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Tag: Asymmetric Information – Adverse Selection and Moral Hazard

  • UGC NET Economics Unit 1-Asymmetric Information – Adverse Selection and Moral Hazard

    1. Introduction

    In traditional microeconomics, markets are assumed to have perfect information, meaning that buyers and sellers know everything relevant about the goods, prices, and market conditions.

    However, in reality, information is imperfect and unevenly distributed — one party often knows more than the other.
    This is known as Asymmetric Information, and it can cause market failures.

    Definition:

    Asymmetric Information occurs when one party in a transaction possesses more or better information than the other party.

    Examples:

    1. A used-car seller knows more about the car’s condition than the buyer.

    2. A borrower knows more about their repayment ability than the lender.

    3. An insured person knows more about their risk level than the insurance company.

    Consequences of Asymmetric Information:

    1. Market inefficiency

    2. Adverse Selection

    3. Moral Hazard

    4. Principal–Agent Problem

    2. Types of Asymmetric Information Problems

    Type When it occurs Key Idea
    Adverse Selection Before a transaction Hidden information about quality or risk leads to poor market outcomes.
    Moral Hazard After a transaction Hidden actions after contract execution lead to opportunistic behavior.

    3. Adverse Selection

    Definition:

    Adverse Selection refers to a situation where hidden information (before a transaction) causes high-risk or low-quality participants to dominate the market.

    It happens before the deal is made because one side cannot distinguish between “good” and “bad” types.

    Origin of Concept:

    Developed by George Akerlof (1970) in his famous paper “The Market for Lemons”, which won him the Nobel Prize in Economics (2001).

    Akerlof’s Example – “The Market for Lemons”

    • Used-car sellers know whether their cars are good (peaches) or bad (lemons).

    • Buyers can’t tell the difference and therefore offer an average price.

    • As a result:

      • Sellers of good cars exit (since price is too low).

      • Only “lemons” remain in the market.

    👉 This leads to market failure — where only low-quality goods are traded, or the market may collapse completely.

    3.1 Characteristics of Adverse Selection

    Feature Description
    Timing Occurs before transaction.
    Type of information Hidden information (quality or risk).
    Effect Drives out good participants; “bad drives out good.”
    Market result Market inefficiency or collapse.

    3.2 Examples of Adverse Selection

    1. Insurance Market:

      • High-risk individuals are more likely to buy insurance.

      • Insurer cannot distinguish between high- and low-risk customers.

      • Leads to high premiums → low-risk people drop out.

    2. Credit Market:

      • Lenders cannot distinguish between good and bad borrowers.

      • Charge a high interest rate → good borrowers avoid loans.

    3. Labour Market:

      • Employers cannot know workers’ productivity before hiring.

      • High wages attract low-quality workers who intend to exploit firms.

    3.3 Solutions to Adverse Selection

    Solution Explanation Example
    Signaling The informed party provides credible information. Education degrees as signals of ability (Spence, 1973).
    Screening The uninformed party designs mechanisms to reveal information. Insurance company offering multiple policy options.
    Warranties / Guarantees Sellers assure buyers of product quality. Warranty on used cars or electronics.
    Reputation / Brand Established firms build credibility over time. Trusted brands reduce information asymmetry.

    Key Economist Contributions:

    • George Akerlof (1970): “Market for Lemons” – Adverse Selection.

    • Michael Spence (1973): “Job Market Signaling.”

    • Joseph Stiglitz (1975): “Screening and Insurance.”
      All three jointly received the 2001 Nobel Prize for their work on Asymmetric Information.

    4. Moral Hazard

    Definition:

    Moral Hazard arises when one party changes their behavior after a contract is signed, because the other party cannot observe or verify their actions.

    It occurs after the transaction, involving hidden actions rather than hidden information.

    Example:

    1. After getting insured, a person may take more risks, knowing the insurer bears the loss.

    2. A manager may shirk after being hired because the employer cannot monitor them constantly.

    3. A borrower may spend loan money irresponsibly once the loan is approved.

    4.1 Characteristics of Moral Hazard

    Feature Description
    Timing Occurs after contract or transaction.
    Type of Information Hidden actions (effort, behavior).
    Cause Lack of monitoring or enforcement.
    Effect Inefficient outcomes, resource misuse, or higher costs.

