Imperfect Information Example
In the Health Insurance Market, buyers know more information about their own health problems than do potential insurance providers. With this better information, buyers have an incentive to conceal their health problems in attempt to get a lower insurance premium. In other words, if insurance providers knew that a person had a history of heart problems, insurance providers could charge him or her a higher rate. This informational disparity is often referred to as asymmetric information.
With this informational asymmetry, insurance providers would charge one price and hope to spread their costs across a diverse group of policy holders. Another way of looking at this is that the insurance provider tries to use some of their large profits from low risk/good health customers to subsidize their losses from high risk/poor health customers. However, we will likely find the buyers in poor health purchase insurance while the healthy individuals find that they are better off paying their smaller medical bills as they go and out of pocket. In this scenario, we find that insurance providers would have a difficult time operating profitably. This is called adverse selection.
Another example of potential market failure caused by imperfect information is in the used car market. For example, the owner (seller) of an automobile likely has much better information on the car's condition. The car's condition, which is typically closely related to its age and mileage, is an important aspect of its market value (aside from make and model). Because it may be difficult for the buyer to correctly appraise the value of the car, the seller has an incentive to conceal some mechanical problems that should decrease the trading price of the car. If a car is actually worth $5000 but is traded for $6300 because the seller was able to conceal the fact that the car needs $1300 in transmission repairs, we have a market failure.
The other form of asymmetric information is called moral hazard. This entails when a person's behavior is hard to monitor and control and thus payment to that person is based on incomplete information. This usually occurs in the insurance and job markets. If a person purchases fire insurance for his home, he might not be as careful to properly store flammable material or never use candles in the house, as he was prior to obtaining insurance. In the workplace, moral hazard is generally known as the principal-agent problem. This is where the owner of a business (the principal) can't fully observe the productive efforts of his employee or manager (the agent). Thus, a flat-rate of compensation for employment, combined with the asymmetric information, can give the employee an incentive to shirk, or to not work as hard as he is capable of. He can follow his own best interest instead of fulling pursuing the best interests of the owner by working diligently, as he will be paid the same regardless of his performance.
Source: Pinydck, Robert S. and Daniel L. Rubinfeld. Microeconomics. 5th Ed. pp.606-609