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Information asymmetry means one party has more or better information than the other. This creates agency problems: hidden information (adverse selection) or hidden actions (moral hazard). Markets with asymmetric information may unravel (market for lemons), produce inefficient equilibria, or fail to exist. Information revelation and screening are mechanisms to mitigate these problems.
In the idealized markets of introductory economics, buyers and sellers share the same information about what is being traded. In reality, one party almost always knows more than the other — the seller knows the car's history; the borrower knows their creditworthiness; the employee knows their own effort level. This information asymmetry is not just an inconvenience. It can systematically distort prices, drive good products out of markets, and cause transactions that would benefit both parties to never happen at all.
Economists distinguish two fundamental types of information asymmetry. Adverse selection (hidden information) arises before a contract is signed: the informed party has private characteristics that affect the transaction's value, and the uninformed party cannot directly observe them. Classic examples include used car markets (sellers know the car's quality), health insurance (buyers know their health risks), and credit markets (borrowers know their default probability). The problem is that at any given price, the population willing to transact at that price is skewed toward the worse types — lemons, high-risk patients, likely defaulters — because better types find the price unattractive.
Moral hazard (hidden action) arises after a contract: once the contract is in place, the informed party can take actions that affect outcomes but that the uninformed party cannot observe or perfectly verify. Car insurance reduces the incentive to drive carefully; employer-provided health insurance may reduce effort to stay healthy; a bank that is "too big to fail" has diminished incentive to manage risk. In each case, the contract that was intended to improve efficiency actually changes behavior in a way that creates new inefficiencies.
The most dramatic consequence is market unraveling, as described by Akerlof's lemons model. Suppose used cars can be either good (worth $10,000) or lemons (worth $2,000), and sellers know which they have but buyers don't. Buyers, uncertain of quality, offer an average price, say $6,000. Good-car sellers, unwilling to sell a $10,000 car for $6,000, withdraw from the market. Now the average quality falls, say to $4,000. Buyers lower their offer. More good sellers exit. In the extreme, the market collapses to lemons only — not because good cars don't exist, but because information asymmetry prevents them from commanding their true value.
These problems are real but not insoluble. Signaling allows the informed party to credibly reveal their type: a job candidate can signal ability through an educational credential; a car seller can signal quality with a warranty. Screening allows the uninformed party to design contracts that induce self-selection: an insurer offers both high-deductible/low-premium and low-deductible/high-premium options, inducing low-risk and high-risk types to sort themselves. Reputation, certification, and mandatory disclosure are further institutional responses. The field of mechanism design — which builds on Bayesian games — asks systematically how to design rules and contracts to achieve good outcomes despite private information.