Questions: Information Asymmetry in Markets

Question 1

A car insurance company cannot observe how carefully its policyholders drive after they purchase coverage. This is an example of:

• A. Adverse selection, because reckless drivers are more likely to buy insurance in the first place.
• B. Moral hazard, because insurance reduces the policyholder's incentive to drive carefully after the contract is signed.
• C. Signaling, because drivers reveal their type through their driving record over time.
• D. Screening, because the insurer designs deductibles to sort drivers by risk level.

Answer: (B)

Moral hazard involves hidden *actions* taken after a contract is formed — the insured party changes behavior because they bear less of the risk. Adverse selection, by contrast, involves hidden *information* that exists before the contract: high-risk drivers self-select into insurance. The scenario here describes post-contract behavior change, which is moral hazard. (Deductibles and co-pays are screening tools designed to mitigate this moral hazard.)

Question 2

Information asymmetry generally leads to complete market failure — there is no mechanism that can restore efficiency in markets where one party has better information.

• T. True
• F. False

Answer: False

Information asymmetry creates inefficiency, but mechanisms exist to partially or fully mitigate it. Signaling (the informed party credibly reveals their type — e.g., education, warranties), screening (the uninformed party offers a menu of contracts to induce self-selection), reputation systems, and mandatory disclosure rules can all restore market function to varying degrees. Complete market unraveling (as in the pure lemons model) requires specific conditions.

Question 3

Why might a used car market partially break down even if most sellers have high-quality cars?

Model answer: Because buyers cannot distinguish high-quality from low-quality cars, they offer only a price reflecting the average quality. Sellers of high-quality cars find this price too low relative to their car's true value and exit the market. With fewer good cars, the average quality falls, pushing the offered price down further. This cascade can unravel the market so that only lemons remain — even if high-quality cars were a majority initially.

This is Akerlof's lemons problem. The key mechanism is adverse selection: at any given price, sellers are more likely to offer cars worth less than that price than cars worth more. The market price signals average quality, but average quality deteriorates as good sellers exit, creating a feedback loop. The unraveling depends on buyers being unable to verify quality before purchase; warranties, inspections, and reputation are real-world solutions.