Microeconomics · Complete guide
Asymmetric information, every type in one place
Markets work when both sides know what is being traded. When one side knows more (about the quality of a car, the riskiness of a borrower, or how hard an employee is working), markets can shrink, misprice or collapse. This guide sorts every version of the problem by one question: is the information hidden before the deal, or is an action hidden after it?
Start here
The idea: one side knows more
Hidden information · before the deal
“What kind are you?”
The seller knows the car is a lemon; the insurance buyer knows they are high-risk; the borrower knows the project is shaky. The other side can't tell types apart, so the wrong types are drawn in. This is adverse selection.
Hidden action · after the deal
“What will you do?”
Once insured, you lock your bicycle less carefully; once hired, an employee may shirk; once lent money, a borrower may gamble with it. Behaviour changes because someone else bears the cost. This is moral hazard.
Key idea
Adverse selection is about types hidden before a contract; moral hazard is about actions hidden after it. Almost every exam question in this topic is answered by placing the example on the right side of that line.
The map
The map: five problems, two moments
Before the contract: hidden information
Adverse selection
The uninformed side attracts the worst types. Akerlof (1970).
Signalling
The informed side proves its type with a costly action. Spence (1973).
Screening
The uninformed side designs choices that make types reveal themselves. Rothschild–Stiglitz (1976).
After the contract: hidden action
Moral hazard
Insulated from the consequences, people take less care or more risk. Arrow (1963).
Principal–agent problem
One party (the principal) hires another (the agent) whose actions it can't fully observe, and their interests differ. Jensen and Meckling (1976).
Interactive
Adverse selection: the market for lemons
George Akerlof's 1970 paper (Nobel Prize 2001) asked why a car loses so much value the moment it leaves the showroom. His answer: used-car buyers can't tell good cars (“peaches”) from bad ones (“lemons”), so they pay only for average quality. Owners of good cars won't sell at that price, which lowers the average, which lowers the price again. Step through it:
Round 1
10 of 10 cars on sale
On sale and stayingWorth more than the offer: leaves next roundWithdrawn
Buyers can't tell good cars from bad, so they offer 1.2× the average quality on sale, 550: that is ₹660 thousand. Owners of the 4 best cars (700, 800, 900, 1000) would be selling at a loss, so pull out, and the average quality falls.
What to take away
Bad quality drives good quality out of the market, a version of Gresham's law. Even though every single trade would benefit both sides, hidden information can shrink the market to its worst products, or kill it entirely. The price falls and the average quality traded falls.
Everywhere
Adverse selection beyond used cars
Health insurance
At a price based on the average person, the healthy find it poor value and drop out, the pool gets sicker, and premiums rise. It is why people over 65 can struggle to buy cover at almost any price, and why many countries make insurance compulsory.
Credit markets
Raising the interest rate drives away safe borrowers first and attracts risky ones who expect not to repay. So banks may refuse loans rather than raise rates: credit rationing (Stiglitz and Weiss, 1981). It helps explain why informal moneylenders, who know their borrowers, lend where banks won't.
Labour markets
If an employer offers a low wage, the most productive applicants, who have better options, don't apply. Paying above the market wage can attract better workers.
Informed side moves
Signalling: the informed side acts
A high-quality type wants to prove it. Words are cheap, anyone can say “my car is good”, so the proof must be an action that is costlier for low types than for high types. Then only high types find it worth taking. Michael Spence's (1973, Nobel 2001) example is education: it signals productivity even if it teaches nothing, because it is easier for able people to complete.
Other signals: a warranty (costly to give on a bad product), a well-known brand, expensive advertising, a firm keeping a high dividend.
Worked question · a separating equilibrium
High-productivity workers are worth ₹20 (thousand a month) to employers; low-productivity workers ₹10. A year of education costs a low type ₹5 and a high type ₹2.5 (in the same units). Employers pay ₹20 to anyone with at least y* years of education and ₹10 otherwise. For which y* does education separate the two types?
- Low types must prefer not to get y*.
- High types must prefer to get y*.
Answer
Any y* between 2 and 4 years separates them. High types get exactly y* years (more would only cost more); low types get none. This is a separating equilibrium. If both types got the same education and the same wage, it would be a pooling equilibrium.
The condition that makes a signal work
Also called the single-crossing condition.
Uninformed side moves
Screening: the uninformed side acts
Here the side that lacks information moves first, offering a menu of contracts designed so that each type prefers a different one and so reveals itself (self-selection).
Insurance menus
A cheap policy with a high deductible and a dear one with full cover. Low-risk drivers pick the first, high-risk drivers the second (Rothschild and Stiglitz, 1976).
Loans
Asking for collateral screens borrowers: those confident of repaying are the ones willing to pledge it.
Hiring
Probation periods and performance-linked pay attract applicants who expect to do well and put off those who don't.
Signalling vs screening in one line
Signalling: the informed party acts first to reveal its type. Screening: the uninformed party acts first to make types reveal themselves.
After the deal
Moral hazard: hidden actions
Insurance
Fully insured people take less care: fewer locks, less caution, more visits to the doctor. The insurer can't watch, so it pays for behaviour it didn't price.
