Asymmetric information creates a moral hazard problem if one party in a transaction cannot observe the (possibly bad) behaviour of the other party. It was moral hazard that caused the sub-prime mortgage meltdown in the U.S. housing market, as those who owned the risky mortgages could not observe the decisions made by mortgage brokers—who were more than willing to dole out money (that wasn’t their own) to high-risk homeowners.
Tag: game theory
Asymmetric information, where one party in a transaction has more accurate information than the other, generally leads to inefficient markets. Formal legal institutions, such as those that make contracts enforceable, reduce the two problems created by asymmetric information: adverse selection and moral hazard. Adverse selection is asymmetric information before a transaction occurs and is a problem when the market attracts more buyers/sellers that we would rather avoid than those we want to do business with. Moral hazard is asymmetric information after the transaction has taken place and happens when the absence of formal commitment causes one party to behave in a way that disadvantages the other. Both of these problems can result in market failure when an otherwise willing participant in a market decides not to partake for fear of negative repercussions.