    4.2 Examples of Moral Hazard

    Market Example
    Insurance Market Insured individuals take more risks (e.g., drive carelessly).
    Financial Market Banks take risky investments expecting government bailouts.
    Labour Market Employees reduce effort after securing a job.
    Corporate Sector Managers pursue personal goals rather than shareholders’ interests.

    4.3 Solutions to Moral Hazard

    Solution Explanation Example
    Incentive contracts Align rewards with performance. Bonus tied to productivity.
    Monitoring & auditing Observe and check actions. Supervisors, audits in firms.
    Deductibles / Co-payments Share risk with insured to discourage recklessness. Insurance deductibles.
    Performance-based pay Link pay to results. Commissions, profit sharing.
    Reputation mechanism Repeat interactions encourage honesty. Online seller ratings.

    4.4 The Principal–Agent Problem

    • Principal: The one who delegates (e.g., employer, shareholder).

    • Agent: The one who acts on behalf of the principal (e.g., employee, manager).

    • When the agent’s actions are not observable, they may act in self-interest rather than in the principal’s interest.

    ➡️ This is a form of moral hazard due to asymmetric information after contract.

    Examples:

    • Shareholders (principals) vs. managers (agents).

    • Government (principal) vs. contractors (agents).

    • Insurance company vs. insured person.

    5. Comparison Between Adverse Selection and Moral Hazard

    Feature Adverse Selection Moral Hazard
    Timing Before the transaction After the transaction
    Type of Problem Hidden information Hidden action
    Key Concept Wrong participants enter market Participants change behavior after deal
    Main Example Buyer cannot judge product quality Insured person becomes careless
    Solution Methods Signaling, screening, warranties Incentive schemes, monitoring, deductibles

    6. Policy Implications

    1. Regulation and disclosure laws (e.g., mandatory product information).

    2. Credit scoring systems to classify borrower risk.

    3. Co-payments and deductibles in health insurance.

    4. Performance-based compensation in management.

    5. Government intervention to ensure transparency and information sharing.

    7. Theoretical Contributions and Nobel Recognition

    Economist Contribution Year
    George Akerlof Adverse selection (“Market for Lemons”) 1970
    Michael Spence Signaling in job markets 1973
    Joseph Stiglitz Screening and insurance behavior 1975
    Joint Nobel Prize For analysis of markets with asymmetric information 2001

    8. Key Takeaways for UGC NET

    • Asymmetric Information → Unequal knowledge between parties.

    • Adverse Selection → Hidden information before contract → Market for lemons.

    • Moral Hazard → Hidden actions after contract → Risky behavior.

    • Principal–Agent Problem → A form of moral hazard.

    • Signaling and Screening → Tools to reduce information asymmetry.

    9. Important Diagrams

    (a) Adverse Selection – Market for Lemons

    • Demand curve: buyers’ expected price for average quality.

    • Supply curve: sellers’ willingness to sell.

    • Equilibrium shifts to low-quality goods only → market collapse.

    (b) Moral Hazard – Principal–Agent Model

    • Principal offers contract: Pay = fixed + performance bonus.

    • Optimal contract balances risk sharing and incentive compatibility.

    10. Summary Table

    Concept Timing Hidden Factor Main Example Key Economist Solution
    Adverse Selection Before contract Hidden Information Used-car market Akerlof Signaling, Screening
    Moral Hazard After contract Hidden Action Insurance market Stiglitz Incentive contracts, Monitoring
    Principal–Agent Problem After contract Hidden Action Employer–Employee Jensen & Meckling Performance pay, Supervision

    📖 11. Suggested Readings

    1. Akerlof, G. (1970) – The Market for Lemons: Quality Uncertainty and the Market Mechanism

    2. Spence, M. (1973) – Job Market Signaling

    3. Stiglitz, J. (1975) – Incentive Effects of Risk Sharing in Insurance

    4. Hal R. Varian – Intermediate Microeconomics

    5. Koutsoyiannis – Modern Microeconomics

    6. D.N. Dwivedi – Microeconomics: Theory and Applications