Summary

1. The lemons problem, a common feature of markets like the used car market, exists when the seller knows more about the quality of a good than does the buyer. The existence of lemons on the market results in adverse selection into the market; low-quality goods are more likely to be put on the market than high-quality goods because consumers cannot differentiate between the two types of goods before buying them. The same type of adverse selection problem occurs in markets in which buyers have more information than sellers, such as the insurance market. [Section 16.1]

2. When one party in an economic transaction cannot observe the behavior of the other party, moral hazard arises. Moral hazard is especially common in insurance markets, because once insured against a bad outcome, the insured party is more likely to act in ways that increase the probability of that bad outcome. Clauses that specify the actions that must be taken by a policyholder in order to be covered are designed to mitigate moral hazard. [Section 16.2]

3. Information asymmetry in the workplace and other economic arenas can lead to principal–agent problems. In this case, the principal hires an agent whose actions the principal cannot fully observe. To ensure that the agent acts in the principal’s best interest, the principal must create incentive structures that align the interests of the agent with the principal’s own best interests. [Section 16.3]

4. One way to solve information asymmetry is through the use of signaling, in which one party in a transaction communicates information that is not immediately observable. A common example of signaling is education, which enables employers to distinguish relatively high-productivity workers from low-productivity workers. [Section 16.4]