14.1 The problem of imperfect information and asymmetric information  (Page 7/24)

On the buyer’s side of the labor market, a standard precaution against hiring a “lemon” of an employee is to specify that the first few months of employment are officially a trial or probationary period, and that the worker can be let go for any reason or no reason after that time. Sometimes workers also receive lower pay during this trial period.

In the financial capital market , before a bank makes a loan, it requires a prospective borrower fill out forms regarding the sources of income; in addition, the bank conducts a credit check on the individual’s past borrowing. Another approach is to require a cosigner    on a loan; that is, another person or firm who legally pledges to repay some or all of the money if the original borrower does not do so. Yet another approach is to require collateral    , often property or equipment that the bank would have a right to seize and sell if the loan is not repaid.

Buyers of goods and services cannot possibly become experts in evaluating the quality of gemstones, used cars, lawyers, and everything else they buy. Employers and lenders cannot be perfectly omniscient about whether possible workers will turn out well or potential borrowers will repay loans on time. But the mechanisms mentioned above can reduce the risks associated with imperfect information so that the buyer and seller are willing to proceed.

Key concepts and summary

Many economic transactions are made in a situation of imperfect information, where either the buyer, the seller, or both are less than 100% certain about the qualities of what is being bought and sold. When information about the quality of products is highly imperfect, it may be difficult for a market to exist.

A “lemon” is the name given to a product that turns out, after the purchase, to have low quality. When the seller has more accurate information about the quality of the product than the buyer, the buyer will be hesitant to buy, out of fear of purchasing a “lemon.”

Markets have many ways to deal with imperfect information. In goods markets, buyers facing imperfect information about products may depend upon money-back guarantees, warranties, service contracts, and reputation. In labor markets, employers facing imperfect information about potential employees may turn to resumes, recommendations, occupational licenses for certain jobs, and employment for trial periods. In capital markets, lenders facing imperfect information about borrowers may require detailed loan applications and credit checks, cosigners, and collateral.

Problem

References

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