Asymmetric information : Adverse Selection and Moral Hazard

Asymmetric information

It is one party’s insufficient and incomplete knowledge about the other party involved in the transaction to make accurate decision making. In other words  it means that one party has more better information then other when making decisions and transactions. It is sometime referred as information failure. Not only in financial market but almost all economic transaction involves asymmetric information.

When it comes to purchase or sale of a financial security, asymmetric information occurs when either the buyers or sellers has more information on the past, present or future performance of that financial security. If the buyer has more information, he knows that security is underpriced relative to its aggregate performance. If the seller has more information, he knows that the security is overpriced relative to its aggregative performance. In this way, asymmetric information gives either the buyer or seller the better opportunity to make a profit over purchase on sale of that financial security. The presence of asymmetric information leads to adverse selection and moral hazard.

Adverse Selection

Adverse selection occurs when one side of the market have better information then the other side and so there is selection of only a high cost or low value being bought or sold. This problem occurs before the transaction occurs.

It is a process by which the prices and quantity of goods or services in a market is altered due to one party having information that other party cannot have at reasonable cost. Adverse selection generally found in insurance market.

Let us take an example, there are two individuals, one who smoke and do not exercise and other who don’t smoke and do exercise daily. It is common sense that, the life expectancy of the first individual is less than other, remaining other things constant. Now, both the individual buy a life insurance policy. When the insurance company ask them to fill out a questionnaire to distinguish between them, the person who smoke and do not exercise knows that answering truth fully means higher insurance premium, so he lies and says that he does not smoke and do exercise. This leads to adverse selection, where insurance company have a disadvantage and thus they charges same premium to both individual. However, insurance is more valuable to the non-exercising smoker than the exercising non-smoker.

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