Chapter 16 — Key Takeaways
Two distinct information problems
Adverse selection (hidden information, before the transaction): the composition of market participants is skewed toward undesirable types because the informed party self-selects in ways that disadvantage the uninformed party. Akerlof's lemons model is the canonical example.
Moral hazard (hidden action, after the transaction): one party changes their behavior after a contract is signed in ways that are costly to the other party. Insurance patients using more care, insured drivers driving less carefully, employees shirking.
Both arise from asymmetric information. They have different solutions.
Akerlof's lemons model
When sellers know quality and buyers don't: (1) buyers assume average quality and price accordingly, (2) good-quality sellers withdraw because the price is too low, (3) average quality falls, (4) buyers lower offers, (5) more good sellers withdraw — a quality spiral that can collapse the market.
Three market solutions to adverse selection
| Solution | Who acts | How it works | Example |
|---|---|---|---|
| Signaling | Informed party | Costly credible action reveals type | Warranties, college degrees, brand investment |
| Screening | Uninformed party | Menu design induces self-selection | High/low deductible insurance options, job probation |
| Reputation systems | Platform/community | Aggregate past behavior information | eBay ratings, Uber stars, Yelp, Amazon reviews |
The 2008 crisis as information failure
The financial crisis was an information catastrophe at every level: - Moral hazard at origination: lenders who planned to sell the loans didn't lend carefully - Adverse selection in securitization: the worst mortgages were most likely to be bundled and sold to uninformed investors - Moral hazard at insurance (AIG): AIG sold CDS protection without adequate reserves, partly because it was "too big to fail" - Information failure at rating agencies: agencies paid by issuers had conflicts of interest
When house prices fell nationally, the information failures were revealed simultaneously and the system collapsed.
Part III summary — five types of market failure
- Externalities (Ch 11)
- Public goods and commons (Ch 12)
- Distributional failures (Ch 13)
- Healthcare's triple failure (Ch 14)
- Climate change (Ch 15) — the largest externality
- Information failures (Ch 16) — adverse selection, moral hazard, lemons
Each requires some form of intervention — regulation, taxation, information provision, contract design, or community governance — to move the market closer to efficiency.
Themes this chapter touched
- Markets power+imperfect — information failures are the fifth and final type of market failure
- Disagreement — about the relative importance of information vs. other factors in 2008
- Behavioral — reputation systems exploit behavioral shortcuts
- Affects daily life — used cars, insurance, credit, online platforms
One sentence summary
When one party to a transaction knows more than the other, markets can fail dramatically — from used-car lots where good cars don't get sold, to financial systems where hidden risk brings down the global economy.
PART III COMPLETE.