Adverse selection is a case of asymmetric information. It occurs when both parties assign or are subject to a different probability of a same (normally adverse) event occurring. In this case, the agent that has the best information is clearly at an advantage. We say that this advantage is ex-ante because, contrary to moral hazard, the advantage occurs before the ‘contract’ (real or otherwise) is signed.

In order to clarify this concept, let’s take a quick look at an example: insurance premiums. The person taking out an insurance policy is at an advantage versus the insurer, who therefore charges a premium for the risk derived from their imperfect information, aside from any mark-up designed purely in order to generate benefits.

Lucy takes out a health insurance plan but ‘forgets’ to tell the insurer that she has been a heavy smoker, drinker and lunatic driver for 50 years. Lucy knows that her probability of contracting heart or lung disease is significantly greater than the national average. The insurance company does not know that she is a hell raising grandmother and base their calculation for her premium based on the probability of an average person being hospitalised for a long stay, an average person who is probably much younger and much healthier than Lucy. Lucy’s advantage is ex-ante. At the same time, healthy Hanna who is 30 will be put off by the price of the premiums because of people like Lucy and will probably never subscribe to a policy.

Of course, insurance companies have ways of getting around this to a certain extent. But an insurance company is never going to be able to segment their policies fully: when was the last time you were asked about your driving style when subscribing to a dental plan? And most sane people won’t risk their life just because their healthcare is covered (in fact, most countries with a free, national health service have longer life expectancies and shorter hospital stays than countries that don’t), but how many of us park our friend’s car more carefully because we are not insured in it?

There are ugly consequences deriving from this example, which can be generalised to markets other than the insurance market, as seen in The Market for Lemons, an article by George Akerlof, or in the article about credit rationing by Joseph E. Stiglitz and Andrew Weiss. Since people like Hanna are asked for premiums higher than the ones they would get with perfect information, this people will decide not to take insurance. The lack of healthy and careful people will make the ‘average person’ considered by insurers be less healthy and careful, which will force insurers to raise premiums. This will encourage people healthier than this ‘average person’ to stop paying insurance, which would start the process all over again. Theoretically, the healthcare insurance market would disappear, since no one wants to pay premiums that high.

The agency theory is based in the relationship between principals and agents. In economics, this theory comes as a result of the separation between business ownership and its management.

The internalisation of a firm’s management instead of hiring external agents is a milestone in Oliver Williamson’s transaction costs theory. The agency theory is necessary in order to provide an incentive structure that acts as a catalyser, between the principal’s desire and the agent’s interest.

In the relationship between principal and agent we face the problem of the existence of asymmetric information and risk aversion. The principal will have the tendency to regard the agent’s actions as imperfect, understood as actions not aligned with the principal’s desires. Therefore, he will have to design a contract were that negative effects are minimised. Asymmetric information can come in two possible ways, depending on the information known at the moment of taking the decision. Ex ante is related to adverse selection and ex post to moral hazard. Agency theory helps determine the optimum incentive relationship between principal and agent so that both parties can achieve a maximum satisfaction. This will have to be done via optimum incentive contracts, so that both interests are linked with a positive correlation.

The critiques to this theory arise from the fact that it does not include limited rationality contrary to the transaction cost theory. It is assumed that the principal knows the agent’s utility function and what contract is more adequate for each one. Furthermore, it is also probable that the theory overestates management problems ineficiency due to its static approach.

This theory has important economic significance. Regarding the public sector it helps explain some attitudes to privatise companies, or to outsource services. It also has other connotations for business’ institutional innovation, as for example, in franchisesand its principal-agent relation framework.

Moral hazard is a case of asymmetric information. It occurs when both parties (usually an agent and a principal) assign or are subject to a different probability of a same (normally adverse) event occurring. The behaviour of the agent changes ex-post, after a contract is signed and as a consequence of their new, advantageous position. As economist Paul Krugman puts it, moral hazard refers to “any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly”.

In order to clarify this concept, let’s take a quick look at an example: insurance premiums. The person taking out an insurance policy is at an advantage versus the insurer, who therefore charges a premium for the risk derived from their imperfect information, aside from any mark-up designed purely in order to generate benefits.

Lucy has never smoked in her life, because she has always been concerned about expensive hospital stays taking away disposable income that could be better spent on her butterfly-collecting hobby. However, her cautious friend who works for a large insurance company talks her into subscribing to a healthcare policy. After this, Lucy decides that as her health is now a fixed cost (she pays the same premium whether she becomes ill or not), she might as well start smoking, drinking, and driving like a lunatic. In fact, she swaps her butterfly collecting hobby for cliff jumping. Lucy’s advantage is ex-post.

Moral hazard also appears in other markets, such as in the credit market. In their article about credit rationing, economists Joseph E. Stiglitz and Andrew Weiss explain how raising interest rates will make indebted people take higher risks.

Adverse selection is a case of asymmetric information. It occurs when both parties assign or are subject to a different probability of a same (normally adverse) event occurring. In this case, the agent that has the best information is clearly at an advantage. We say that this advantage is ex-ante because, contrary to moral hazard, the advantage occurs before the ‘contract’ (real or otherwise) is signed.

In order to clarify this concept, let’s take a quick look at an example: insurance premiums. The person taking out an insurance policy is at an advantage versus the insurer, who therefore charges a premium for the risk derived from their imperfect information, aside from any mark-up designed purely in order to generate benefits.

Lucy takes out a health insurance plan but ‘forgets’ to tell the insurer that she has been a heavy smoker, drinker and lunatic driver for 50 years. Lucy knows that her probability of contracting heart or lung disease is significantly greater than the national average. The insurance company does not know that she is a hell raising grandmother and base their calculation for her premium based on the probability of an average person being hospitalised for a long stay, an average person who is probably much younger and much healthier than Lucy. Lucy’s advantage is ex-ante. At the same time, healthy Hanna who is 30 will be put off by the price of the premiums because of people like Lucy and will probably never subscribe to a policy.

Of course, insurance companies have ways of getting around this to a certain extent. But an insurance company is never going to be able to segment their policies fully: when was the last time you were asked about your driving style when subscribing to a dental plan? And most sane people won’t risk their life just because their healthcare is covered (in fact, most countries with a free, national health service have longer life expectancies and shorter hospital stays than countries that don’t), but how many of us park our friend’s car more carefully because we are not insured in it?

There are ugly consequences deriving from this example, which can be generalised to markets other than the insurance market, as seen in The Market for Lemons, an article by George Akerlof, or in the article about credit rationing by Joseph E. Stiglitz and Andrew Weiss. Since people like Hanna are asked for premiums higher than the ones they would get with perfect information, this people will decide not to take insurance. The lack of healthy and careful people will make the ‘average person’ considered by insurers be less healthy and careful, which will force insurers to raise premiums. This will encourage people healthier than this ‘average person’ to stop paying insurance, which would start the process all over again. Theoretically, the healthcare insurance market would disappear, since no one wants to pay premiums that high.

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.

The perfection of information is an important notion in game theory when considering sequential and simultaneous games. It is a key concept when analysing the possibility of punishment strategies in collusion agreements.

Perfect information refers to the fact that each player has the same information that would be available at the end of the game. This is, each player knows or can see other player’s moves. A good example would be chess, where ech player sees the other player’s pieces on the board.

Imperfect information appears when decisions have to be made simultaneously, and players need to balance all possible outcomes when making a decision. A good example of imperfect information games is a card game where each player’s card are hidden from the rest of the players.