Hidden Information

Definition

Hidden information refers to the concept of asymmetric information, where one party in a transaction has more or better information than the other party. This information imbalance can lead to market inefficiencies and suboptimal outcomes, as the party with less information may make decisions that are not in their best interest.

5 Must Know Facts For Your Next Test

1. Hidden information can lead to adverse selection, where the party with more information selects against the party with less information.
2. Moral hazard can arise when one party takes on more risk because another party bears the cost, leading to suboptimal outcomes.
3. Government regulations, such as mandatory disclosures and information sharing, can help mitigate the effects of hidden information.
4. The principal-agent problem is a type of hidden information scenario, where the agent (e.g., a manager) has more information than the principal (e.g., a shareholder).
5. Signaling and screening are strategies used to overcome hidden information, where the party with more information sends signals or the party with less information screens for relevant information.

Review Questions

• Explain how hidden information can lead to adverse selection in a market.
  • Hidden information can lead to adverse selection when the party with more information, such as a seller, takes advantage of the party with less information, such as a buyer. For example, in the used car market, the seller may have more information about the true condition of the car than the buyer. This information asymmetry can lead the seller to sell lower-quality cars to the buyer, as the buyer is unable to accurately assess the car's true value. The result is a market failure, where only the 'lemons' (low-quality cars) are sold, and the high-quality cars are driven out of the market.
• Describe the role of moral hazard in the context of hidden information.
  • Moral hazard arises when one party takes on more risk because another party bears the cost. In the context of hidden information, moral hazard can occur when the party with more information takes actions that benefit themselves but are detrimental to the party with less information. For example, in the insurance industry, policyholders may engage in riskier behavior because they know the insurance company will bear the cost of any claims. This can lead to higher premiums for all policyholders and a less efficient market. Governments and institutions can use regulations and incentives to mitigate the effects of moral hazard in markets with hidden information.
• Evaluate the effectiveness of signaling and screening as strategies to overcome hidden information in a market.
  • Signaling and screening are two strategies used to overcome hidden information in a market. Signaling involves the party with more information sending a credible signal to the party with less information, such as a warranty or certification, to convey the quality of their product or service. Screening involves the party with less information actively seeking out relevant information to assess the quality of the product or service, such as requesting financial statements or references. Both strategies can be effective in mitigating the effects of hidden information, but their success depends on factors such as the cost of signaling, the reliability of the signal, and the ability of the party with less information to accurately screen for relevant information. In some cases, a combination of signaling and screening may be the most effective approach to overcoming hidden information in a market.

Related terms

Asymmetric Information: Asymmetric information occurs when one party in a transaction has more or better information than the other party, leading to an imbalance of knowledge.

Adverse Selection: Adverse selection is a situation where the party with more information takes advantage of the party with less information, leading to a market failure.

Moral Hazard: Moral hazard refers to a situation where one party takes on more risk because another party bears the cost, leading to suboptimal outcomes.