asymmetric-information

What is asymmetric information?

Asymmetric information as a concept has probably existed for thousands of years, but it became mainstream in 2001 after Michael Spence, George Akerlof, and Joseph Stiglitz won the Nobel Prize in Economics for their work on information asymmetry in capital markets. Asymmetric information, otherwise known as information asymmetry, occurs when one party in a business transaction has access to more information than the other party.

Understanding asymmetric information

In essence, the work showed that the financial sector – equipped with more knowledge, better networks, and proprietary information – tended to exploit retail market participants who in comparison were less knowledgeable, informed, and connected. The researchers found that this scenario was common in developing nations.

The committee responsible for awarding the prize also made mention of a report Akerlof had written over three decades earlier. His 1970 essay The Market For Lemons, the committee argued, was an invaluable study on the economics of information. The essay described the information asymmetry that occurs in the used car market where the seller possesses more information about the quality of the vehicle than the buyer. Far from being a mild inconvenience, Akerlof posited that information asymmetry had much broader implications and could impact capital markets and even cause market failures.

Three ways asymmetric information impacts business

How does asymmetric information impact business transactions, exactly? 

Let’s take a look:

Moral hazard

In the economic context, a moral hazard occurs when one party in the transaction takes on more risk because they will not experience the full consequences of that risk should a problem occur. The classic example of a moral hazard is a fund manager who invests their clients’ money. Some invest in riskier securities than if the capital was their own to invest, which causes an imbalance in information. Indeed, would the client approve of the investment if they had access to this knowledge? 

Monopoly of knowledge

Where only a few privileged individuals have access to the necessary information to make a decision. Knowledge monopolies are most associated with governments and other high-level organizations. Whatever the situation, however, the result of a knowledge monopoly is often a lower-level employee having to make a decision without access to the proper information.

Adverse selection

This occurs when the buyer and seller in a transaction have access to different information. However, it should be noted that the information the buyer holds is not necessarily superior to the information the seller holds, or vice versa. This form of information asymmetry, which is common in labor markets, retail markets, and even personal relationships, causes the buyer and seller to act based on the presumption that the other possesses the same information.

How can information asymmetry be avoided?

Information asymmetry is inherent to many industries and situations. As a result, strategies to avoid the phenomenon are as numerous as they are diverse.

With that in mind, we have listed a few general avoidance mechanisms below:

Provide more information

The simplest and most obvious solution is to provide more information. For the used car seller, this may involve not withholding the fact that the vehicle has a major engine fault that needs urgent attention.

Warranties and guarantees

Similarly, the used car buyer may elect to visit a business that specializes in second hand vehicles as opposed to purchasing from a private seller. This is because these businesses tend to offer warranties and other guarantees that compensate for any information asymmetry. 

Subsidies and taxes

In some healthcare markets, doctors benefit from information asymmetry by charging patients for medication or other services they do not actually need. In this case, governments often step in with heavier taxes on doctors or increased subsidies for patients.

Licensing and liability laws

These encompass consumer protection initiatives that force individuals to acquire the relevant licenses or permits before selling goods and services to buyers. Laws are also in place in most countries to protect the buyer in the case of scams, unfair treatment, and products that are otherwise unsafe, defective, or not as advertised.

Key takeaways:

  • Asymmetric information, otherwise known as information asymmetry, occurs when one party in a business transaction has access to more information than the other party.
  • Asymmetric information has three main impacts on business. These include moral hazards, knowledge monopolies, and adverse selections.
  • Asymmetric information is inherent in most industries and can never be eliminated completely. The best way to avoid it is simple: provide more information! Other strategies involve warranties, guarantees, subsidies, taxes, and legal protection.

Connected Business Concepts

Circle of Competence

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The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.

What is a Moat

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Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.

Buffet Indicator

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The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.

Warren Buffet Companies

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Warren Buffett is an American investor, business tycoon, and philanthropist. Known as the “Oracle of Omaha”, Buffett is best known for his strict adherence to value investing and frugality despite his immense wealth. He is among the wealthiest people in the world. Most of his wealth is tied up in Berkshire-Hathaway and its 65 subsidiaries.

Price Sensitivity

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Price sensitivity can be explained using the price elasticity of demand, a concept in economics that measures the variation in product demand as the price of the product itself varies. In consumer behavior, price sensitivity describes and measures fluctuations in product demand as the price of that product changes.

Price Ceiling

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price ceiling is a price control or limit on how high a price can be charged for a product, service, or commodity. Price ceilings are limits imposed on the price of a product, service, or commodity to protect consumers from prohibitively expensive items. These limits are usually imposed by the government but can also be set in the resale price maintenance (RPM) agreement between a product manufacturer and its distributors. 

Price Elasticity

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Price elasticity measures the responsiveness of the quantity demanded or supplied of a good to a change in its price. It can be described as elastic, where consumers are responsive to price changes, or inelastic, where consumers are less responsive to price changes. Price elasticity, therefore, is a measure of how consumers react to the price of products and services.

Economies of Scale

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In Economics, Economies of Scale is a theory for which, as companies grow, they gain cost advantages. More precisely, companies manage to benefit from these cost advantages as they grow, due to increased efficiency in production. Thus, as companies scale and increase production, a subsequent decrease in the costs associated with it will help the organization scale further.

Diseconomies of Scale

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In Economics, a Diseconomy of Scale happens when a company has grown so large that its costs per unit will start to increase. Thus, losing the benefits of scale. That can happen due to several factors arising as a company scales. From coordination issues to management inefficiencies and lack of proper communication flows.

Network Effects

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network effect is a phenomenon in which as more people or users join a platform, the more the value of the service offered by the platform improves for those joining afterward.

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