One key element that affects how people behave in different situations is the information they have about the issue. But, generally speaking, people do not possess same levels of information. This difference in the amount of information between two parties is known as information asymmetry. In business transactions, this asymmetry results in information advantage for one party against the other. Usually, it’s the sellers who have more information which can earn them excess profits at the expense of the buyers.
Consider two people who are engaging in the transaction of a certain stock in a stock market. The seller may have some information about the future of the company that ensures him its price will lower during the next days. The buyer, on the other hand, may believe that the market, as a whole, will be bullish and prices are going to to rise. The information asymmetry between the seller and the buyer makes the transaction work.
Another instance, is the case of health insurance. People who buy health insurance have more information about their health, therefore, they may try to hide their health problems so that they can obtain insurance at a lower cost.
Two models describe information asymmetry: adverse selection and moral hazard.
Adverse selection happens before transaction and refers to the situation where the buyer has more information than the seller. For example, it is the individuals who participate more in risky behaviors that buy insurance more often. As a result, and because the insurance companies do not have efficient tools to assess the risks associated with individuals precisely, they may cover applicants whose risks are way more than the insurance company’s risk exposure.
On the contrary, moral hazard, which happens after the transaction, states that when an entity is insured, they may take greater risks compared to when they were not secured by the insurance and may expose themselves to greater risks.