Information asymmetry explains the decision in transaction where it involves two parties, buyers and sellers. It emphasizes the situation of the buyer or the seller who has more information than other. It will lead a harmful situation where one party will take the advantage from the other party who has lack of information. Information Asymmetry is also known as quality uncertainly.
It has two main problems in information asymmetry. First problem is adverse selection where the sellers or buyers disable to ensure weather the product is good or not. It will lead to the risky in purchasing certain product where the conflict between lower price and higher price occur. If the product is a good quality but buyer and seller cannot ensure it, the buyer purchase it at lower price may able to take the risk. But not the sellers, a good quality should sell at its standard price. Selling at the lower price may lead unwillingness for the seller to take the risk. Same goes to the product that not a good quality. The fact is buyer and seller unable to ensure the quality of the product. In the reverse case, the seller sells that product at a high price and he is willingness to take the risk. But not the buyer, they pay a high price to the product which is not a good quality. The buyer may unwilling to take the risk. American economist George Arthur Akerlof, the first economist noted the adverse selection problem which arises from the inability of the buyer or a seller to differentiate between the quality of certain product.
The second problem is moral hazard. It involves two parties in the transaction where one party has more information than other. Each party in the transaction may have the opportunity to gain from acting contrary to the principles laid out by the agreement. One party is tendency to do negative action or something that unexpected (by other party) and let the other party responsible of it.
In Malaysia, any commercial agreement, transaction or contract is under Ordinance of Contract act, 1950. Regarding to Contract act, 1950, Section 2(h), any agreement can be legal under this law. This agreement will let the parties who involved in the contract responsible to the particular agreement. If one party doesn’t follow the agreement, other party has the right to take the law action. To make the agreement legal, Contract act, 1950 state three main character of the agreement that will make the agreement accepted. The three character are :
a. Offer
Section 2(a) “when a person states that he/she is ready to do something or not to do something, by hopping that the other person will agree to do something or not to do something, we can say that he/she is offer a contract.
b. Agree or acceptance
Section 2(b) “when a person state that he/she agree to accept the contract from a person who offered the contract, we can say that he/she is willing to do transaction. Automatically the transaction is legal.”
c. The principle thing in the contract
Section 2(d) “An agreement to do something or not to do something is the principle of the contract.”
Back to the theory, although the agreement or contract is unfair to one party who involved in the contract, it is still legal. Other party who gain the disadvantage from the transaction, disables to take the law action because the agreement is legal and not contradict with the law. In term of economic, the information asymmetric will lead the failure market. The law cannot restrict this problem that will lead market failure. Below is the example of some cases adverse selection and moral hazard.
Adverse Selection
• Insurance
DZUL Insurance Company offers some insurance policy. One of it, the life policy and the premium is at one price to the entire customer. Let say, the population in the society divide by two, the smoker and non-smoker. The probability of the smoker die early or suffer a chronic disease is higher than the non-smoker. So the life policy is better for the smoker than non-smoker. The price of the policy is same regardless the smoker or non-smoker. At the end, the smoker will insured but non-smoker will uninsured because DZUL Insurance notice that the mortally rate of the policy holder is greater than the general population and the set of premium accordingly. This will lead market failure.
DZUL Insurance Company take an initiative to make sure all of the policy holders are going to insured. They reduce some policy and set the premium at a high price so that the set of premium able to compensate the future claims. The result from their initiative, some of the policy holders disable to pay the premium and lead to cancel the policy and go uninsured. The fewer policy offers by the company, the less policy holders, the less set of premium company get. Company tendency to increase the premium to avoid them to lose. The higher premium, the more policy holders cancel their police. It will continue until no want able to pay premium and go uninsured. At this point, DZUL Insurance Company will close their business because there no more policy holder wants to buy a life policy.
• Used Car
DZUL Jual Motorkar Bagus Pun Bah Sdn Bhd sells the used car. Not all the car do they sell is good quality. Some of it is not good. So they sell the car at difference price base on the date of the car produce. The latest date of producing, the higher price of the car. But it doesn’t mean that the new car is still good and the old car is no quality anymore. This condition shows that the sellers and the buyers inability to ensure the quality of the product. If the company sells the car at the lower price, the buyer is willing to take the risk but not the seller. If the company sells the car at a high price, the seller is willing to take the risk but not the buyers. It is because of the uncertain quality that the two parties disable to ensure it.
