HL only This topic is for Higher Level students.
Markets work well only when buyers and sellers understand what they are trading. When one side knows much more than the other, the market can produce the wrong quantity, or collapse altogether.
Asymmetric information can affect either side. Sellers often know more about quality (used cars, financial products, food ingredients); buyers often know more about their own risk (health, driving habits). Two problems result.
Used-car buyers cannot tell good cars from bad ones → they will only pay an average price → owners of good cars refuse to sell at that price and leave the market → the average quality of cars for sale falls → buyers lower the price they will pay → more good cars leave → the market shrinks or collapses.
The same logic applies to health insurance: if insurers cannot tell healthy from unhealthy applicants, premiums are set for average risk, healthy people drop out, and premiums rise further.
| Adverse selection | Moral hazard | |
|---|---|---|
| When? | Before the transaction | After the transaction |
| Problem | Hidden characteristics (quality, risk) | Hidden actions (behaviour changes) |
| Example | Unhealthy people are more likely to buy health insurance | Insured people take fewer precautions |