The presence of asymmetric information in a market leads to adverse selection. This asymmetric information means that the principle does not have the information the agent has and may put them in a disadvantageous situation (Shi et al, 2007). Adverse selection will develop when the principle cannot observe the characteristics of his claims and the agent cannot verify his claims (Mulej, 2006. ) Due to information asymmetry the principle may be provided with untrue or exaggerated information to get the principle to sign the contract.
All potential agents will claim superior expertise (Mulej, 2006. ) The plans of the agent may be to maximise his profits so therefore possibly leading to a lower quality of product or a higher price. The decision made due to this is adverse selection, the principle ends up picking an agent who is not fit and inefficient. If you consider Akerlof’s example above, the principles price is too low for high quality suppliers, therefore only low quality firms will be taken on. This can lead to partial market failure due to the bad firms driving the good firms out (Keil, 2005.)
In general customers in insurance and credit card markets is adverse selection however to counter this companies may choose to increase prices or increase interest rates. Possible remedies Agency relationships and Moral Hazard: Monitoring would be one possible remedy, it has all the means that the principal intends to decrease there information advantage. (Keil, 2005. ) Performance should be contractually agreed between the principle and the agent however a way of measuring this would be needed.
However even with contractual targets it depends on the quality of its measurability and verifiability (Mulej, 2006. ) An incentive based contract could be an option where the agent’s payment is down to the principle profit. Asymmetric information: If the company does not know about the market or has a lack of knowledge on a certain market, then they can higher someone with experience. You see this all the time in Dragons Den there, not just in there for the money but the Dragons expertise. Also they could make contracts with the agent for guarantees over products if they do come in faulty or below standard.
Adverse selection: To avoid adverse selection the principle should collect a lot of information and do thorough research on the contractors. Their financial situation, strengths, other clients, trust, security experience and many more should all be taken in to account for this decision. No one characteristic is specifically important but what is important for the company (Mulej, 2006. ) Conclusion The firm needs to decide and consider all of the costs of outsourcing. Obviously sometimes it is impossible to foresee a situation with the problems raised above.
It always important to be prepared, defining the requirements, building up the infrastructure and defining project guidelines before appointing an external firm (Kiel 2005) For the outsourcing to work, the participants must have a long term objective to cooperate. However if there are such issues, then in-house production is an option, although accumulation of cost will be different to outsourcing. “The make or buy decision involves a calculated balancing of several benefits and costs of integration. Managers can easily get lost in this balancing act. ” (Besanko, 2007)