Let say, this year the company sell the use car with no quality more than a good quality. Most of the buyers buy the car with no quality at certain price. Just a bit buyer got a car with a good quality at certain price. They will inform to the other not buying the car at DZUL Jual Motorkar Bagus Pun Bah Sdn bhd because the company sell a car with no quality. They will stop buy the car and influence the other to not buy the car at the company. At the end, less customer buy the car at DZUL Jual Bagus Pun Bah Motorkar Sdn bhd. Although the company takes an initiative to restock their product with a good quality, the buyer may not buy it because it is still uncertain quality. This situation will continue happen and the result, DZUL Jual Motorkar Bagus Pun Sdn bhd close their business because of less customer. The adverse selection actually brings the market failure
Moral Hazard
• Insurance
Dzul buy insurance for his motorbike in one year. He pay a premium and the insurer will responsible if something bad happen with his motorbike. When all of the transaction done, automatically DzuL’s motorbike is cover under policy insurance 1 year. Within that period, if Dzul’s motorbike was stolen or damage cause of accident, the insurer will responsible as compensation. Because of that, Dzul less to take care of his motorbike from any danger. Dzul thing that if anything happen to his motorbike, the insurer will responsible on it. He didn’t lose anything. The action of Dzul who not really care about his motorbike safety is what we call as moral hazard. He let the insurer responsible on his lose.
• Computer attach with warranty
Dzul buy computer at PC image with warranty 1 year. If anything happen or damage on his new computer, PC Image will responsible on it. Within 1 year warranty, Dzul use his new computer unwisely and will let the software or hardware damage. He realize it but don’t care about it because he thing that if the computer got a problem, PC Image will responsible on it. Dzul action refer to the problem of moral hazard.
Joseph E. Stigletz famous theory is the theory of screening. This theory is the approach against the problem of adverse selection. A party how lack in information that other is call “screener”. He advocate that the party who has more information sincere or not keep it as a private information so that the other party that lack of that particular information (screener) will able to know better about the transaction is. It can be many ways such as explain the very details information to the other party before agree to have a deal or provide a menu of choices in a way to explain about particular transaction. Below are some cases of the screening.
1. Insurance
We take DZUL Insurance Company case above as our example of screening theory. Base on the screening theory, it advocates that the party who has more information should sincerely tell the information to the other party who is lack of information. We refer back to our cases. The policy holder should sincerely or honestly tell the trust about his/her health condition. Let the insurer know so that they may arrange the suitable price base on the health condition. A person who has good health may pay a low premium. A person who is not good health condition will pay a high premium. As a result, no matter a policy holder health good or not good, the insurer able to responsible on them if something happened at the future. At the end, there is no market failure occur.
2. Bank offer loan
One of the bank products is offer loan and levies the interest rate. Bank faces the risk if the borrower cannot pay back the money. Banks may lose if the borrower not pays back the loan. To avoid this risk happen, bank require a guarantor and the history of income statement of the borrower before they approve the loan. They need the information to get to know the ability of the borrower to pay the loan back.
3. Used Car
Again we take the case of DZUL Jual Motorkar Bagus Pun Bah Sdn Bhd who sells the used car. Base on the screening, the company should research and check up the used car before sell it to the buyers. The result of check up, they should honestly tell to the buyers and let them decide themselves whether they willing to take the risk or not. From the result of the car check up, the company may set a different price of cars base on the level of quality. A good quality of product should sell at it standard price. Buyers will satisfy with the transaction and not willing to boycott the company because the company not keeps the private information of the product.
4. Interview (scholarship)
Yayasan Sarawak offers the scholarship to the University student. They will give the scholarship to the excellent student only. It is not enough to judge the candidates who apply the scholarship base on the history of academic achievement from the certificate or the statement or testimonial. So, they provide an interview to the some of the potential candidates. From that interview, they may get the information of the candidate as much as they want. They will able to strictly judge the best candidate to get the scholarship.
