Asymmetric Information

Idea

Asymmetric information is a market failure in which one party to a transaction knows more than the other, and exploits the gap. The more-informed party’s opportunism shrinks the market and so under-allocates resources to goods society wants. It takes two forms, distinguished by when the opportunism occurs.

Mechanism

Adverse selection — opportunism before the transaction. The more-informed party withholds information in a way that harms the other. In the used-car market, dealers hide the true condition of cars; buyers, anticipating this, lower the price they will pay; at that lower price, owners of good cars withdraw, leaving disproportionately many “lemons” — the market has adversely selected against quality. The same logic afflicts insurance, where consumers conceal their true health, premiums rise, and lower-risk consumers exit.
Moral hazard — opportunism after the transaction. The more-informed party changes its behaviour once the deal is struck. An employee (the “producer” of labour) shirks after being hired, because continuous monitoring is costly; an insured driver takes fewer precautions against theft or damage. Either change harms the less-informed party.

The government’s aim is to discourage the opportunism by levelling information:

Screening — the less-informed party acquires information (compulsory medical check-ups for insurers; independent inspection of used cars).
Signalling — the more-informed party communicates information willingly (warranties).
Monitoring — the less-informed party gathers information after the transaction (workplace CCTV), addressing moral hazard.
Regulation — universal coverage makes consumption compulsory, removing the diminishing-market dynamic of adverse selection (Singapore’s MediShield Life); anti-opportunistic laws (product-liability rules) penalise exploitation directly.

Considerations

A neutral catalogue of the trade-offs:

Enforcement cost. Anti-opportunistic laws can be difficult and prohibitively expensive to enforce in the long run.
Compulsion versus choice. Universal coverage cures adverse selection by mandating consumption, but at the cost of compelling agents who might rationally have opted out.

This market failure is examined in prose only — there is no asymmetric-information diagram in the 9570 syllabus.