Market failure may occur due to the problem of asymmetric information in the economy. The two fraudulent consequences of asymmetric information are moral hazard and adverse selection.

The problem of moral hazard occurs due to the unobserved efforts of the individuals in the economic transactions. It refers to the situation when the unobserved efforts of the individuals lead to disadvantage to the other individuals in the transaction.

For example: Considering a situation of the insurance market. The two parties are involved- insured person and the insurer. If there are two insure persons involved, one is a smoker and other is a non smoker there are more chances of the smoker to get ill. The smoker will hide his habit while filling the policy form, for the sake of not paying higher premiums as compared to the non smoker. Thus the unobserved efforts of the smoker lead to disadvantage to the insurer. This incentive compatibility constraint of the smoker person refers to moral hazard.

Adverse selection refers to the situation when the person has asymmetric material information as compared to the other individuals involved in the transaction. Consider a lemon market, where the seller has greater material information regarding the quality of lemons. If the purchaser does not know whether the lemon is rotten or fresh, the seller can take his advantage by selling the rotten lemons for the price of fresh lemons. Thus the unobserved type of material knowledge leads to develop the participation constrains in the market, this is referred as adverse selection problem.