Information asymmetry affects decisions in transactions where one side is informed more than the other. It creates an imbalance of power that can lead to transactional errors or market failure in the worst case. Examples of this problem are adverse selection, the monopoly of knowledge, and moral hazard.
The concept
Information asymmetry occurs when one side of an economic transaction has greater material knowledge than the other. This usually manifests itself when the seller of the product or service has more knowledge than the buyer, although the opposite is possible. Almost all economic operations are associated with information asymmetry.
Breakdown of information
Information asymmetry is a specialization and sharing of knowledge in society in relation to economic trade. For example, doctors generally know more about medical practice than their patients. Indeed, thanks to extensive education and training, doctors specialize in medicine, while most patients do not. The same principle applies to architects, teachers, police, lawyers, engineers, fitness instructors and other specially trained professionals.
Models
Models of information asymmetry and its manifestations suggest that at least one participant in the transaction has relevant information, while the other does not. Some of them can also be used in situations where at least one party can enforce certain parts of the agreement or take effective retaliatory measures for violating them, while the other party cannot.
In unfavorable selection models, the ignorant party has no information when agreeing on a deal. In the event of moral hazard, she is not aware of the execution of the agreed transaction or does not have the opportunity to avenge violation of the agreement.
Economic benefits
The consequences of information asymmetry for the economy can be not only negative, but also favorable. Its growth is a desirable result of a market economy. When workers specialize and become more productive in their fields, they can provide greater value to employees in other areas. For example, the services of an exchange broker are more valuable to customers who do not know enough to buy or sell their own shares with confidence.
One alternative to the ever-expanding information asymmetry is to train workers in all areas, rather than specializing in those where they can provide the greatest value. Although this may be associated with high costs and, possibly, lower total output, which will lead to a decrease in living standards.
Another alternative is to make large amounts of information accessible and affordable, for example via the Internet. It is important to note that this does not replace information asymmetry. This only leads to its displacement from simpler to more complex areas.
disadvantages
In certain circumstances, information asymmetries can lead to adverse selection and moral hazard. These are situations when individual economic decisions are hypothetically worse than they would be if all parties had more symmetrical information. In most cases, solving the problem of moral hazard and adverse selection is quite simple. The news agency can help.
Consider an unfavorable choice for life insurance or fire insurance. High-risk customers, such as smokers, the elderly, or people living in drylands, are more likely to get insurance. This can increase insurance premiums for all customers, forcing others to opt out of insurance. The solution is to perform actuarial work and insurance screening, and then charge various premiums to clients based on their potential risks.
Finance
Information asymmetry, as a rule, is greatest in those areas where information is complex, difficult to access, or both at once. For example, it is relatively difficult to obtain exclusive information when trading in antiques, but quite easily in areas such as law, medicine, technology or finance.
Financial markets often rely on reputational mechanisms to prevent abuse by financial professionals in relation to clients. Financial advisors and stock companies that turn out to be the most honest and efficient asset managers tend to receive clients. Dishonest or ineffective agents lose customers or face legal losses.
Adverse selection
According to economic theory, information asymmetry is most problematic when it leads to adverse selection in the market. Theoretically, it leads to a non-optimal market, even when both sides of the exchange behave rationally. This suboptimality gives entrepreneurs an incentive to take risks and contribute to a more effective outcome.
Market reaction
There are several broad methods for resolving adverse selection problems. One of them is a solution for manufacturers to provide warranties and returns. This is especially noticeable in the used car market.
Another intuitive and natural answer for consumers and competitors is to act as monitors for each other. Consumer reports, laboratories of insurers, notaries, an overview of online services, and news agencies will help fill in the information gaps.
The study of effective market mechanisms is known as design theory, which is a more flexible branch of game theory. Its authors are Leonid Gurvich and David Fridman.
Signaling
One of the ways to eliminate information asymmetry is signaling. This idea was originally voiced by Michael Spence. He invited people to signal their situation, credibly transmitting information to the other side and eliminating the asymmetry. This idea was studied in the context of selection in the labor market. The employer is interested in hiring a new employee who is "experienced in training." Of course, all future employees will claim that they are qualified in training, but only they know whether this is true. This is information asymmetry.
Spence suggests, for example, considering college entrance a reliable signal of learning ability. After graduating from college, qualified people signal their skills to potential employers. However, graduation can simply be a signal that they are able to pay for tuition, a signal of people's readiness to adhere to orthodox views or to obey authority.
Screening
The pioneer in screening theory was Joseph Stiglitz. It consists in the fact that an insufficiently informed party may induce the other party to disclose its information. Parties may provide a selection menu in such a way that it will depend on the private information of another participant.
Examples of situations where the seller usually has more complete information than the buyer are numerous. These include used car dealers, mortgage brokers and lenders, stockbrokers, and real estate agents.
Examples of situations where the buyer usually has better information than the seller, include the sale of real estate, life insurance or the sale of antiques without a preliminary professional cost estimate. This situation was first described by J. Kenneth Arrow in his 1963 Health Care Article.
George Akerlof in his scientific work “Lemon Market” notes that the average cost of goods tends to decrease even for those who have products of excellent quality. Due to the information asymmetry, unscrupulous sellers can fake goods and deceive the buyer. As a result, many people are not willing to take risks.