Refference
www.answers.com/topic/information-asymmetry
http://www.economyprofessor.com/economictheories/adverse-selection.php
http://www.investopedia.com/terms/m/moralhazard.asp
wekepedia.com
Government of Malaysia., (2005) Contract Act. 1950 & Government Contract Act 1949
It has two main problems in information asymmetry. First problem is adverse selection where the sellers or buyers disable to ensure weather the product is good or not. It will lead to the risky in purchasing certain product where the conflict between lower price and higher price occur. If the product is a good quality but buyer and seller cannot ensure it, the buyer purchase it at lower price may able to take the risk. But not the sellers, a good quality should sell at its standard price. Selling at the lower price may lead unwillingness for the seller to take the risk. Same goes to the product that not a good quality. The fact is buyer and seller unable to ensure the quality of the product. In the reverse case, the seller sells that product at a high price and he is willingness to take the risk. But not the buyer, they pay a high price to the product which is not a good quality. The buyer may unwilling to take the risk. American economist George Arthur Akerlof, the first economist noted the adverse selection problem which arises from the inability of the buyer or a seller to differentiate between the quality of certain product.
The second problem is moral hazard. It involves two parties in the transaction where one party has more information than other. Each party in the transaction may have the opportunity to gain from acting contrary to the principles laid out by the agreement. One party is tendency to do negative action or something that unexpected (by other party) and let the other party responsible of it.
In Malaysia, any commercial agreement, transaction or contract is under Ordinance of Contract act, 1950. Regarding to Contract act, 1950, Section 2(h), any agreement can be legal under this law. This agreement will let the parties who involved in the contract responsible to the particular agreement. If one party doesn’t follow the agreement, other party has the right to take the law action. To make the agreement legal, Contract act, 1950 state three main character of the agreement that will make the agreement accepted. The three character are :
a. Offer
Section 2(a) “when a person states that he/she is ready to do something or not to do something, by hopping that the other person will agree to do something or not to do something, we can say that he/she is offer a contract.
b. Agree or acceptance
Section 2(b) “when a person state that he/she agree to accept the contract from a person who offered the contract, we can say that he/she is willing to do transaction. Automatically the transaction is legal.”
c. The principle thing in the contract
Section 2(d) “An agreement to do something or not to do something is the principle of the contract.”
Back to the theory, although the agreement or contract is unfair to one party who involved in the contract, it is still legal. Other party who gain the disadvantage from the transaction, disables to take the law action because the agreement is legal and not contradict with the law. In term of economic, the information asymmetric will lead the failure market. The law cannot restrict this problem that will lead market failure. Below is the example of some cases adverse selection and moral hazard.
Adverse Selection
• Insurance
DZUL Insurance Company offers some insurance policy. One of it, the life policy and the premium is at one price to the entire customer. Let say, the population in the society divide by two, the smoker and non-smoker. The probability of the smoker die early or suffer a chronic disease is higher than the non-smoker. So the life policy is better for the smoker than non-smoker. The price of the policy is same regardless the smoker or non-smoker. At the end, the smoker will insured but non-smoker will uninsured because DZUL Insurance notice that the mortally rate of the policy holder is greater than the general population and the set of premium accordingly. This will lead market failure.
DZUL Insurance Company take an initiative to make sure all of the policy holders are going to insured. They reduce some policy and set the premium at a high price so that the set of premium able to compensate the future claims. The result from their initiative, some of the policy holders disable to pay the premium and lead to cancel the policy and go uninsured. The fewer policy offers by the company, the less policy holders, the less set of premium company get. Company tendency to increase the premium to avoid them to lose. The higher premium, the more policy holders cancel their police. It will continue until no want able to pay premium and go uninsured. At this point, DZUL Insurance Company will close their business because there no more policy holder wants to buy a life policy.
• Used Car
DZUL Jual Motorkar Bagus Pun Bah Sdn Bhd sells the used car. Not all the car do they sell is good quality. Some of it is not good. So they sell the car at difference price base on the date of the car produce. The latest date of producing, the higher price of the car. But it doesn’t mean that the new car is still good and the old car is no quality anymore. This condition shows that the sellers and the buyers inability to ensure the quality of the product. If the company sells the car at the lower price, the buyer is willing to take the risk but not the seller. If the company sells the car at a high price, the seller is willing to take the risk but not the buyers. It is because of the uncertain quality that the two parties disable to ensure it.
