Takeaway

Markets work best when both buyers and sellers know exactly what is being exchanged. When one party to an exchange has more or better information than the other party, we get problems of asymmetric information, such as moral hazard and adverse selection.

Moral hazard is when an agent tries to exploit an information advantage in a dishonest or undesirable way. Not all people try to exploit their information advantage but incentives do matter. When moral hazard is possible, the less informed party may be exploited and resources may be consumed without generating value (the mechanic who replaces the part that doesn’t need replacing). Or, fearing moral hazard, parties with less information may simply decide not to trade, thereby reducing the gains from trade.

Adverse selection occurs when an offer conveys negative information about the product being offered. When buyers can’t easily evaluate the quality of a good, they may assume that any good offered for sale will be of low quality and they will be willing to pay only accordingly. Sellers, seeing that the price is low, will choose to sell only the low-quality good. Buyers and sellers both get what they paid for (unlike with moral hazard) but both would be better off if they could also buy and sell high-quality goods.

Moral hazard and adverse selection problems challenge markets, but market institutions, laws, and regulations have evolved to deal with these problems. Ratings, reviews, and inspections all work to generate more information and to reduce asymmetry. Reputation and certification, second opinions (separating the provider of information from the provider of the service), and contingent fees all help to align buyer and seller interests. Even when the relevant information cannot be shown directly (only the heart knows its secrets), sometimes it can be signaled by an investment in something else.

The solutions to asymmetric information problems are never without cost and they are rarely perfect or complete. Ratings and reviews can be faked, reputations are sometimes undeserved, contracts rarely fully align incentives, and signals are noisy. Nevertheless, we think that understanding the problems of asymmetric information and their (partial) solutions can help you to understand and navigate your world.