Markets do very well at dealing with diversifiable risk and with risk due to uncertainty: situations in which nobody knows what is going to happen, whose house will be flooded, or who will get sick. However, markets have much more trouble with situations in which some people know things that other people don’t know—situations of private information. As we will see, private information can distort economic decisions and sometimes prevent mutually beneficial economic transactions from taking place. (Sometimes economists use the term asymmetric information rather than private information, but they are equivalent.)

Why is some information private? The most important reason is that people generally know more about themselves than other people do. For example, you know whether or not you are a careful driver; but unless you have already been in several accidents, your auto insurance company does not. You are more likely to have a better estimate than your insurance company of whether or not you will need an expensive medical procedure. And if you are selling me your used car, you are more likely to be aware of any problems with it than I am.

But why should such differences in who knows what be a problem? It turns out that there are two distinct sources of trouble: adverse selection, which arises from having private information about the way things are, and moral hazard, which arises from having private information about what people do.