The first problem relates to the existence of asymmetric information. Sometimes this is referred to as hidden information, meaning that one party to a transaction has more information regarding the past that is relevant to the transaction than the other party or parties. An example is the secondhand car market, where sellers have much more information about the history and condition of the car than buyers. This situation provides an incentive for pre-contract opportunism; this means that one party can try to take advantage of the other by obtaining better contractual terms than they would obtain under conditions of perfect information. Thus in the secondhand car market sellers will try to obtain higher prices than they would get if buyers had complete knowledge; this presents a strategic situation, since buyers know this and will therefore not be prepared to pay as much as they might otherwise do. In turn this leads to a problem known as adverse selection. This means that only the products or customers with the worst quality characteristics are able to have or make transactions and others are driven from the market. Such a situation is obviously inefficient.
In order to understand this phenomenon further, let us examine the secondhand car market again, and review the conclusions reached in a classic article by Akerlof.30 According to his analysis, sellers with better-quality secondhand cars would not put them on the market, since they could not obtain a good price for them. Buyers discounted them in terms of quality because of their lack of complete information. This in turn meant that the average quality of cars on the secondhand market declined, further reducing the prices that buyers were willing to pay, driving more sellers from the market, and so on in a vicious circle. The end result was that only 'lemons', or the worst-quality cars, were put on the market. This explained the observation that secondhand cars that were nearly new were selling for much lower prices than new cars.
Adverse selection can occur in many situations, and it is not always the seller who has the informational advantage. The insurance market is an example where buyers have more information than sellers relating to their risk profile. However, the result is similar in that buyers with more risk are the most anxious to take out insurance, driving up premiums, which in turn drives the less risky buyers from the market. The end result is that only the riskiest buyers will stay in the market - if they can afford it. This is one reason why governments often intervene in the market, either providing certain types of insurance themselves (like health), or requiring buyers to have insurance by law (drivers). Government intervention, however, does not eliminate the problem of achieving efficiency, as will be seen in Chapter 12.
The examples of adverse selection given above relate to market transactions, but the problem applies equally well to situations within organizations. For example, a firm may advertise an employment position at a low salary; it is likely that only less skilled or experienced persons will apply for the position.
The question of how firms can reduce this problem of adverse selection and improve efficiency is discussed in the last subsection.
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