Undrea wants to sell her motorcycle and Gregory is looking for a used motorcycle to buy. Gregory takes it for a test drive. Undrea knows that the clutch is going out on her motorcycle, the fuel filter is leaking, and the tires will need to be replaced soon. If she does not disclose this information to Gregory and he cannot tell from his test drive, this is an example of:

a. an external cost.

b. asymmetric information.

c. an external benefit.

d. a public good.

Option (b) is correct.

Explanation:

Asymmetric information refers to the problem that occurs in a transaction in which two parties are involved and one of the party have more information about the other party. In our example, the seller of the second hand motorcycle have more about the conditions of his motorcycle and the buyer have no idea about the working conditions of the motorcycle. This will mostly occurs in the insurance industry.

There are two problems occurs due to asymmetric information:

(a) Adverse selection

(b) Moral hazard