We have examined two kinds of asymmetric information: moral hazard and adverse selection. And we have seen how individuals may respond to the problem with signaling or screening. Now let’s consider what the study of asymmetric information suggests about the proper scope of public policy The tension between market success and market failure is central in microeconomics. We learned in Chapter 7 that the equilibrium of supply and demand is efficient in the sense that it maximizes the total surplus that society. can obtain in a market. Adam Smith’s invisible hand seemed to reign supreme This conclusion was then tempered with the study of externalities (Chapter 10), public goods (Chapter 11) imperfect competition (Chapters 15 through 17), and poverty (Chapter 20). These examples of market failure showed that government can sometimes improve market outcomes The study of asymmetric information gives us a new reason to be wary of markets. When some people know more than others, the market may fail to put resources to their best use. People with high-quality used cars may have trouble selling them because buyers will be afraid of getting a lemon People with few health problems may have trouble getting low-cost health insurance because insurance companies lump them together with those who have significant (but hidden) health problems. Although asymmetric information may call for government action in some cases, three facts complicate the issue. First, as we have seen, the private market can sometimes deal with information asymmetries on its own using a combination of signaling and screening. Second, the government rarely has more information than the private parties. Even if the market’s allocation of resources is not first-best, it may be
second-best. That is, when there are information asymmetries, policymakers may find it hard to improve upon the market’s admittedly imperfect outcome. Third, the government is itself an imperfect institution topic we take up in the next section.

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