Question

The text points out that asymmetric information can have deleterious effects on market outcomes.

a. Explain how asymmetric information about a hidden action or a hidden characteristic can lead to moral hazard or adverse selection.

b. Discuss a few tactics that managers can use to overcome these problems.

Short answer

1. When any of both parties in a transaction holds the information or attributes that are necessary for the other party to make a decision, it then results in an unfavorable selection process. Moral hazard situations, on the other hand, emerge when one of the negotiating parties hides actions in order to earn profits.

1. To avoid the situation of moral hazard, companies and employers enter into a contract in which one of the parties, mainly the employees, promises to protect the other from financial harm. Managers have established signalling and screening systems to enable them to give better information to the customer or other party involved in the transaction in the case of unfavourable selection.

Step-by-step solution

Define Asymmetric Information

"Asymmetric information" refers to when one party to a transaction has more information than the other. Asymmetric information, when one party has more knowledge about the goods being sold than the other, makes it possible for sellers to exploit buyers in some situations.

Explanation on how asymmetric information about a hidden action or a hidden characteristic can lead to moral hazard or adverse selection 

Asymmetric information occurs when one of the parties in a transaction has better information than the other parties, creating a situation of advantage and disadvantage that can cause the party without information to refuse to complete the transaction, resulting in economic losses and profit reduction.

Hidden qualities cause unfavorable selection processes when one of the two parties in a transaction withholds information or traits that are required for the other party to make a decision. These scenarios commonly arise during the recruiting process, when the company or employer cannot be certain of the traits and talents of the applicant.

Moral hazard scenarios, on the other hand, occur when one of the parties to a negotiation conceals acts in order to make a profit. For example, if I decide to sell my old automobile to someone else without commenting or omitting mechanical faults from the buyer, I will be concealing facts that might influence the buyer's decision or reduce the values.

Therefore, when one of the two parties in a transaction withholds information or attributes that are essential for the other side to make a choice, it results in unfavorable selection processes.

Moral hazard situations, on the other hand, emerge when one of the negotiating parties hides actions in order to profit.

Discussing a few tactics that managers can use to overcome these problems.

Businesses and employers can sign in to a contract where one of the parties, frequently the employee, promises to protect the other from financial harm as a way to minimise moral hazard. Contract-bound managers could not care whether the company makes a profit or not because they will still be paid a salary. If a firm's objectives aren't met, contracts provide the company with the right to terminate an employee's services.

Managers have developed signalling and screening procedures that allow them to provide the customer or other party involved in the transaction with greater information in the case of unfavourable selection. When it comes to products, the managers make an effort to highlight critical details like certifications and approval from medical organisations, the release date, a money-back guarantee, or other aspects that enable the client to learn more about the products.

Because of this, businesses and employers may engage in a contract where one party, often the employee, undertakes to shield the other from financial harm in order to avoid moral hazards.

In the event of a poor pick, managers have built signalling and screening systems to enable them to provide the consumer or other parties engaged with the transaction with better information.