Information
- The free market assumes that consumers and producers are rational, profit/utility maximizing and that both parties have perfect information (which is one of the criteria for perfect competition).
- Consumer and producer surplus are maximized.
- However, in reality, all parties typically don't have perfect information.
Asymmetric Information
- Where one party in an economic transaction has access to more or better information than another.
- Information is not symmetrical, so it is asymmetric.
Adverse Selection
- A situation where one participant has more information than another before the transaction occurs.
- Bad drives out good.
Examples (names are for comedic effect)
Tragedy of the Plums and Lemons
- Used car dealers are aware of which used cars are in good condition (plums) and which are in bad condition (lemons), while the buyer does not.
- As buyers cannot tell the difference, they are only willing to pay for the price of the average conditioned car. The sellers of the best plums, cannot make profit and leave the market.
- This causes the average to go down. Then the next best plum sellers have to leave on, and the cycle continues in a so called "death spiral" where consumers aren't willing to buy any cars. Warranties and guarantees can prevent this from occurring.
Tragedy of the Health Insurance Firms That Never Happens in Reality Because They Never Pay Insurance Anyway so That They Can Hoard Profits Instead
- As people in good health might not deem it necessary, only people with bad health will apply for insurance.
- As the people in bad health receive the insurance more often, the insurance company needs to increase their price to continue making profit.
- However, as the price increases, only those who know they will need the insurance keep paying for it. This leads to a feedback loop eventually leading to the bankruptcy of the firm. This can be avoided by making health insurance a requirement.
- When everyone has health insurance, healthy people who don't need the insurance as much can pay for the insurance of those that do.
Moral Hazard
- A situation where one participant takes on more risk because they understand they will not pay the consequences of that risk.
- Unlike Adverse Selection, the information only changes after the transaction occurred.
- Moral hazard takes place after the purchase, unlike adverse selection which takes place before.
Example
Tragedy of the Drunk Driver
- Car insurance can be used as an example.
- Drivers with insurance may feel more at ease when they have insurance because if they are involved in an accident they only pay a fraction of the costs.
- This may encourage drives to engage in more risky driving.
- Insurance firms can make rules, such as not paying for the car insurance if the driver was responsible for the car crash.