Question

Lack of information creates problems in the financial system whereby one party often does not know enough about the other party to make accurate decisions .What is this inequality. Explain the two problems the inequality further creates?

Answer 1

Lack of information creates problems in the financial system whereby one party often does not know enough about the other party to make acurite decisions. This inequality is called asymmetric information or also known as information failure.

Asymmetric information further leads to two types of inequality. They are –

A. Adverse selection

B. Moral hazard

A. Adverse selection

It occurs when sellers have information that buyers do not have or vice versa, about the aspects of the product being transacted. This type of inequality resulting in lack of information with one party helps in better trade practices, or more specifically selective trade practices. The standard example is the second hand car market (lemons).

In case of secondhand market or the lemons market, usually the seller have more information about the quality of the cars being sold as compared to the buyer. Here, the seller tries to hide information for trading purposes. So, here the buyer is at disadvantage if he gets hold of a bad quality product.

In case of insurance market, adverse selection is the tendency of those in dangerous jobs or high risk lifestyles to purchase products like life insurance. In this case the buyer of life insurance has more information and knowledge about the utility and potentiality of the insurance’s investment in future, but the seller lacks any appropriate information unless claims are made by the clients. To fight these situations, usually insurance companies charge high premiums or limit the coverage of the policy.

B. Moral Hazard

Moral hazard occurs when there is asymmetric information between two parties, but change in behavior of one party is exposed after the deal is struck. It is the risk that a party has not entered into a contract in good faith or has provided false data about his assets, liabilities or credit capacities. For example when a property owner have taken insurance for a certain property, he tends to be less careful as compared to the situation before having got the insurance. This type of activity can bring the insurance company at loss as it has to issue claims against any damage to the property.

Moral hazard can exist in employer-employee relationships, as well. If an employee has a company car for which he does not have to pay for repairs or maintenance, the employee might be less likely to be careful and more likely to take risks with the vehicle.