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FIN 444 Asymmetric Information A situation where one party to a market transaction has much more information about a product or service than the other. Moral Hazard Problem There is a tendency of one party to a contract to alter his/her behaviour in ways that are costly to the other party .

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FIN 444Asymmetric InformationA situation where one party to a market transaction has much more information about a product or service than the other.


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Moral Hazard ProblemThere is a tendency of one party to a contract to alter his/her behaviour in ways that are costly to the other party

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Adverse Selection ProblemInformation known by the first party to a contract is unknown to the second and, as a result, the second party incurs major costs.


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Used Cars: The Market for “Lemons”A new car loses much of its market value as the buyers drives it off the sales lot. The question is, why?


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One explanation relates to inadequate information about used cars, some are good and some are “lemons” of poor quality.


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Consumers cannot distinguish the good from the defective, so a single price emerges for used cars, which roughly reflects the average-quality car.


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This leads to an adverse selection problem. Owner of lemons have an incentive to sell their cars because the average price is above that for the low-quality car they own.


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Therefore, there will be proportionately more low-quality cars offered than good-quality cars whose owners hold onto them rather than offer them at the average-quality price.


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At the extreme, only lemons would appear on the used-car market, but even without the extreme, this theory offers one explanation of the pricing of used cars.


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