Banking and finance
A bank that expects a bailout (“too big to fail”) or has insured deposits can take bigger risks, keeping the upside while taxpayers bear the downside. A borrower may switch a loan to a riskier project after getting it.
At work
A worker on a fixed salary whose effort can't be seen may shirk. That's why pay is often tied to output, or set above the market rate.
Remedies
- Deductibles and co-payments: leave some of the loss with the insured, so care still pays.
- Monitoring: inspections, audits, telematics in cars.
- Collateral: gives the borrower something to lose.
- Incentive pay: commissions, bonuses, piece rates, stock options.
- Regulation: capital requirements for banks.
Efficiency wages
If a firm pays above the market wage, being fired for shirking becomes costly, so workers put in effort even when unobserved (Shapiro and Stiglitz, 1984). It also reduces turnover and attracts better applicants. A side effect: wages don't fall to clear the market, so some unemployment persists.
The frame
The principal–agent problem
A principal needs an agent to act for them but can't see everything the agent does, and the agent has goals of their own. The task is to design a contract that makes the agent want what the principal wants. Two conditions:
Participation constraint
The contract must be good enough that the agent accepts it at all, compared with their next-best option.
Incentive-compatibility constraint
Given the contract, the agent must be better off choosing the action the principal wants (working hard, choosing the safe project).
| Principal | Agent | The conflict | Typical fix |
|---|---|---|---|
| Shareholders | Managers | Managers may prefer empire-building, perks or a quiet life to profit | Stock options, bonuses, takeover threat, board oversight |
| Landowner | Tenant farmer | Under sharecropping the tenant keeps only part of any extra output, so puts in less effort (Marshallian inefficiency) | Fixed rent, which gives the tenant the full return on effort |
| Employer | Employee | Effort is hard to observe | Piece rates, efficiency wages, promotion tournaments |
| Voters | Politicians | Politicians' interests may diverge from voters' | Elections, transparency, term limits |
Summary
Remedies at a glance
| Problem | What is hidden | When | Classic example | Private fixes | Policy fixes |
|---|---|---|---|---|---|
| Adverse selection | Type (quality, risk) | Before | Used cars, health insurance, loans | Warranties, reputation, signalling, screening | Compulsory insurance, disclosure laws, certification |
| Moral hazard | Action (care, effort, risk) | After | Insured behaviour, bank risk-taking | Deductibles, co-pay, collateral, monitoring, incentive pay | Bank regulation, capital requirements |
| Principal–agent | Action and interests | After | Shareholders and managers | Performance pay, stock options, efficiency wages | Corporate governance rules |
Practice
Exercises, with answers
A. Numbers
Problem 1 · a two-type lemons market
Half the used cars are good (worth ₹10 lakh to owners and ₹12 lakh to buyers) and half are lemons (₹4 lakh to owners, ₹5 lakh to buyers). Buyers can't tell them apart and pay the expected value. What do they first offer, and what is the price once the market settles?
Problem 2 · Spence signalling
High types are worth ₹30 to employers and low types ₹18. A unit of education costs a low type ₹6 and a high type ₹3. Employers pay ₹30 to anyone with at least y* units and ₹18 otherwise. Find the smallest and largest y* that separate the types.
B. Name the problem
One attempt each.
1After buying comprehensive car insurance, Karan stops locking his car. This is:
2People who know they are in poor health are the keenest to buy health insurance. This is:
3An insurer offers a cheap policy with a high deductible and an expensive one with no deductible, so that low-risk customers choose the first. This is:
4For education to act as a signal of productivity, it must be:
5In Akerlof's market for lemons, asymmetric information leads to:
6Banks refuse some loan applicants rather than raising the interest rate because a higher rate would:
Revise
One-page revision sheet
The one question
Hidden type before the deal: adverse selection. Hidden action after the deal: moral hazard.
Lemons (Akerlof 1970)
Buyers pay for average quality, good sellers leave, average falls, price falls. The market can unravel.
Signalling (Spence 1973)
Informed side acts. Works only if the signal costs low types more. Education, warranties, brands.
Screening
Uninformed side offers a menu so types self-select: deductible menus, collateral, probation.
Moral hazard (Arrow 1963)
Less care once protected. Fix with deductibles, co-pay, monitoring, collateral, incentive pay, efficiency wages.
Principal–agent
Contracts must satisfy participation and incentive compatibility. Stock options, piece rates, fixed rent.
Watch out for
The mistakes examiners are fishing for
- Calling careless driving after buying insurance adverse selection. It happens after the contract: moral hazard.
- Calling risky people buying more insurance moral hazard. Their type exists before the contract: adverse selection.
- Forgetting the cost condition in signalling. A signal equally cheap for everyone reveals nothing.
- Mixing up signalling and screening. Ask who moves first: the informed party (signalling) or the uninformed one (screening).
- Thinking a higher interest rate always clears the credit market. It can worsen the pool of borrowers, so banks ration instead.
Try it on real questions
Twelve past-paper questions on this
From UGC NET, IIT JAM, CUET-PG, JNU and the University of Hyderabad: adverse selection and the lemons market, signalling, moral hazard in lending, principal–agent and efficiency wages.
These are questions from the TestStop bank. A free account answers 10 a day, each with its worked solution; All-Access opens every set with no daily limit.
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