Steve Bain

Asymmetric Information Explained (models & examples)

Asymmetric information theory addresses situations where one party in a transaction possesses more, or superior, information compared to the other. This often leads to market inefficiencies in the allocation of goods and resources.

One notable illustration of asymmetric information is the ‘lemons problem,’ introduced in the 1970s by the Nobel Prize winning economist George Akerlof in the context of the used car market. The presence of information asymmetry leads potential buyers to be wary of paying a premium for used cars, as sellers may have more information about the vehicles' quality.

This fear of purchasing a ‘lemon’ (a low-quality product) lowers the prices that buyers are prepared to pay, with the result that only lower-quality goods will be offered by sellers. This adversely impacts overall market efficiency.

The theory has widespread applications, influencing analyses of insurance markets, labor markets, financial systems, and the formulation of effective government regulations to mitigate these market failures.

Contract Theory

Contract theory is closely related to asymmetric information, as it provides a framework for understanding and addressing issues that arise when parties to a contract have different or incomplete information. It explores how individuals or entities can design agreements to overcome these challenges.

In situations of asymmetric information, contracts may be incomplete because it is challenging to specify all possible contingencies and outcomes in an agreement. Contract theory recognizes the risk of hidden information or hidden actions that may impact the fulfillment of contractual obligations.

Contract design aims to create incentives that encourage both parties to act in ways that benefit the overall success of the agreement. It explores ways to structure contracts to align incentives, manage uncertainty, and address the informational disparities between contracting parties, ultimately contributing to more efficient outcomes.

Asymmetric Information Models

Adverse Selection - This occurs when the party with more information takes advantage of this by selectively participating in transactions that benefit them. In the context of the insurance market, for example, individuals with higher risks may be more inclined to purchase insurance, leading to higher costs for the insurer.

Moral Hazard - This arises when one party, insulated from risk, behaves differently than it would if it were fully exposed to the risk. For instance, if an insurance policy covers all damages resulting from a car accident, the driver may be less cautious, knowing that the costs will be borne by the insurance company.

Principal-Agent Problem - When one party (principal) hires another party (agent) to act on their behalf, inefficiencies are likely to arise if that agent can build up information that is not available to the principal. This typically happens when executives of a firm enjoy greater information than the shareholders that they represent.

Efficiency Wage Theory - Related to the principal-agent problem, when the managers of a firm hire workers, those workers enjoy more information about their own productivity levels than do their employers, and they often know that they can ‘shirk’ some of their responsibilities. An efficiency wage is thought to incentivize workers to increase their productivity.

Market Signaling & Screening - When firms have more information about the quality of their products than their customers do, the lemons problem mentioned above can arise. To combat this, firms can send market signals to potential buyers e.g., guarantees and warranties, that reassure customers. Work by Michael Spence has shown that signaling is important across a wide range of markets.

Standardized Products - In many industries there are information asymmetries that arise due to the nature of the production process. Buyers usually lack information about that process and thus the quality of products. Firms can tackle this by offering standardized products e.g., products that are the same at all outlets, like McDonald's hamburgers.

Two Examples of Asymmetric Information

1. Finance

The market for credit has received a great deal of attention from the renowned economist Joseph Stiglitz. It suffers an asymmetric information problem that favors the borrower (buyer) over the lender (seller i.e., financial institution) because borrowers know more about their own willingness and/or ability to repay their loans. If lenders can’t build up an accurate estimate of an individual lender’s credit rating, then it will not be able to reflect this in the interest rate that it charges.

With a high uniform interest rate charged to all potential lenders, the least risky borrowers will be deterred from borrowing. Highly risky borrowers, on the other hand, will accept the interest rate. Essentially, this is another form of ‘lemon’ market, where the high-quality borrowers have been driven out of the market by the low-quality borrowers.

In the real world there is, of course, a great deal of information that can be gathered about borrowers, and financial companies use this to build up reasonably accurate estimates of individual risk profiles. Reliable risk assessments are improving all the time with the ever-greater amount of consumer information that is available in the modern world, but it can never fully match the lender’s own knowledge of his/her own risk.

