Asymmetric Information
Asymmetric information is a situation in which one party to a transaction possesses more or better information than the other. When information is unevenly distributed, the party with superior knowledge can exploit that advantage, leading to market outcomes that are inefficient and, in extreme cases, can cause markets to break down altogether. Asymmetric information is a fundamental source of market failure.
Definition
Asymmetric information arises whenever the parties to a transaction do not share the same information relevant to that transaction. This is a pervasive feature of economic life: sellers typically know more about the quality of their products than buyers do; borrowers typically know more about their own creditworthiness than lenders; and managers typically know more about the prospects of their firms than shareholders.
The economics of asymmetric information was developed by George Akerlof, Michael Spence, and Joseph Stiglitz, whose work was recognised with the Nobel Memorial Prize in Economic Sciences in 2001. Their research demonstrated that information problems have profound consequences for market structure and efficiency.
Adverse selection
Adverse selection occurs before a transaction takes place, when one party cannot observe the type or quality of the other. The classic illustration is the market for used cars, analysed by Akerlof in his 1970 paper "The Market for Lemons." Suppose that sellers know whether their cars are of good quality ("peaches") or poor quality ("lemons"), but buyers cannot tell them apart. Buyers will be willing to pay only a price reflecting the average quality of cars on the market. At that price, owners of good cars are unwilling to sell, so the average quality of cars offered for sale falls, which in turn reduces the price that buyers are willing to pay. This process can continue until the market collapses entirely.
Adverse selection also affects insurance markets. If insurers cannot distinguish between high-risk and low-risk individuals and charge a uniform premium, low-risk individuals may find the premium unattractive and withdraw, leaving a pool of higher-risk individuals and pushing premiums up further—a phenomenon known as the death spiral of insurance.
In credit markets, adverse selection can occur when lenders cannot distinguish good borrowers from bad. Raising interest rates to compensate for default risk may drive away the safest borrowers, leaving a riskier pool behind.
Moral hazard
Moral hazard arises after a transaction has taken place, when one party can take actions that affect the other party's interests but that the other party cannot observe or control. Because the informed party does not bear the full consequences of its actions, it has an incentive to behave in a way that is harmful to the uninformed party.
The classic example is insurance. Once insured, a person may take fewer precautions against loss, because the cost of a loss is borne by the insurer. In financial markets, moral hazard can arise when institutions believe they will be rescued if they fail—the "too big to fail" problem—leading them to take excessive risks.
Signalling
The problem of asymmetric information can be mitigated through signalling, in which the informed party takes an action to convey information credibly to the uninformed party. For a signal to be credible, it must be costly for those with unfavourable characteristics to imitate. Education is often cited as a signal in the labour market: if more able workers find it easier to obtain qualifications, then qualifications signal ability even if they do not directly increase productivity.
Screening
Screening is the process by which the uninformed party designs mechanisms to induce the informed party to reveal information. Insurers may offer a menu of contracts with different combinations of premiums and deductibles, so that high-risk and low-risk individuals self-select into the appropriate contract. Banks may require collateral or extensive documentation before extending credit.
Applications in economics
Asymmetric information has important applications across economics. In corporate finance, it explains why firms prefer to finance investment from retained earnings first, then debt, and only then equity—the pecking order theory. In labour economics, it explains the role of education, references, and probationary periods. In financial regulation, it justifies disclosure requirements, capital standards, and deposit insurance.
The principal–agent problem is a closely related concept, arising when a principal (such as a shareholder) delegates work to an agent (such as a manager) whose interests differ and whose actions cannot be perfectly observed.
Policy responses
Governments and institutions respond to asymmetric information in several ways. Regulation may require the disclosure of information, as with securities laws that mandate financial reporting. Guarantees and warranties shift risk and provide assurance to buyers. Certification and licensing establish minimum standards. Insurance mandates can prevent adverse selection by requiring broad participation. Monitoring and supervision reduce moral hazard.
These measures are not costless and may create their own distortions, but they reflect the recognition that markets, left completely to themselves, may fail when information is unevenly distributed.