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.

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