2. Healthcare

In healthcare it is the sellers (doctors) that have an information advantage about the services they provide to their prospective patients (buyers). In countries where healthcare procedures are provided by the private sector, there is an incentive to profit by selling unnecessary treatments and procedures. While this sort of selling would be highly unethical, financial incentives have a way of clouding ethical judgements.

For anyone suffering with an ailment of some sort, it is extremely difficult (not to mention potentially dangerous) to self-diagnose a problem and structure an appropriate course of remedial measures. This is why we rely on doctors, and the information asymmetry at play between the doctor and the patient is significant. With some treatments being extremely expensive, the potential for poor choices to be made is concerning. Similarly, it is very difficult for a patient to be able to judge the quality of care once it is given.

Given the potential for market failure in healthcare, some countries in the developed world have opted for full or partial nationalization of the industry, while others have opted to heavily regulate it. Where the private sector delivers healthcare, it is usually done via health insurance, but that comes with other problems as discussed in my articles about Adverse Selection and Moral Hazard.

Government Regulations

Regulations aimed at addressing asymmetric information are designed to reduce the information gap between parties involved in economic transactions, and thereby promote fair and efficient markets. Here are some examples of regulations and mechanisms used:

Disclosure Requirements - In financial markets, companies are often required to disclose relevant information to investors. This can include financial statements, risk factors, and other material information that can impact investment decisions. For instance, the Securities and Exchange Commission (SEC) in the United States mandates companies to provide regular financial reports and disclose material events.

Consumer Protection Laws - Many countries have consumer protection laws that require sellers to provide accurate and complete information about the products they sell. For instance, food labeling regulations mandate the disclosure of nutritional information, ingredients, and potential allergens.

Product Standards and Certification - Certification bodies can verify and certify that a product meets certain standards. For instance, the USDA Organic label indicates that a product has met specific organic farming standards. This helps consumers make informed choices about the products they purchase.

Licensing and Accreditation - Professionals in various fields often need to obtain licenses or certifications. For example, doctors, lawyers, and financial advisors are typically required to be licensed. This helps ensure that consumers can trust the expertise and qualifications of service providers.

Insurance Regulations - Insurance markets are highly affected by asymmetric information. Regulations may require insurers to disclose policy terms and conditions clearly. Additionally, rules may be in place to prevent adverse selection, such as mandating coverage for certain risks or prohibiting insurers from discriminating based on certain factors.

Truth in Lending Laws - These laws require lenders to disclose the terms and conditions of loans, including interest rates, fees, and repayment schedules. This ensures that borrowers have a clear understanding of the costs associated with borrowing and can make informed decisions.

Whistleblower Protections - Protections for whistleblowers who expose fraudulent or deceptive practices within organizations can incentivize individuals to come forward with information that can uncover asymmetrical information. Whistleblower protections are often present in financial regulations and corporate governance frameworks.

Government Oversight and Auditing - Regulatory bodies, such as the Federal Reserve in the United States or the Financial Conduct Authority (FCA) in the United Kingdom, play a role in overseeing financial institutions and markets. Audits conducted by independent auditors can help ensure that companies are providing accurate and reliable information.

Conclusion

In conclusion, asymmetric information stands as a fundamental challenge in economic transactions, introducing uncertainties that can lead to adverse outcomes for market participants.

Adverse selection, moral hazard, and the principal-agent problem, the three primary manifestations of information asymmetry, underscore the importance of finding effective responses to ensure fair and efficient economic interactions.

From the innovative solutions of signaling and screening in contract design, to the standardization of products, and the implementation of government regulations aimed at reducing information gaps, the responses to asymmetric information are varied and dynamic.

These responses strive to align incentives, enhance transparency, and mitigate the potential distortions that arise when one party possesses better information than the other. Perfect information is unattainable, and some degree of market failure almost always exists, but even with imperfect information markets can reach a high degree of efficiency if both buyers and sellers have access to it.

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