Welcome to asymmetric information! This happens when one party in a transaction knows more than the other party.
Think about buying a used car - the seller knows if it's a "lemon" but you don't. This information gap creates serious market problems.
Engagement Message
Can you think of another situation where one side knows much more than the other?
Adverse selection occurs when hidden information leads to bad outcomes being more likely than good ones.
In health insurance, sick people are more eager to buy coverage than healthy people. This drives up costs and premiums for everyone.
Engagement Message
In one line, why do premiums climb for healthy people under adverse selection?
Moral hazard happens when someone changes their behavior because they don't bear the full consequences of their actions.
If your car is fully insured, you might park in riskier spots since you won't pay for theft damage. Insurance companies worry about this.
Engagement Message
How might complete job security change someone's work effort?
Both problems cause market failures. Adverse selection can destroy markets entirely - if only "bad risks" participate, prices become too high for anyone else.
Moral hazard wastes resources - people take excessive risks when others bear the costs.
Engagement Message
Aadverse selection or moral hazard: which one is tougher for markets to fix?
Signaling helps solve asymmetric information. The informed party voluntarily reveals information to prove their quality.
A college degree signals intelligence and work ethic. Warranties signal product quality. Good drivers might accept monitoring devices for insurance discounts.
Engagement Message
What does a restaurant's long line signal to potential customers?
