Syllabus points
- Explain asymmetric information as a source of market failure.
- Distinguish adverse selection from moral hazard.
- Evaluate responses to information failure.
Information failure
Efficient markets assume buyers and sellers are well informed. Asymmetric information exists when one party in a transaction has more or better information than the other. This can lead to the wrong quantity being traded, or markets breaking down entirely.
Adverse selection and moral hazard
- Adverse selection happens *before* a transaction: the better-informed party self-selects in a way that harms the other. In insurance, the highest-risk people are keenest to buy, so insurers face worse-than-average customers and may raise prices or withdraw cover.
- Moral hazard happens *after* a transaction: being protected changes behaviour. An insured driver may take more risks because they no longer bear the full cost.
Adverse selection = hidden information *before* the deal. Moral hazard = hidden action *after* the deal.
Key definitions
| Term | Exam-ready definition |
|---|---|
| Asymmetric information | One party has more or better information than the other. |
| Adverse selection | Those most likely to benefit self-select, worsening the pool for the other party. |
| Moral hazard | A protected party changes behaviour and takes more risk. |
Responses to information failure
- Signalling — the informed party credibly reveals quality (qualifications, warranties, brand reputation).
- Screening — the uninformed party designs choices to sort types (insurance excess/deductibles, health checks).
- Government action — licensing, mandatory disclosure (food labels, financial disclosure), and regulation of standards.
These reduce but rarely eliminate the problem, and can be costly to enforce.
Worked example
In a used-car market, sellers know each car's quality but buyers do not. Fearing "lemons", buyers only offer an average price, which drives good cars out of the market — an adverse-selection breakdown. Warranties (signalling) and independent inspections (screening) help restore trust and trade.
Common exam mistakes
- Swapping adverse selection and moral hazard.
- Treating any lack of information as asymmetric — it must be *unequal* between parties.
- Ignoring evaluation of enforcement costs.
Exam technique
State clearly whether the failure is *before* (adverse selection) or *after* (moral hazard) the transaction, then match a suitable response (signalling, screening, regulation) and evaluate its cost and effectiveness.
Quick revision
- Asymmetric information → wrong quantity traded or market breakdown.
- Adverse selection (before) vs moral hazard (after).
- Fixes: signalling, screening, regulation/disclosure.