Asymmetry of Information:

Another source of market failure is a situation in which an asymmetry of information exists among market participants. The assumption of complete market in the first welfare theorem implicitly requires that the characteristics of traded commodities be observable by all market participants. Otherwise, distinct markets cannot exist for commodities that have different characteristics. Consider, for example, a second hand car. All consumers agree that the car is of a certain model, manufactured in a certain year, but they may not know the precise quality of the car. Many other goods have quality variations of a similar sort: there are good and bad workers, good and bad restaurants, good and bad houses, and so on. Economic agents may not be fdly informed because, in general, it is costly to obtain information. Asymmetry of information causes welfare loss and thus market outcomes are Pareto inefficient.

In this unit we shall discuss two important problems that information asymmetry causes, viz., moral hazard and adverse selection. We first discuss the problem of moral hazard through an example. Suppose a landlord needs to hire workers to work on his farm. The harvest depends on weather and therefore, is likely to be stochastic. The remuneration of at least one party, either the landlord or the workers, must be stochastic. As workers live close to poverty line, they cannot tolerate large uncertainty. We, therefore, assume that workers are risk averse agents, and the landlord is a risk neutral agent. An-optimal arrangement in this situation would be where the landlord pays a fixed wage to the workers and bears the entire risk. This potentially good arrangement gives security to the workers and a higher long run (expected) payoff to the landlord. But the problem with this arrangement is that the workers no longer have incentives to work hard and maximize the harvest. As a result, they may end up not working at all. The landowner may have to spend large amounts of resources in monitoring their effort level.