Asymmetric information is an imbalance in the quality or quantity of information possessed by two or more people. Some people simply have more information than others. This asymmetry is a direct consequence of efficient information search. Because the acquisition of information, like the production of any good, uses scarce resources and incurs an opportunity cost, no one knows everything and everyone is ignorant about something (usually most things). In particular, those who stand to benefit more are rationally motivated to incur greater cost and thus obtain more information.
The unequal distribution of information throughout the economy gives rise to three related problems -- adverse selection, moral hazard, and the principal-agent problem. Asymmetric information can result in market inefficiency that limits the quality of goods exchanged in a market (adverse selection). It can also lead to a discrepancy between who benefits from an action and who incurs the cost (moral hazard). And it can cause a disconnection in the objectives of an agent authorized to represent a principal and the principal who is unaware of the specific actions of the agent (principal-agent problem).
The Why of Asymmetric InformationInformation is not equally available to everyone in the economy. Some know more and some know less. The reason for this is efficient information search, the balance between the cost and benefit of information search.
The bottom line is that those who stand to benefit most from information are willing to incur the necessary search cost. And those who benefit less, are not.
- Benefit: Information provides different benefits to different people. Most people receive little benefit knowing the wages paid to computer programmers in Milwaukee, Wisconsin. However, this information is bound to be extremely beneficial to a student majoring in computer programming at the University of Wisconsin.
- Cost: The acquisition of information requires the use of scarce resources and thus incurs a cost. This means that everyone stops short of obtaining complete information. It's just not worth the cost, it's not worth the effort. And because people benefit differently from information, some pursue more search effort, and have more information, while others do less and end up with less.
For example, Winston Smythe Kennsington III, who earns his living in the financial markets buying and selling corporate stock, is bound to find it beneficial to study the mind-numbing detail of corporate annual reports, balance sheets, and profit and loss statements. This information provides fewer benefits to Dan the drywall installer, who makes a living installing drywall.
Dan, however, might be very motivated to search out information about new light-weight, mold-resistant, forms of drywall -- information that provides almost no benefit to Winston.
Markets and MoreAsymmetric information shows up in most market exchanges. Rarely do both sides of the market have equal information about the good exchanged. Because they produce or at least have control of the good, sellers generally have better information than the buyers. Sellers are more likely to know the pros and cons of the good, the features and defects, and what it can do and what it can't.
Buyers, in contrast, are likely to be less familiar with the good. They often gain possession of the good only after purchase and any information obtained about the good prior to purchase is usually limited to that provided by the seller.
Asymmetric information is particular important in the financial markets. Stock prices are based in large part on the information buyers and sellers have about productivity and profitability of the company. Those with better information are usually more successful at "buying low and selling high."
The financial market for insurance also relies heavily on accurate information. For example, the insured generally have better information about their own health than the health insurance providers.
The employment of labor is another market where asymmetric information plays a key role. Employees have more information about their own skills, talents, and productivity than do employers.
Adverse SelectionA problem that arises from asymmetric information is adverse selection. Adverse selection occurs when an inefficient, bad, or adverse outcome of a market exchange results because buyers and/or sellers make decisions based on imperfect information. This commonly results in a market that exchanges a lesser quality good, what is termed the market for lemons.
To illustrate, suppose that the market for used OmniMotors XL GT 9000 sports coupes contains two different "qualities." The "lemon" is of poor quality and the "gem" is of high quality. The sellers are well aware of the specific quality of their own XL GT 9000, but buyers are not. If they had complete information about each type of car, buyers would be willing to pay $4,000 for the lemon and $6,000 for the gem.
However, all that the buyers know is that they have an equal chance of buying either a lemon or a gem. In this case, not knowing which quality they will end up with, buyers would be willing to offer a price of $5,000. The chance of paying $1,000 too much for a lemon is offset by the chance of paying $1,000 less than the value of the gem.
Unfortunately, sellers have better information and know whether their XL GT 9000s are lemons or gems. At a $5,000 offer price, those selling lemons are more than willing to sell, coming out $1,000 ahead. In contrast, those selling gems are not willing to sell. They would receive $1,000 less than the value their cars.
The end result is that the ONLY cars sold are lemons. The market adversely selects against the higher quality products in favor of the lower quality ones.
Moral HazardA second problem that results from asymmetric information is moral hazard. Moral hazard exists when one person undertakes an action that is detrimental to another person after the two people have entered into an agreement. The problem is that the person harmed is unaware of the actions of the other.
Moral hazard is most commonly seen in the insurance industry. For example, an insurance company provides automobile insurance based on a driver's record, average miles driven a week, number of accidents, and traffic tickets. However, once the driver has insurance, once the driver knows that the insurance company incurs the cost of an accident, then moral hazard occurs if the driver changes behavior -- drives faster, takes more risks, or fails to obey traffic laws. And the insurance company is unaware of this change in behavior. If the insurance provider was aware of the change, then it would be inclined to charge different insurance premiums.
In addition to automobile insurance, most other types of private insurance (health, life, home), in which the actions of the insured can affect the cost to the provider, are subject to moral hazard.
Public or government insurance programs are also subject to moral hazard. The existence of deposit insurance, for example, can create moral hazard for the operation of banks. With the deposits of their customers insured, banks might be inclined to make high-risk loans. If the bank fails, the government bears the cost of paying off the deposits.
Principal-Agent ProblemA third problem that occurs due to asymmetric information is the principal-agent problem. The principal-agent problem is a disconnection or conflict between the goals and objectives of the "principal" and those of the "agent" authorized to represent the principal. The problem arises because the principal does not have accurate information about the behavior of the agent.
This problem is common in corporations, when the owners (principals) hire managers (agents) to run the company. The agents, however, might make decisions that benefit themselves (higher salaries, fringe benefits) that are unknown to and not in the best interests of the owners (profit).
The principal-agent problem also arises in the government, where citizens (principals) elect leaders (agents) to run the government. The agents in this case might seek personal benefits (higher salaries, lobbyist-paid vacations) that are unknown to and not in the best interests of the citizens (efficient, effective government).
Related IssuesThe problems caused by asymmetric information can be lessened through signalling and screening.
- Signalling: This is the provision of small bits of information that is intended to indicate other more complete information. Sellers, for example, knowing that buyers have less information about their products might pass along signals about product quality. Guarantees and warranties are common signals. Brand names established over long periods of customer satisfaction and/or advertising are another method of signalling. Of course, the signals might not be accurate and those with less quality products might deceptively mimic the signals of the higher quality goods.
- Screening: This is the attempt by those with limited information to identify indicators suggesting more complete information. Employers, for example, commonly use grade point averages, aptitude tests, or school quality as a means of screening out high quality from low quality prospective employees. Of course, screening can also be inaccurate. A good student, from a good school, with a high grade point average, might be a lousy worker.
ASYMMETRIC INFORMATION, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2019. [Accessed: October 19, 2019].