Let say, this year the company sell the use car with no quality more than a good quality. Most of the buyers buy the car with no quality at certain price. Just a bit buyer got a car with a good quality at certain price. They will inform to the other not buying the car at DZUL Jual Motorkar Bagus Pun Bah Sdn bhd because the company sell a car with no quality. They will stop buy the car and influence the other to not buy the car at the company. At the end, less customer buy the car at DZUL Jual Bagus Pun Bah Motorkar Sdn bhd. Although the company takes an initiative to restock their product with a good quality, the buyer may not buy it because it is still uncertain quality. This situation will continue happen and the result, DZUL Jual Motorkar Bagus Pun Sdn bhd close their business because of less customer. The adverse selection actually brings the market failure
Moral Hazard
• Insurance
Dzul buy insurance for his motorbike in one year. He pay a premium and the insurer will responsible if something bad happen with his motorbike. When all of the transaction done, automatically DzuL’s motorbike is cover under policy insurance 1 year. Within that period, if Dzul’s motorbike was stolen or damage cause of accident, the insurer will responsible as compensation. Because of that, Dzul less to take care of his motorbike from any danger. Dzul thing that if anything happen to his motorbike, the insurer will responsible on it. He didn’t lose anything. The action of Dzul who not really care about his motorbike safety is what we call as moral hazard. He let the insurer responsible on his lose.
• Computer attach with warranty
Dzul buy computer at PC image with warranty 1 year. If anything happen or damage on his new computer, PC Image will responsible on it. Within 1 year warranty, Dzul use his new computer unwisely and will let the software or hardware damage. He realize it but don’t care about it because he thing that if the computer got a problem, PC Image will responsible on it. Dzul action refer to the problem of moral hazard.
Joseph E. Stigletz famous theory is the theory of screening. This theory is the approach against the problem of adverse selection. A party how lack in information that other is call “screener”. He advocate that the party who has more information sincere or not keep it as a private information so that the other party that lack of that particular information (screener) will able to know better about the transaction is. It can be many ways such as explain the very details information to the other party before agree to have a deal or provide a menu of choices in a way to explain about particular transaction. Below are some cases of the screening.
1. Insurance
We take DZUL Insurance Company case above as our example of screening theory. Base on the screening theory, it advocates that the party who has more information should sincerely tell the information to the other party who is lack of information. We refer back to our cases. The policy holder should sincerely or honestly tell the trust about his/her health condition. Let the insurer know so that they may arrange the suitable price base on the health condition. A person who has good health may pay a low premium. A person who is not good health condition will pay a high premium. As a result, no matter a policy holder health good or not good, the insurer able to responsible on them if something happened at the future. At the end, there is no market failure occur.
2. Bank offer loan
One of the bank products is offer loan and levies the interest rate. Bank faces the risk if the borrower cannot pay back the money. Banks may lose if the borrower not pays back the loan. To avoid this risk happen, bank require a guarantor and the history of income statement of the borrower before they approve the loan. They need the information to get to know the ability of the borrower to pay the loan back.
3. Used Car
Again we take the case of DZUL Jual Motorkar Bagus Pun Bah Sdn Bhd who sells the used car. Base on the screening, the company should research and check up the used car before sell it to the buyers. The result of check up, they should honestly tell to the buyers and let them decide themselves whether they willing to take the risk or not. From the result of the car check up, the company may set a different price of cars base on the level of quality. A good quality of product should sell at it standard price. Buyers will satisfy with the transaction and not willing to boycott the company because the company not keeps the private information of the product.
4. Interview (scholarship)
Yayasan Sarawak offers the scholarship to the University student. They will give the scholarship to the excellent student only. It is not enough to judge the candidates who apply the scholarship base on the history of academic achievement from the certificate or the statement or testimonial. So, they provide an interview to the some of the potential candidates. From that interview, they may get the information of the candidate as much as they want. They will able to strictly judge the best candidate to get the scholarship.
Refference
www.answers.com/topic/information-asymmetry
http://www.economyprofessor.com/economictheories/adverse-selection.php
http://www.investopedia.com/terms/m/moralhazard.asp
wekepedia.com
Government of Malaysia., (2005) Contract Act. 1950 & Government Contract Act 1949
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