Ambo University

College of Business and Economics

Department of Economics

(Msc. Program in development Economics)

Advanced Microeconomics (Econ 5011)

Instructor Name: Derese G. (Assistant professor)

Student Name: Lechisa Bekele Jebessa

ID. Number: PGR/56486/14

Assignment 1 Term Paper

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Asymmetric Information

(i.e Adverse selection, Moral hazard). How problem for Market failure
and Uncertainty

Abstract

We study that if the adverse selection and moral hazard are a problem for
market failure and uncertainty. We study a principal-agent with moral hazard
and adverse selection. Agents have private information about the distribution
of outcomes conditional on each effort. We prove existence, characterize the
solution, and establish several ways of screening problem. When agents are
risk neutral, an intermediate mass of types is also pooled, although they are
offered contracts with variable payments and get positive rents. There is
asymmetric information in case one party to the transaction has relevant
information that is unavailable to the other. Under additional conditions, the
optimal mechanism offers only finitely many contracts. How eliminate
adverse selection problem by applying private production information,
regulatory requirements and financial intermediation and how eliminate
moral hazard by Effective auditing and government regulation.

1. Introduction

Markets may not be fully efficient when one side has information that the
other side does not (asymmetric information). The two important classes of
asymmetric information problems are adverse selection problems, in which a
party obtains asymmetric information about market conditions before signing
the contract, and moral hazard problems, in which one party’s actions during
the term of the contract are unobservable to the other. Transactions can
involve a considerable amount of uncertainty. Uncertainty need not introduce
inefficiencies. Buyers and sellers can handle uncertainty by exchanging
contingent commodities. Uncertainty need not lead to inefficiency when both
sides of a transaction have the same limited knowledge concerning the future,
but it can lead to inefficiency when one side has better information.
Asymmetric information arises when what is being bought is an agent’s
service. The buyer may not always be able to monitor how hard and well the

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agent is working. The agent may have better information about the
requirements of the project because of his or her expertise, which is the
reason the agent was hired in the first place. The analysis of markets with
asymmetric information raises new questions and offers important challenges
to economists. It is an area that offers few simple and broadly applicable
answers, but it is one where all the analyst’s creativity, insight, and logical
rigour can pay handsome dividends.

2. Asymmetric Information

Markets may not be fully efficient when one side has information that the
other side does not (asymmetric information). Many transactions in
economics involve two parties: one buyer and one seller. There is asymmetric
information in case one party to the transaction has relevant information that
is unavailable to the other. The more informed party than take advantage of
the less informed. Insider dealing on stock markets has been outlawed, even if
those laws are not always easy to enforce. Efficient transactions can be
seriously impeded when one side has better information.

3. How Adverse selection and Moral Hazard problem for Market failure
3.1. Adverse selection
Adverse selection, also called ant selection, term used in economics and
insurance to describe a market process in which buyers or sellers of a
product or service are able to use their private knowledge of the risk
factor involved in the transaction to maximize their outcomes, at the
expense of the other parties. It is a market situation where buyers and
sellers have different information. The result is that participant
selectively in trade in at the expense of other parties who do not have
the same information. In ideal world, buyers should pay a price which
reflects their willingness to pay and the value to them of the product or
service, and sellers should sell at a price which reflects the quality of
their goods and services. For example, a poor quality product should be

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inexpensive and a high quality product should have a high price.
However, when one party holds information that the other party does
not have, they have the opportunity to damage the other party by
maximizing self-utility, concealing relevant information, and perhaps
even lying. Taking advantage in an economic contract or trade of
possession of undisclosed information is adverse selection. This
opportunity has secondary effect: the party without the information can
take steps to avoid entering into an unfair contract, perhaps by
withdrawing from the interaction, or a seller(buyer) asking a
higher(lower) price, thus diminishing the volume of trade in the market.
Furthermore, it can deter people from participating in the market,
leading to less competition and thus higher profit margins for
participants
A standard example is the market for used cars hidden flows
(lemons).Georg Akerlof in 1970 paper ‘The market for lemons’
highlights the effect adverse selection has in the used car market,
creating an imbalance between the sellers and the buyers that may lead
to market failure.
The theory behind market failure starts with consumers who want to
buy goods from an unfamiliar market. Sellers, who do have information
about which good is high or poor quality, would aim to sell the poor
quality goods at the same price as better goods, leading to a larger profit
margin. The high quality sellers now no longer reap the full benefits of
having superior goods, because poor quality goods pull the average
price down to one which is no longer profitable for the sale of high
quality goods. High quality sellers thus leave the market, thus reducing
the quality and price of goods even further. The market collapse is then
caused by demand not rising in response to a fall in price, and the lower
overall quality of market provisions. Sometimes the seller is the
uninformed party instead, when consumers with undisclosed attributes
purchase goods or contracts that are priced for other demographics.
(Wikipedia)

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3.2. Moral Hazard
In economics, a moral hazard is situation where an economic actor has
an incentive to increase its exposure to risk because it does not bear the
full costs of that risk. It may occur where the actions of the risk-taking
party change to the determinant of the cost –bearing party after a
financial transaction has taken place. It occurs under a type of
information asymmetry where the risk-taking party is tendency of a
person who is imperfectly monitored to engage in dishonest or
otherwise undesirable behavior. Moral hazard can occur under a type of
asymmetry information where the risk taking party to a transaction
knows more about its intentions than the party paying the
consequences of the risk and has an incentive to take on too much risk
from the perspective of the party with less information. One example is
a principal- agent problem, where one party, called an agent, acts on
behalf of another party, called the principal. If the agent has more
information about his actions or intentions than the principal then the
agent may have an incentive to act too riskily (from the viewpoint of the
principal) if the interests of the agent and the principal are not aligned.
Moral hazard is the risk that a party has not entered in to a contract in
good faith or has provided misleading information about its assets,
liabilities, or credit capacity. Moral hazard can be present at any time
two parties come into agreement with one another. Each party in a
contract may have the opportunity to gain from acting country to the
principles laid out by the agreement. Any time a party in an agreement
does not have to suffer the potential consequences of risk, the likelihood
of moral hazard increases. It also occurs when one party in transaction
has opportunity to assume additional risks that negatively affect the
other party. The decision is based not on what is considered right, but
what provides the highest level of benefit, hence the reference to
morality.
Moral hazard can exist in employer- employee relationships, as well. An
office employee may spend time shirking (slacking), studying for an
exam, or chatting on the phone with friends when there is work waiting
to be done which is a problem of moral hazard.(Investopedia)

