Asymmetric information

When either the buyer or seller have far more information about product than other party.

Example - used cars.

• Sellers have far more information. This makes buyers skeptical.
• Due to this skepticism, without any other innovation, all cars may get priced at average.
• This reduces incentives for the best used cars to be sold. This lowers the average price further.
• In the end only worst deals will get made and marketplace for used cars collapses.
• In reality innovation like certified used cars, third party checks and so on reduce the information gap and the market continues to thrive.

Adverse selection - When offer contains negative information.

Examples of asymmetric information

• Health insurance - consumers know more about their health than sellers.
• Healthiest consumers may get priced out of market if insurance is priced at average cost.
• Innovations like health checkups and price discrimination helps in reducing information gap and creating a functioning market.

Moral Hazard

Principal agent problem - When one party has far too much information.

Examples

• A person leaves the house and then 2 mins later realizes he has forgotten to lock the door. If they already have home insurance should they return to lock or just ignore? Ignoring it will be a moral hazard.
• A car mechanic has too much information on which repairs are required compared to consumer and can use this to get higher price.

Solutions to principal agent problem

• User reviews
  • User reviews which affect reputation of a seller will help ensure that seller trades in good faith and does not leverage asymmetric information.
  • This solutions works for many markets like car mechanic, dental services, laundries and other businesses.
• Consumer reports
  • Trade and consumer magazines often review and publish information which a consumer on their own does not have access to.
  • This information, like car safety, helps bridge asymmetric information gap.
  • Even credit rating agencies do the same job of reducing asymmetric information.
• Signalling
  • A business may use signalling to overcome asymmetric information problem.
  • 30 day return guarantee, free lifelong warranty and many others are examples of using signalling to convey information.
  • For signalling to work, it has to be expensive.

Consumer choice

Consumers instinctively use marginal utility to make purchase decisions.

• Consumers have a preference for products at certain price point.
• Consumers are restricted by a finite budget.
• Within a given budget a consumer expresses the value she gets from a certain good at a given price by either purchasing or not purchasing the product.
• Within a budget consumers tend to maximize marginal utility across all purchase decisions.

Information is a public good.