SummaryInformation economics, also known as economics of information, is the study of how different degrees of information affect economic analysis. Since it’s usually studied as a part of microeconomic theory, information economics mainly deal with micro problems. In this Learning Path we learn the basics about information economics, especially about adverse selection and moral hazard.
Asymmetric information refers to transactions in which one of the parties has better information than the other one. Adverse selection and moral hazard can result from the worst cases of asymmetric information in transactions between economic agents.
A key article on this subject is “The Market for Lemons: Quality Uncertainty and the Market Mechanism”, 1970, in which George Akerlof develops a classical example of second hand car market in which the seller is the only one that truly has complete information about the quality of the car, to simply explain the risk of asymmetric information.
Sellers of low-quality products will try to sell “lemons” –bad cars- as if they were high-quality cars. This will cause potential buyers to be suspicious of all these types of transactions and thus difficult the transactions of sellers that are trying to sell good quality second hand cars. Sellers with high-quality goods would then exit this market, leaving only an adverse selection of low-quality goods. Then, a distinction of quality will be made within the remaining low-quality cars, which will start the process again. In the end, the market of second hand cars will disappear.
This example can be generalized, and therefore applied to other economic matters, such as the labour market or the credit market.