Asymmetric information describes situations wherein one party to the transaction (e.g., the seller) has more information about the product or service in question than another party (e.g., the buyer). For example, in many cases, the producer will possess better information about the quality of raw materials used in the manufacture of a product than the buyer. The producer may present the product to the buyer as representing the finest quality. The buyer could inspect the product prior to purchase, but there may be ways that the producer could mask shoddy workmanship. In many cases, the buyer will be unable to distinguish between good and poor quality before the sale. The consumer may only learn whether the producer used substandard inputs after consumption of the product or through its extended use. In short, the producer could use better information (and the buyer’s lack of information) to his or her advantage.
If only as a savvy consumer, you can relate to the scenario just described. In a famous paper, Akerlof (1970) noted that asymmetric information could, in severe cases, cause markets for high quality products to fail. He described a “lemons market,” where only low-quality products are provided. In this context, the term “lemons” refers to used automobiles of poor quality, the example used in Akerlof’s (1970) paper. The lemons market occurs because no buyer would be willing to pay a premium for high quality because everyone understands that sellers have an incentive to pass off low-quality products at a high-quality price.
To consider further how asymmetric information could cause market failures, let us explore two problems that relate to asymmetric information. One is called adverse selection. The other is called moral hazard. Adverse selection refers to cases where asymmetric information makes it difficult for parties to enter into a mutually beneficial transaction because of concerns that one party could use its informational advantage to the detriment of the other. The lemons market is an example of adverse selection. Adverse selection problems are the primary focus of this chapter. Moral hazard, on the other hand, refers to cases where asymmetric information can create problems after two parties have entered into a business arrangement because of one party’s inability to accurately monitor the behavior or effort of the other. According to Milgrom and Roberts (1992), adverse selection and moral hazard arose out of insurance market terminology but have since taken on broader meanings. Given the origins in insurance markets, let us use insurance as an example to illustrate each of these two problems.
Adverse Selection
Adverse selection results when asymmetric information creates pre-contractual problems. For example, customers who buy dental insurance likely know more about their risks of needing costly dental procedures than do insurance providers. Let us take the hypothetical case of John Doe. John is a recent graduate and knows that he has a high likelihood of being predisposed to dental problems because they run in his family. Moreover, he has had many cavities up to this point in his life. John is fairly certain that there will be expensive dental procedures in his near future. When there is an opportunity to sign up for dental insurance through his employer, John Doe jumps at the chance. To him it seems like a great deal. Jane Doe (no relation to John), on the other hand, has the same opportunity to sign up for dental insurance. Jane has never had a cavity before and feels fortunate to have a good set of teeth. To Jane, the premiums for dental insurance seem high. She would like to have some insurance against the costs of expensive dental care should she need it, but she knows that the most she will pay her dentist in a normal year will be the cost of routine cleanings and checkups. She can pay those out-of-pocket for much less than what she would pay in dental insurance premiums. Because of this, Jane decides not to enroll in the dental insurance program.
In the end, one would expect customers with bad teeth to enroll in dental insurance and customers with good teeth not to enroll. This is adverse selection. Many people with good teeth would like to insure against the cost of dental care should it be needed. but a problem arises because the insurance company is unable to distinguish between high-risk and low-risk customers a priori. It is possible that dental insurance is lemons market in that only high-premium insurance catering to high-risk customers is available. Asymmetric information, in this example, could prevent the emergence of a market for lower-cost dental insurance tailored to lower-risk customers.
Moral Hazard
Moral hazard results when asymmetric information creates post-contractual problems that result from one party being unable to fully monitor the effort or actions of the other. Once a people buy insurance, they may be less careful because they are at least partially insured against a loss. Insurance companies cannot monitor customers all the time, so an asymmetric information problem emerges after an insurance policy has been sold. Moral hazard is partially mitigated by providing incentives in the form of deductibles, co-payments, and partial coverage. For example, a person who has dental insurance, will likely still practice good oral hygiene. Aside from large deductibles and copayments, corrective dental procedures such as fillings, root canals, and crowns can be painful and inconvenient. Such losses in utility are not covered by the insurance.
Market Solutions to Adverse Selection and Moral Hazard
In the case of moral hazard, a common market solution is to develop contracts that provide incentives. For example, your automobile insurance company probably gives you a discount on your premiums if you have not filed a claim in the past few years, have a good driving record (few or no arrests for traffic violations), and/or have good grades. Basically, the company that insures you would like you to drive carefully. Since you are often in a hurry and have coverage that at least partially offsets the costs you would incur in the event of an accident, it knows that you may, on occasion, not be as careful as it would like you to be. It is prohibitively costly for the company to have a representative follow you around and file detailed reports on the carefulness of your driving habits. Instead, the insurance company offers you a set of incentives, based on things that it can observe (like the number of traffic violations) and that it knows are correlated with the degree of risk it takes in insuring you.
Livestock production contracts in agriculture are good examples of incentive-based contracts designed to address moral hazard problems. In broiler chicken production, an integrator provides contract growers with chicks, feed, and other inputs. The integrator would like its contract growers to work hard to minimize mortality and increase feed conversion. The integrator could offer a fixed payment for each flock of birds grown. However, this would result in a moral hazard problem because contract growers would get the same payment regardless of whether they put lots of effort or minimal effort into growing the birds. To address moral hazard, broiler contracts are designed so that growers who do well relative to others in their settlement pool receive premiums while those who do less well receive penalties. Again, it is costly for the integrator to monitor the effort expended by each of its contract growers, but it can easily measure mortality and feed conversion rates. If these are correlated with grower effort, it can design contract provisions to provide incentives for growers to put the desired levels of effort into raising the birds.
A common market solution to adverse selection problems is to rely on an economic signal. A signal is a way for one party to send a believable message to another about the characteristics contained in the products. Advertising is an example of an economic signal. As you will see, advertising clearly has a multifaceted role and can address problems of costly information as well as problems of asymmetric information. The remainder of the chapter is comprised primarily of a discussion of advertising and other economic signals to overcome adverse selection problems resulting from asymmetric information.
