Why might information asymmetry result in suboptimal contracts?

Information asymmetry can result in suboptimal contracts as it creates an imbalance of power and knowledge between contracting parties.

Information asymmetry refers to a situation where one party in a transaction has more or better information than the other. This often makes the transaction less efficient and can lead to a lack of fairness in the contract. In the context of contracts, this could mean that one party is able to negotiate terms that are more favourable to them, at the expense of the other party.

For instance, in the case of insurance contracts, the insurer may have more information about the risks involved than the insured. This could lead to the insurer setting premiums that are too high, or including terms in the contract that are overly restrictive. On the other hand, the insured may have more information about their own health or behaviour than the insurer. This could lead to adverse selection, where only those who are high risk choose to buy insurance, resulting in higher overall costs for the insurer.

Similarly, in employment contracts, the employer may have more information about the job and its requirements than the employee. This could lead to the employer setting wages that are too low, or including terms in the contract that are overly demanding. Conversely, the employee may have more information about their own skills and abilities than the employer. This could lead to moral hazard, where the employee shirks their responsibilities, knowing that the employer cannot perfectly monitor their behaviour.

In both these examples, the party with more information is able to negotiate a contract that is more favourable to them, but less efficient overall. This is because the contract does not accurately reflect the true risks or rewards involved in the transaction. The party with less information may also be less willing to enter into the contract, reducing the overall number of transactions that take place. This is why information asymmetry can lead to suboptimal contracts.