Question

Define and explain asymmetric information outlining its two sources

Answer 1

The definition of Asymmetric Information revolves around a situation in which each party to a transaction has unequal knowledge, where one party has better information than the other. That type of asymmetry produces a transaction imbalance.

Adverse selection defines situations in which either buyers or sellers have knowledge not available to the other party. When these two groups are informed to different degrees in these cases, that creates asymmetric knowledge. The problem with asymmetric information arises before the transaction takes place / pre-contractual issues where one party has more information than another. Drivers of used cars have more knowledge than they share when selling their vehicles. Cover-seekers are more likely to require cover, meaning the decision-maker typically has a limited range.

Moral hazard is a situation where a party is more likely to take risks, since the risk-taking party will not bear the costs that could result. This asymmetric knowledge problem arises after transaction. For example, a person with auto theft insurance could be less vigilant about locking their car because the adverse consequences of vehicle theft are now (partially) the insurance company's fault. Another example may be people receiving welfare insurance; they may be less likely to obtain jobs than in a case in which they have had no insurance.