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4. How Adverse selection and Moral Hazard problem for Uncertainty
Uncertainty - a broad range of possible outcomes and complexity makes
it impossible to define a set of probabilities. We can create and use
scenarios to describe the different paths that may happen in the future,
but we have no way of knowing which future will actually happen.
The failure of the market to insure against uncertainties has created many
social institutions in which the usual assumptions of the market are to
some extent contradicted.
4.1 Method for examining uncertainty and risk
The method outlined here is to start by scanning what is known about the
problem with a checklist. The scan will look for what we think we know
and can learn easily compared to the information that may be difficult or
even impossible to get. The second step is to describe the problem in
terms of bounded rationality. The third step is to describe the structure of
the information that is available. The fourth step is to bring in values and
cultural interpretations of the problem.
5. The way to eliminate Adverse selection and Moral Hazard Problem
5.1 The way to eliminate adverse selection problem
The way to eliminate adverse selection problem in a transaction is to find
a way to establish trust between the parties involved.
A way to do this is by bridging the perceived information gap between the
two parties by helping them know as much as possible. This will establish
perceived information transparency and optimize the market function.
The solution to the adverse selection problem in markets is to eliminate
asymmetric information by providing the relevant information regarding
sellers and buyers. This can be done, by making public the clearing price
for as many transactions as possible and the market will do its intended
job of channeling the appropriate commodities to the people who want
them at the right price. That way both parties will have sufficient
knowledge about the other party involved in the transaction necessary to
make an informed decision and the transaction will take place.
Private Production of Information
The private companies that have stepped in to provide for this
need(standards and poor’s, Moody’s, value line) do not completely solve

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the adverse selection problem because of the free rider problem: The
people who do not actually pay to bridge the information asymmetry gap,
take advantage of the information other people have paid for, and
eliminating any possible profits that can be made from paid information,
removing thus the incentive information providers to producer
information, and the incentive of buyers to purchase the produced
information, and thus perpetuating the adverse selection problem.
Regulatory Requirements
Governments provide a partial solution by mandating for information
transparency in order to curb information asymmetry and the adverse
selection problem though different agencies and the adoption of
international accounting standards and generally accepted accounting
principles.
Financial Intermediation
The problem is solved by the introduction of intermediaries who minimize
the asymmetric information gap by becoming experts and establishing
trust between buyers and sellers. The Financial Intermediation establishes
trust by providing a form of guarantee of investment performance to the
buyers and fair price to the sellers.
As information transparency is enhanced, market will be more efficient
and it will be more advantageous for firms to finance their investments
though them. Also private firms information is easier to collect the more
developed an economy.
The problem of adverse selection is mitigated by the presence of collateral
because it cuts down the potential losses of a lender. (Max Laios, 2014 )
5.2 The way to eliminate Moral Hazard problem
Moral hazard is the post transaction problem of information asymmetry in
financial markets. In equity contracts it manifests as the principal- agent
problem where the separation of ownership and control incentivizes
managers (the agents) to act against the interest of the owners (the
principals). The principal- agent problem would not arise if the
shareholders and complete oversight (information symmetry) of the
manager’s action s and could prevent unproductive expenditures and
possible fraud, or if there was no separation between ownership and

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control. Therefore, effective auditing may alleviate the moral hazard
problem. Nonetheless the monitoring process can be expensive giving rise
costly state verification that makes equities less attractive and explains
the prevalence of debt as means of financing. Similarly to the adverse
selection situation, government regulation provides only a partially
effective deterrent. Again, financial intermediaries such as the venture
capital firm, curtail the negative effects of moral hazard and the free rider
problems arising from information asymmetry: these firms provide equity
capital in exchange for the supervisory oversight in the form of appointed
board members and exclusive equity shares. As a result the venture
capital has increased oversight and is safe from the free rider problem.
(Mishkin, 2004)
Conclusion
Markets may not be fully efficient when one side has information that the
other side does not (asymmetric information) and a more informed party
than take advantage of the less informed
Adverse selection is when a market process in which buyers or sellers of a
product or service are able to use their private knowledge of the risk
factor involved in the transaction to maximize their outcomes, at the
expense of the other parties. This situation is caused for market collapse
by demand not rising in response to a fall in price, and the lower overall
quality of market provisions.
A moral hazard is situation where an economic actor has an incentive to
increase its exposure to risk because it does not bear the full costs of that
risk. And it is caused market failure and uncertainty.
The way to eliminate adverse selection problem in a transaction is to find
a way to establish trust between the parties involved and both parties will
have sufficient knowledge about the other party involved in the
transaction necessary to make an informed decision and the transaction
will take place.
Effective auditing may alleviate the moral hazard problem and similarly to
the adverse selection situation, government regulation provides only a
partially effective deterrent.

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References
Wikipedia
Investopedia
Mishkin, 2004
Max Laios, 2014 macroeconomics and bank funding)