Question

Are the concepts of Moral Hazard and Asymmetric Information useful for economic analysis?

Answer 1

Asymmetric information means that one party has more or better information than the other when making decisions and transactions. The imperfect information causes an imbalance of power.

When you are trying to negotiate your salary, you will not know the maximum your employer is willing to pay and your employer will not know the minimum you will be willing to accept. Accurate information is essential for sound economic decisions.

When a market experiences an imbalance it can lead to market failure. Adverse selection is a term used in economics that refers to a process in which undesired results occur when buyers and sellers have access to different/imperfect information.

The uneven knowledge causes the price and quantity of goods or services in a market to shift. This results in "Bad" products or services being selected. If a bank sets one price for all of its checking account customers it runs the risk of being adversely affected by its low-balance and high activity customers.
The individual price would generate a low profit for the bank.

In addition to adverse selection, moral hazards are also a result of asymmetric information. A moral hazard is a situation where a party will take risks because the cost that could incur will not be felt by the party taking the risk.

A moral hazard can occur when the actions of one party may change to the detriment of another after a financial transaction. Concerning asymmetric information, moral hazard may occur if one party is insulated from risk and has more information about its actions and intentions than the party paying for the negative consequences of the risk.

Moral hazards occur in employment relationships involving employees and management. When a firm cannot observe all of the actions of employees and managers there is the chance that careless and selfish decision-making will occur.

Asymmetric information starts the downward economic spiral for a firm. A lack of equal information causes economic imbalances that result in adverse selection and moral hazards. All of these economic weaknesses have the potential to lead to market failure. A market failure is any scenario where an individual or firm's pursuit of pure self-interest leads to inefficient results.