Information Failure and Asymmetric Information

Statement

Information failure is market failure that arises from the absence of perfect information in the free market, so that economic agents cannot make optimal decisions. It takes two forms:

• Imperfect information — agents are ignorant or misinformed, causing a divergence between perceived and actual private cost or benefit.
• Asymmetric information — the parties to a transaction do not have the same amount of knowledge, distorting incentives and producing inefficient outcomes. Its two manifestations are:
  • Adverse selection — the more informed party withholds information from the less informed party in a way that harms them, before the transaction is made.
  • Moral hazard — the more informed party changes its behaviour after the transaction is made, in a way that harms the less informed party.

Notes

The defining contrast between the two forms of asymmetric information is timing: adverse selection is opportunism before the transaction (the used-car dealer concealing a car’s condition, driving good cars out of the market — the “lemons” problem), moral hazard is opportunism after it (the insured driver taking fewer precautions). How each distorts the market and how the government responds — screening, signalling, monitoring, regulation — is set out in imperfect information and asymmetric information. Note that 9570 examines these in prose only: there is no information-failure diagram in the syllabus.