ASYMMETRIC INFORMATION

July 2018, Paper-II
Question

When information asymmetry is observed after an agreement is obtained between individuals, it is called:

a) Signaling
b) Moral hazard
c) None of the above
d) Both (1) and (2) above

Answer B
 In contract theory, signaling is the idea that one party (termed the agent) credibly conveys some information about itself to another party (the principal).
 Moral hazard is the idea that a party protected in some way from risk will act differently than if they didn’t have that protection. Moral hazard is usually applied to the insurance industry. Insurance companies worry that by offering payouts to protect against losses from accidents, they may actually encourage risk-taking, which results in them paying more in claims.