Markets for information abound in the modern economy. Governments frequently supply information on account of its public good characteristics. But the problem of asymmetric information poses additional challenges. Asymmetric information is where at least one party in an economic relationship has less than full information. This situation characterizes many interactions: bosses do not always know how hard their subordinates work; life-insurance companies do not have perfect information on the lifestyle and health of their clients.
Asymmetric information is where at least one party in an economic relationship has less than full information and has a different amount of information from another party.
Asymmetric information can lead to two kinds of problems. The first is adverse selection. For example, can the life-insurance company be sure that it is not insuring only the lives of people who are high risk and likely to die young? If primarily high-risk people buy such insurance then the insurance company must set its premiums accordingly. In effect the company is getting an adverse selection rather than a random selection of clients. Frequently governments decide to run compulsory-membership insurance plans (auto or health are examples in Canada) precisely because they may not wish to charge higher rates to higher-risk individuals.
Adverse selection occurs when incomplete or asymmetric information describes an economic relationship.
The second type of problem is moral hazard. If an individual does not face the full consequences of his actions, his behaviour may be influenced: If the boss cannot observe the worker’s effort level, the worker may shirk. Or, if a homeowner has a fully insured home he may be less security conscious than an owner who does not.
In Firms, investors and capital markets we described how US mortgage providers lent large sums to borrowers with uncertain incomes in the early years of the new millennium. The lenders were being rewarded on the basis of the amount lent, not the safety of the loan. Nor were the lenders responsible for loans that were not repaid. This ‘sub-prime mortgage crisis’ was certainly a case of moral hazard.
Moral hazard may characterize behaviour where the costs of certain activities are not incurred by those undertaking them.
Solutions to these problems do not always involve the government, but in critical situations do. For example, the government requires most professional societies and orders to ensure that their members are trained, accredited and capable. Whether for a medical doctor, a plumber or an engineer, a license or certificate of competence is a signal that the work and advice of these professionals is bona fide. Equally, the government sets standards so that individuals do not have to incur the cost of ascertaining the quality of their purchases – bicycle helmets must satisfy specific crash norms.
These situations differ from those where solutions to the information problem may be implemented in the market place: life insurance companies can establish the past medical history of its clients, and employers may be able to provide incentives to its employees to work hard.
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