Essay on Asymmetric Information

1780 Words 8 Pages
Asymmetric information is a problem which faces managers of firms everywhere. It occurs where one party to a transaction has more information than the other party to said transaction. This of course creates other problems for the managers as well. We can identify four main areas where asymmetric information causes problems. The problems caused are adverse selection, moral hazard, hiring practices and insider trading. This essay will follow the structure of firstly defining and further explaining each of these topics and what affect each has on the manager. We will then move onto possible solutions for these problems, which include screening, signalling and government intervention. Finally in this essay each of these solutions will be …show more content…
Therefore the unlucky good drivers will not be willing to pay the higher rate and the insurance company will end up with only those who are likely to wreck their cars. This means that the insurance company has adverse selection due to hidden characteristics. Insurance generally works when there are some drivers who don't wreck their cars, so the insurance company would be well advised to lower the premiums and not insure the drivers with poor records. Health insurance is another good example, as the company may charge premiums based on the average risk of people getting sick. This will probably lead to those who are of poorer health, or a higher risk of getting sick being over represented among its clients. Of course one of the main problems of the hidden characteristics is that even if there is only the suspicion of hidden characteristics, one party may refuse to enter into the transaction. Also when buyers in a market can only observe average quality, there is a tendency for sellers not fully rewarded for high quality to withdraw from the market (Hirshleifer, 1989) Hence the market is left with those lower quality sellers.

Moral hazard is the consequence of asymmetric information that generally occurs after the transaction has been entered into. It results from hidden action, that is, actions that
Open Document