Concept and background
The classic model of competitive markets assumes everyone has the same information. Friedrich Hayek stressed in 1945 that knowledge is dispersed across society, and in 1963 Kenneth Arrow showed how the knowledge gap between doctors and patients reshapes the market for medical care. In 1970 George Akerlof showed that if only sellers know the quality of used cars, buyers will pay only an average price; good cars then exit, and the market unravels into a market for lemons. The paper launched information economics, and Akerlof, Michael Spence and Joseph Stiglitz shared the 2001 Nobel Prize in economics.
Adverse selection and moral hazard
Information asymmetry produces two problems depending on timing. Adverse selection arises before a contract from hidden characteristics, as when higher-risk people are more eager to buy insurance; Rothschild and Stiglitz (1976) analyzed screening, in which insurers offer policies with different deductibles so customers reveal their own type. Moral hazard arises after a contract from hidden actions, as when insured people take less care, and Holmström (1979) studied contracts that tie pay to whatever can be observed. Jensen and Meckling's agency theory (1976) of managers and shareholders grew from the same root.
How markets respond
Informed parties send costly signals such as degrees, warranties and brands to reveal quality, while uninformed parties screen through vetting and contract design. Stiglitz and Weiss (1981) explained credit rationing: because raising interest rates drives away safe borrowers, banks limit lending instead of raising rates. Myers and Majluf (1984) argued that because managers have inside information, firms prefer internal funds, then debt, then new equity, the pecking order of financing. Seller ratings and reviews on resale platforms, disclosure rules and quality certification are all read as institutions that shrink information gaps.
FAQ
- How is adverse selection different from moral hazard?
- Adverse selection stems from hidden characteristics before a contract (such as health status); moral hazard stems from hidden actions after a contract (such as reduced care) that cannot be observed.
- Can information asymmetry be eliminated?
- Rarely completely. Disclosure requirements, warranties, reputation systems and third-party certification, however, narrow information gaps and the inefficiencies they cause.
Sources reviewed: 2026-10-26
References
- Hayek, F. A. (1945). The use of knowledge in society. American Economic Review, 35(4), 519–530.
- Arrow, K. J. (1963). Uncertainty and the welfare economics of medical care. American Economic Review, 53(5), 941–973.
- Akerlof, G. A. (1970). The market for 'lemons': Quality uncertainty and the market mechanism. Quarterly Journal of Economics, 84(3), 488–500.
- Spence, M. (1973). Job market signaling. Quarterly Journal of Economics, 87(3), 355–374.
- Rothschild, M., & Stiglitz, J. (1976). Equilibrium in competitive insurance markets: An essay on the economics of imperfect information. Quarterly Journal of Economics, 90(4), 629–649.
- Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305–360.
- Holmström, B. (1979). Moral hazard and observability. Bell Journal of Economics, 10(1), 74–91.
- Stiglitz, J. E., & Weiss, A. (1981). Credit rationing in markets with imperfect information. American Economic Review, 71(3), 393–410.
- Myers, S. C., & Majluf, N. S. (1984). Corporate financing and investment decisions when firms have information that investors do not have. Journal of Financial Economics, 13(2), 187–221.
- Stiglitz, J. E. (2002). Information and the change in the paradigm in economics. American Economic Review, 92(3), 460–501.