mutually
beneficial trade
– Too many low and too few high quality cars
are on the market
– Adverse selection occurs; the only cars on the
market will be low quality cars
 THE MARKET FOR USED CARS
• The problem of adverse selection that arises
from asymmetric information can be overcome
or reduced by the acquisition of more
information by the party lacking it.

• For e.g., in the used car market, a prospective

buyer can have the car evaluated at an
independent automotive service centre, or the
used car dealer can signal above average
quality cars by providing guarantees.
 MARKET FOR INSURANCE AND
ADVERSE SELECTION
• People know more about their health than the
insurance company.

• As a result, when an insurance company sets

the insurance premium for the average health
individual, unhealthy people are more likely to
purchase insurance than healthy people.

• Because unhealthy people are more likely to

want insurance, the proportion of unhealthy
people in the pool of insured people rises.
 MARKET FOR INSURANCE AND
ADVERSE SELECTION
• Price of insurance rises so healthy people with
low risk drop out (Adverse Selection) –
proportion of unhealthy people rises, increasing
price more.

• Insurance companies try to overcome the

problem of adverse selection by requiring
medical check ups, charging different premiums
for different age groups and occupations, and
offering different rates of coinsurance, length of
contract, and so on.
 Market For Credit
• The Market for Credit
– Asymmetric information creates the potential
that only high risk borrowers will seek loans.
– Can end up with a lemons problem again.
– However, banks and credit agencies use
credit histories to gauge risk of borrowers.
 The Problem Of Moral Hazard
• Moral hazard occurs when the insured party whose
actions are unobserved can affect the probability or
magnitude of a payment associated with an event.
– If my home is insured, I might be less likely to lock
my doors or install a security system
– Individual may change behavior because of
insurance – moral hazard
– When a loss does occur, insurer may tend to inflate
the amount of the loss

• Moral hazard arises in any market where

behaviour can change after a deal has been done.
THE PROBLEM OF MORAL HAZARD
• If the problem of moral hazard is not reduced or
somehow contained, it could lead to unacceptably high
insurance rates and costs and thus defeat the very
reason for insurance.

• To deal with moral hazard, insurance companies create

incentives for purchasers of insurance to be careful.

1. Car drivers get no claim bonus.

2. Excess clause in many policies – require installation of

a fire detector before providing fire insurance to a firm;
require yearly physical check ups as a condition for
continuing to provide health insurance to an individual.
THE PROBLEM OF MORAL HAZARD

• Incentives continued –
3. Another way to reduce the problem of moral hazard is
coinsurance. This refers to insuring only part of the
possible loss or value of the property being insured. The
idea is that if the individual or firm shares a significant
portion of a potential loss with the insurance company,
the individual or firm will be more prudent and will take
more precautions to avoid losses from illness or
accidents.