How does information asymmetry contribute to market failure?

Information asymmetry contributes to market failure primarily because it results in one party having more or better information than another. This imbalance can lead to adverse selection and moral hazard, where the party with less information is at a disadvantage, unable to make fully informed decisions. For instance, in the market for used cars, sellers often know more about the vehicle's condition than buyers. This can lead buyers to distrust the market, ultimately resulting in lower overall sales and potentially driving good-quality cars out of the market, as informed sellers pull their products.

In contexts where one party is more informed, it can exploit that knowledge for profit at the expense of the less-informed party, which disrupts fair competition and leads to inefficiencies in the market. As such, the imbalance of information creates barriers to optimal transactions, diminishing the overall efficiency of the market and causing it to fail in achieving equilibrium where supply meets demand at a fair price.