The Problem of Asymmetric Information

A key assumption of perfect market efficiency is perfect information, where buyers and sellers have equal, complete knowledge.

In reality, information gaps are common.

The most significant is asymmetric information, where one party in a transaction has more or better information than the other.

This distorts decision-making and leads to market failure.

Consequences of Asymmetric Information

Adverse Selection

Adverse selection: occurs before a transaction.

The party with less information cannot judge quality accurately, so they assume the worst. This drives high-quality goods out of the market.

Example: In the used car market, sellers know the car's history but buyers do not.

Buyers assume that all cars may be low-quality "lemons", so they are only willing to pay a low price. This pushes sellers of good cars out of the market, leaving only lemons.

Moral Hazard

Moral hazard: occurs after a transaction.

One party changes their behaviour in a riskier way because they do not bear the full consequences of their actions.

Example: With comprehensive car insurance, a driver may become less cautious because the insurer bears the cost of an accident.

Result: Market Failure

Asymmetric information causes a misallocation of resources.

Markets may over-provide low-quality or harmful goods because buyers are unaware of defects.

Markets may also under-provide high-quality or beneficial goods because buyers cannot identify them.

This results in a loss of allocative efficiency.

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