Information Asymmetry

Information asymmetry is the study of information and decisions during transactions related to economics and contract, in which one of the parties has more or better information than the other parties. Because of information asymmetry, there is an imbalance in the power of the transaction that might lead to future transaction problems. Some of these problems are the moral hazard of the transaction and the adverse selection. In most cases, information asymmetries occur in agent and principal transactions.

The models of information asymmetry assume that one of the persons in a transaction has the advantage of having more information related to the transactions. One of the examples of information asymmetry is when one of the parties is more capable of enforcing or defending the breech of a contract, while the other party does not have enough information about doing so.

To differentiate the adverse selection model of information asymmetry from the moral hazard model, the adverse selection involves a party during the negotiation of a contract. On the other hand, the moral hazard model has an ignorant party that is less knowledgeable in implementing or retaliating the beech of a transaction or agreement.

A good example of the adverse selection is when a greater number of high-risk people buy insurance because the insurance company cannot reject them. Usually, this is because of government regulations and because of lack of information about the individual's risk. The moral hazard occurs when the insured person becomes reckless after being insured because the insurance company has no way to monitor the individual's behavior.