Asymmetric information

Asymmetric information, also known as “information failure,” occurs when one party to an economic transaction possesses greater material knowledge than the other party. This typically manifests when the seller of a good possesses greater knowledge than the buyer; however, the reverse dynamic is also possible. Almost all economic transactions involve information asymmetries. Asymmetric information can also be viewed as the specialization and division of knowledge, as applied to any economic trade. Asymmetric information examples are everywhere. In the financial world, consider a situation where a lending firms enters into an agreement with a borrower. The lender establishes the terms and agreements that the borrower must stipulate to, and, usually, background checks are done.

Moral hazard is a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost. It arises when both the parties have incomplete information about each other.

In a financial market, there is a risk that the borrower might engage in activities that are undesirable from the lender’s point of view because they make him less likely to pay back a loan. It occurs when the borrower knows that someone else will pay for the mistake he makes. This in turn gives him the incentive to act in a riskier way. This economic concept is known as moral hazard.

Adverse Selection describes a situation in which one party in a deal has more accurate and different information than the other party. The party with less information is at a disadvantage to the party with more information. This asymmetry causes a lack of efficiency in the price and the number of goods and services provided. Most information in a market economy is transferred through prices, which means that adverse selection tends to result from ineffective price signals.