One of the essential assumptions made for a perfectly competitive market is that buyers and sellers possess 'perfect information.' This enables economic transactions to be undertaken with certainty about the value of what is being bought and sold in particular market places. In reality, markets rarely operate in this environment. Most markets are characterised by some form of information asymmetry, where one party to a transaction knows more about the product than the other party. This ultimately leads to an over or under allocation of resources to the production of certain goods or services.
Take for example the market for insurance products, such as car insurance. A young male seeking to take out a comprehensive insurance policy on their car is likely to face a very high annual premium due to the fact that young male drivers have a much higher probability of being involved in an accident compared to an older person. The insurance companies base their premiums on complicated formulas that relate to the probability of an insurance payout for each type of insurance policy. It therefore stands to reason then that the young male should pay a higher premium compared to someone twice his age. However, what if the young man is highly risk averse and extremely responsible for his age? He is atypical for his demographic and, in fact, may have a much lower probability of having an accident compared to a 40 year old risk taker who drives erratically.
The insurance company will not possess the information about both drivers, and will therefore base the price of their policies on average statistics for each type of policy holder. This information asymmetry results in an inefficient outcome because the young driver may avoid insurance altogether, and the older driver will be paying a premium well below the rate that should be paid by a driver in his risk class. Effectively, the older risk taking driver is being cross subsidized by other policy holders and his premium is not high enough to deter an appropriate amount of risk taking behaviour. This information asymmetry is commonly referred to as the problem of adverse selection, and it results in an undesirable outcome for society. This occurs because there is an over-allocation of resources devoted to the production of insurance services for older drivers and an under-allocation of resources devoted to the production of insurance services for younger drivers.
Another example of adverse selection relates to those with life insurance policies. Again, the insured party possesses information about the probability of death that is unknown to the insurer. For example, the insured party may engage in excessive alcohol consumption, illicit drug taking or other more legitimate risk taking behaviours such as mountain climbing or hand gliding. Whilst an insurer will seek to elicit as much information about risk taking behaviour to correctly price 'risk,' it is unlikely that they will obtain all the relevant information needed. From society's point of view, an inefficient outcome will once again result because the higher risk groups in society are more likely to purchase life insurance policies. Knowing this, insurance companies will price policies at a relatively high level, thereby deterring some lower risk groups from purchasing life insurance policies. The fact that high risk groups are 'selecting' insurance and low risk groups are more likely to abstain from insurance is another example of 'adverse selection.'
Adverse selection also occurs when businesses have information about products that cannot be known by consumers. For example, second hand car yards will sometimes seek to sell defective cars on the basis that consumers are not aware of the defects. Similarly, some mechanics might fabricate mechanical problems knowing that the average consumer will be unable to verify the accuracy of the information provided. These information asymmetries tend to prevent some consumers from purchasing second hand cars and other consumers from taking their vehicles to mechanics, resulting in an under-allocation of resources to the production of these products and an inefficient allocation of the nation's resources.
Sometimes businesses will seek to mislead or deceive consumers by making false claims about the quality or price of a good or service. This can create demand for a product that would otherwise not occur, and therefore lead to an over-allocation of resources to the production of that product, particularly in the short term. However, over the longer term, the increased incidence of misleading and deceptive conduct that would occur in an unregulated environment may actually serve to stifle consumer spending on some goods and services, leading to a less efficient allocation of resources. A recent example of misleading and deceptive conduct relates to Zamel's jewelers, who were fined $250,000 by the Federal Court in early 2013. It follows an ACCC investigation into claims that the business made false claims that prices of some items were heavily reduced. For example, a May catalogue used statements such as "WAS $275 NOW $149", when investigations revealed that the items had never sold for $275 in the first place. This leads to a less efficient allocation of resources because, possessed with full information, consumers would have been less likely to purchase these items. Accordingly, by purchasing Zamel's jewellery on the basis of these false claims, consumers will have 'over-estimated' their value and will have forgone the purchase of another product that may have derived them greater value. In this respect, there was is over-allocation of resources to the production of Zamel's jewellery.
In the earlier example with the older driver, there is the additional problem of moral hazard. When the insurance company is unable to monitor the behaviour of an insured party, it reduces the incentive for the insured party to reduce risk taking behaviour. This is because they are financially insured against the risk of loss. Accordingly, the older driver may continue to drive erratically knowing that he is insured against loss. This is why insurance companies require a part payment of the cost of any damage (commonly referred to as the excess). Nevertheless, even with an excess, the problem of moral hazard remains.
This is a common information asymmetry that surfaces in relationships such as those between an employer (principal) and an employee (agent). All employers hire employees to perform tasks that are in the best interests of the employer. However, there is a clear information asymmetry because it is virtually impossible for an employer to know how the employee is performing at all times, and whether the employee is always acting in his/her employers' interests. This is a key reason why many employment contracts contain clauses related to bonuses, commission payments or other types of incentive payments that are designed to align the motivations and performance of employees with that of their employers. These Principal Agent problems result in both adverse selection (e.g. the wrong person being hired) as well as moral hazard (e.g. an employee not acting in the interests of his/her employee).
Overall, in the presence of asymmetric information, markets will tend to over or under-produce certain goods and services such that allocative efficiency is not achieved. Government efforts to assist in reducing the inefficiencies associated with asymmetric information include the examples below.