Transactors (buyers and sellers) seldom have equal knowledge.

Asymmetric information occurs when people have different levels of knowledge about a bargaining situation.

At times, knowledge asymmetries are not a problem. For example, a stereo dealer may have vast technical knowledge about woofers, tweeters, distortion, and so on, when all you care about is whether a stereo has a great sound.

 

Economists categorize problems of asymmetric information into two major groups: moral hazard, where an inadequately monitored party to a contract takes a hidden action that violates the other party’s interests, and adverse selection, where, before a contract is finalized, one party conceals information that would make the contract unacceptable to the other. Moral hazard is present, for example, if a cashier skims cash paid for meals at a restaurant, or if a seller later decides to renege on a guarantee. Adverse selection, on the other hand, is at fault if only high-risk drivers buy car insurance, or if a firm buys merchandise on credit knowing that it will file for bankruptcy before paying. We will deal with inefficiencies arising from moral hazard before exploring problems of adverse selection.