Introduction

In the last chapter, we discussed von Neumann–Morgenstern utility functions, which are used to represent people's preferences in situations in which there is uncertainty – where information is imperfect or missing. We continue the analysis of decision making under uncertainty in this chapter. But now we focus on the problems that arise when information is distributed unequally, in the sense that some people in the market know more than other people.

More precisely, we are now considering markets for goods or services when there is uncertainty, and the uncertainty is more on one side of the market (e.g., the buyers' side) than on the the other side of the market (e.g., the sellers' side). These are called markets with asymmetric information; the information is “asymmetric” because people on one side know more than people on the other side. In a world of perfect certainty, there would be no asymmetric information, but in this chapter we allow uncertainty. It turns out that asymmetric information may create serious market failures – failures that may need remedies.

In particular, what happens when the sellers of some risky or uncertain good or service know more than the buyers? For example, what happens in the market for used cars, when the sellers often know much more about the condition of the cars they are selling than the buyers? We look at the used car market in Section 20.2. What happens in insurance markets if insurance companies cannot distinguish between low-risk clients and high-risk clients?