2.10 Market failure - asymmetric information

Asymmetric information exists when one side knows more relevant information than the other. It can cause adverse selection before agreement or moral hazard after agreement.

Hidden quality can drive good products out; hidden actions can shift risk to others.

Identify who knows what and when the gap occurs.

Used-car sellers know quality better than buyers, so low offers may drive good cars out.

An information gap is not automatically harmful if contracts solve it.

Government responses are legislation, regulation and provision of information. Private responses are signalling by the informed party and screening by the less-informed party.

Legislation can require disclosure or prohibit misleading conduct; regulation sets and enforces standards; public information makes quality or risk easier to compare. A credible signal separates types because it is harder for a low-quality party to imitate, while screening offers tests or contract choices that induce parties to reveal information.

For hidden quality before agreement, ask whether disclosure, a signal or screening can improve selection. For hidden action after agreement, ask whether rules and monitoring change incentives without creating excessive cost or exclusion.

A qualified worker signals ability with a verifiable credential. An insurer screens applicants using relevant risk information or a menu of deductibles, while regulation controls what information may be requested and requires truthful disclosure.

Warranties or certification can be examples only when their signalling or regulatory mechanism is explicit. More information is not enough if it is unreliable, unusable or costly, and screening can create equity or privacy concerns.