Lack of information has come to be seen as a fundamental cause of market failure. Resale markets, housing markets and markets for corporate securities suffer to some extent from the problem that market participants have better information security than others about the value of the good are traded. The market of lemons is a situation where bad goods always drive out good ones from the market. This is done in the same manner, which bad money drives out the good. This means there is no price at which trades will take place. In the lemon market there is possibility that one of the individual has quite more information about something that affect both individuals’ payoffs from trade. Such markets are very common and economist has done intensive research in the context information security on different market actions. (Anke 17).
The lemons markets are typically inefficient because sellers with high quality objects may refuse to exchange goods, although there are other individuals who would want to trade with them. The basic insight for this main observation arises from the incentives of the sellers owning low-quality objects. Each of these individuals has an incentive to pretend to have a high quality product to receive a high price for her or him for low-quality objects. The outcome of such incentives is that buyers may not be prepared to purchase at a price that is high for venture to be profitable for the sellers to have high-quality products. This happens because there is insufficient information security in the transaction between the parties.
Therefore, it has been recognized that adverse selection may be a serious issue in markets where informational asymmetries play a significant role. A good example of this is the Akerlof (1970) argument in the field of adverse selection that used stylized market for used cars (Anke 18). He demonstrated that if only the sellers know that no transaction will occur in the market, the information security may disappear. His argument presumes that whereas one side of the market is uninformed, the information structure on the other side of the market is perfect. This means these agents are always fully informed about a factor important for their own transaction. He evaluates a simple exchange economy with two traders each with goods of high and low quality. He shows that if the exchange of products is treated as a non-cooperative game the strategy pair of low quality and low quality develops Nash equilibrium.
In the used car market, unlike other markets with information security, the insurance market and the labor market, an agent can change his position from buyer to seller or vice versa with little or no transaction cost. In the used car, the agents are divided into buyer and seller, where for example an agent in the buyer group is supposed to purchase only a used car. This is unnecessarily limiting because there is chance that when the price of used cars increases, a used car buyer may want to shift his demand for a used car to a new car and as a result he or she will be a used car seller.
Meanwhile, in similar markets such as insurance policies there may be no incentives to cover older, unhealthy (lemons) individuals in part because of the associated principle of moral hazards. Private health insurance policies offer for a price reduction at the time the insured purchases medical care. Therefore, an insured individual would respond to the price decrease by purchasing more medical care than he would have purchased at the market price. This effect of insurance on medical care demand is referred to as the moral hazard effect. It refers to the effect of insurance on the net price of medical care and the consequent incentive effects on medical care consumption (Major 149).
Another example of moral hazards the criteria used to price initial public offering (IPO). The IPO pricing process has used under pricing in measuring the discount of the offer price.
When IPO companies are young or have had a significant shift in strategy, investors lack the perfect knowledge available for more established firms to reduce information security regarding the inherent quality of a stock. Meanwhile, new, privately held firms might operate with unproven business models and their managers exercise significant discretion over more information about the firm’s operations and resources. Owing to the information security and its associated risks, the valuation of such firms might particularly be prone to moral hazard, which means hidden intentions.
Therefore, there are a variety of mechanisms and strategies used to overcome problems of “market of lemons” and “moral hazard effect. Therefore, as an Information Security Consultant, I will search for network protocols and interfaces that are strategy-proof. They are designed so that the incentives of the principals are well aligned and no one can gain by cheating. Similarly, designing bad behavior out of systems at the beginning is much easier than trying to involve the police (Anderson and Tyler 613).
In mitigating the risk of moral hazard as a result of IPO pricing, I will use both signaling and institutional strategies that suggest organizational and governance traits can serve as a useful measure for reducing uncertainty of IPOs (Major 150). This is so because the firm valuation is prone to opportunistic behavior by agents within the investment. Moral hazard shows these traits because it is featured by the potential for hidden actions or intentions that managers may have.
Signaling theories are based on the assumption that certain behavior will send signals to potential investors about the capabilities and therefore the future value of the firms. It suggests that new investment attributes contain information that reduces investors’ uncertainty about intrinsic quality and opportunistic behavior especially when they are expensive or hard to imitate (Justin, 312). This will substitute the available information by signaling quality and therefore resulting in the market sorting the valuation of new firms.
Likewise, the institutional strategy suggests that organizations might positively affect investor’s perceptions by adopting attributes and connections that are viewed as legitimate and conforming to industry norms (Justin 307). It will reduce the moral hazards by the use of secondary information which creates opinion about incentives and the value of the new forms. Meanwhile, the cost sharing strategy will also be a measure to reduce the moral hazard effects in the example. The uniform cost sharing across the principals and agent in insurance policies that imposes the same level of cost sharing will discourage the use of valuable services just as much as these policies discourage the use of inefficient services.
I can consult the Securities and Exchange Commission and congress that focuses on a significant deal of attention on price and quality of external audit services to investors. They have considered the regulation of investment banking contracts because of their concern over the price and the level of services offered. This has happened because most agency relationships in these services offered by the agent have a hidden trait. The principal cannot costless observe the level of service offered by the agent and therefore cannot determine whether insufficient information is due to the agent’s shirking or due to an unfortunate occurrence of a state of nature (Jan 26). These will help to reduce market of lemon issues in the used car example because it will eliminate the shirking behavior by buyers and sellers.
Similarly, the signaling approach can be used to address the situations of “market of lemons. This is because the market of lemons is characterized by lack of information. The incentives in the used car affect detailed design of privacy technology. Therefore, anonymity systems, which depend on the network externalities, can be used to mitigate the market of lemons because it can facilitate perfect information between the parties.
Therefore, the research program on the economics of security has created several cross-disciplinary connections and has generated many useful insights from unexpected places. Economic factors explain various challenges to discriminatory pricing as seen from “market of lemons” and “moral hazard effect”. This opportunistic behavior is economically efficient but socially controversial. They help to understand that information security is much more from just a technical issue because diverse types of externalities characterize information industries, where individual actions have severe effects on others. Therefore, the proper measures can help to mitigate the risks caused by individual actions.
Anderson , Ross, and Tyler Moore. "The Economics of Information Security." Science Review314.27 (2006): 610-613.
Anke , Kessler. "Revisiting the Lemons Market." International Economic Review42.1 (2001): 17-25.
Jan, Devos. "SMEs and IT: Evidence for a Market for "Lemons"." Electronic Journal of Information Systems Evaluation 15.1 (2012): 26-35. Web.
Justin, Johnson. "Leasing, Lemons, and Moral Hazard." Journal of Law & Economics53.2 (2011): 307-328. Web.
Major , Coleman. "Are Reports of Discrimination Valid? Considering the Moral Hazard Effect."American Journal of Economics & Sociology 67.2 (2008): 149-175. Web.