Asymmetric Information, Adverse Selection, Moral Hazard, Lemons Problem

Asymmetric Information, Adverse Selection, Moral Hazard, Lemons Problem

• Asymmetric Information – When one person has more or better information than another person. Example: In real estate, the seller of the house has more information about the house (water leaks and other problems) than the buyer.

• Moral Hazard – When an individual or a firm takes advantage of special knowledge while doing socially inefficient behavior. Examples: If you have house insurance, you’re probably more likely to leave your door unlocked. This is socially inefficient. If you ask a car mechanic for advice, it’s in their interest to exaggerate the problems with your car so that you use more of their services.

• Adverse Selection – The tendency for people that are more at risk to purchase insurance than those who are less at risk to reject insurance. Example: People that are smokers should be paying higher health insurance premiums since they are more likely to get sick. Let's say smokers should pay $200 per month and non-smokers should pay $100. Since some people can lie to the insurance company about whether or not they are smokers, the company takes an average of $150. This is good for the smokers who should be paying more and they take the insurance but the non-smokers are less likely to take the insurance at this price since they are healthy.

• Lemons Problem - This is when the low quality products drive out the high quality products until only lemons (low quality products) are left in the market. Example: The market for used cars. Let's say Sarah is selling high quality used cars and is willing to sell each one for $20,000 and Ameen is selling low quality used cars for $10,000. Due to asymmetric information, most customers do not know the difference between low and high quality used cars so they take an average of the prices at $15,000 and that is the price they think is fair. Sarah will not be willing to sell her high quality used cars at this price so she will stop selling and leave the market. This process will keep happening until only low quality cars are left in the market.