Information, Incentives, and Moral Hazard
What happens when one side of a deal knows more than the other: adverse selection and the market for lemons, signaling and screening, moral hazard and why insurance has deductibles, the principal-agent problem and how pay can be designed, and what all this means for investors reading a company or a deal.
The short version
In many markets one side knows more: borrowers know more than lenders about repaying, managers more than shareholders about profits, and insurance applicants more than insurers about their risk. George Akerlof showed that when sellers know more about quality, a market can shrink until mostly low-quality goods are left. The better informed can send costly signals, and the less informed can screen, as insurers do with a menu of deductibles. Once a deal is made, the protected side may take less care, which is moral hazard. Contract theory shows how pay can be linked to what's informative about effort, such as a manager's share price relative to similar firms.
By the end of this lesson, you'll be able to
- Explain asymmetric information and how adverse selection can shrink a market
- Describe signaling and screening as responses, with examples from jobs, insurance, and dividends
- Explain moral hazard and the principal-agent problem, and how contracts and pay try to address them
Why this matters
Simple market models assume both sides know what they're trading. Often they don't. In awarding the 2001 economics prize to George Akerlof, Michael Spence, and Joseph Stiglitz for their analyses of markets with asymmetric information, the Royal Swedish Academy of Sciences listed everyday examples: borrowers know more than lenders about their repayment prospects, managers and boards know more than shareholders about the firm's profitability, and prospective clients know more than insurance companies about their accident risk.1 Each of those gaps shapes how lenders, insurers, and investors behave, and each is a risk for whoever knows less.
Adverse selection: the market for lemons
Asymmetric information. A situation in which one side of a deal knows more than the other, such as a seller who knows a car's faults or a borrower who knows their own repayment prospects. Glossary means one side of a deal knows more than the other. Akerlof showed how a market where sellers know more than buyers about quality can contract into an Adverse selection. When an information gap means the deals that actually happen are skewed toward the worst risks or lowest quality, as when only lemons are left for sale. Glossary of low-quality products.1
| Step | What happens |
|---|---|
| Half the cars are good, worth $10,000; half are lemons, worth $4,000 | Sellers know which they have; buyers can't tell |
| Buyers offer the average value | $7,000 |
| Owners of good cars refuse $7,000 | They take their cars off the market |
| Buyers realize who's still selling | The offer falls toward $4,000, and mostly lemons trade |
The good cars were worth more to buyers than to sellers, so trading them would have helped both. The information gap stopped it. The same logic, Akerlof showed, helps explain very high borrowing rates in some local credit markets and why elderly people found it hard to buy individual health insurance.1
Two responses: signaling and screening
Signaling
The better-informed side can try to prove its quality by taking a costly action. Spence studied this Signaling. A costly action by the better-informed side of a deal to show its quality, such as offering a long warranty. Glossary and showed when it actually works; his own research centered on education as a signal of productivity in job markets. Later research applied the idea to how firms may use dividends to signal their profitability to investors.1 A signal works only if it's cheaper for the genuinely good to send than for the bad to fake. A long warranty is easy for a maker of reliable products to offer and expensive for a maker of unreliable ones.
Screening
The less-informed side can design choices that make the other side reveal itself. Stiglitz clarified this kind of Screening. A way for the less-informed side to sort the other side, such as an insurer offering a menu of deductibles and premiums. Glossary, with the example of insurers dividing customers into risk classes by offering a menu of contracts in which a higher deductible can be exchanged for a significantly lower premium.1
| Plan | Premium | Deductible | Who tends to choose it |
|---|---|---|---|
| Low deductible | $1,600 | $250 | Drivers who expect to claim often |
| High deductible | $1,100 | $2,000 | Drivers who expect few claims |
A careful driver who rarely claims saves $500 a year with the high deductible and seldom pays it. A driver who expects accidents values the low deductible more. By choosing, each tells the insurer something it couldn't observe directly.
Stiglitz also showed that information gaps can help explain credit rationing, when lenders limit how much they lend rather than simply raising the rate.1
The rest of this lesson is for members
Still to come in this lesson: Moral hazard, The principal-agent problem, For investors, the key takeaways, and 2 quiz questions with explanations.
Membership opens every lesson in the curriculum, the capstone projects, the interactive tools, and the members-only channels in the Hyperion Entities Discord. The first lesson of every module stays free.
Go deeper
- Management Incentives and Corporate GovernanceCorporate Finance (depth track)
- Money, Banking, and CreditEconomics for Investors (depth track)
- Who Regulates the MarketsPart 1: Foundations
- Game Theory and Strategic RivalsEconomics for Investors (depth track)
Notes and sources
- The Royal Swedish Academy of Sciences, via NobelPrize.org. Press release: The Prize in Economic Sciences 2001 (October 10, 2001). Checked 2026-10-14. Back to text
- The Royal Swedish Academy of Sciences, via NobelPrize.org. Popular information: The Prize in Economic Sciences 2016 (Oliver Hart and Bengt Holmström). Checked 2026-10-14.