Asymmetric information exists when one participant in trade knows something that the other participant does not know about the quality of the particular good or service they are trading. This violates one assumption of perfect competition—“perfect information” (when market participants have all the information relevant to goods’ and services’ quality and price). The canonical example is the market for used cars (Akerlof 1970): The seller knows her attention to the car’s maintenance, but the buyer’s evaluation of the car’s value is limited to the features he can observe and his knowledge of the average quality of this type of car. In this case, the seller has more information about the product’s quality, but there are also markets in which the buyer has more information. When buying health insurance, for example, the buyer knows his own eating, drinking, and smoking habits, and the seller (the insurer) does not have as clear a picture of the buyer’s quality of health.
The concern of the economist or policy maker is that this asymmetry can lead to market failure: The asymmetric knowledge causes less trade between buyers and sellers than would be optimal for society; in the extreme case, only low-quality goods or services are traded. In this case of complete market failure, high quality goods are not sold: Used-car buyers assume (correctly) that only owners of “lemons” want to sell their cars, and insurance companies assume (correctly) that only less healthy individuals desire insurance. Like other market failures, asymmetric information corrupts the price mechanism: If the buyer lacks information (used cars), the market price will be too low for higher-quality exchange; if the seller lacks information (health insurance), the market price will be too high for higher-quality exchange.
Consider a numerical example in the case of used cars to make these ideas concrete. There are two types: high quality cars valued at $15,000 and low quality cars valued at $10,000. These values, common to both buyer and seller, indicate the utility gained from owning a car. If 10 percent of the cars are low quality, then the prospective buyer could assume with 90 percent probability that he is buying a high-quality car and will offer to pay (0.90)($15,000) + (0.10)($10,000) = $14,500 or less. But at this price, only the owners of low-quality cars will be willing to sell. As a result, buyers and sellers expect only low-quality cars to be available on the market, and those cars sell for $10,000. Sellers of the low-quality cars know who they are, but the buyers do not. This phenomenon explains why a new car loses so much of its value as soon as it is driven off the dealer’s lot.
A similar example illustrating the case of health insurance would show that there is less incentive for the high-quality (healthy) types to buy insurance, which drives up the price of insurance. Only the customers with poor health and higher willingness to pay are served because the insurer cannot sufficiently differentiate between the high-and low-quality types, but the buyers know their own quality of health. Of course, these extreme examples seldom occur because buyers and sellers find ways to mitigate the asymmetric information, as described below.
The similarity between outcomes under imperfect information and some other types of market failure is the existence of a “free rider.” The buyers (in the case of health insurance) or sellers (in the case of used cars) of the lower quality goods are “free riding” on the reputation of the higher quality goods. The increased incentive for low quality goods and services to be traded is known as “adverse selection.” This is also related to, but different from, the concept of “moral hazard.” The distinction between the two is one of timing: Moral hazard describes the incentive, once an individual has health insurance, to behave more recklessly because he no longer faces the full financial impact of addressing medical conditions brought on by his poor health habits.
Asymmetric information is not simply a lack of information. Even though each piece of fruit at the grocery, for example, may hide some information from the buyer, it is hidden from the seller, too, and the market price can reflect this chance of selling and buying poor-quality fruit. We are also not focused directly on some advantage held by the seller of a low-quality car, or an advantage held by an unhealthy purchaser of insurance. The market failure is simply the lack of a market for high-quality goods. If there were perfect information in the market for used cars, for example, then there would be two car markets, one for trading high quality and one for trading low quality.
There are various solutions to this market failure, but they often have their own drawbacks. Experts may provide the inadequately informed party with improved information, but this also increases the transaction cost—and if there is any remaining unknown information, high-quality goods are still difficult to sell. A physical examination may reveal a health insurance buyer’s health to potential insurers. Regulations may require a minimum quality (of cars or physicians, for example) or certification exams (for electricians or plumbers, for example), but this barrier to entry may provide the regulated group with market power. Quality regulations may also inhibit the provision of lower-quality goods and services for which a market (with lower prices) would otherwise exist (with perfect information).
Could the high-quality agents simply state that they have the high-quality product or characteristics? If this statement, or “signal,” is costly for those with a low-quality product or service, then such a solution is feasible. For example, offering warranties is expensive for those selling low-quality cars, but not for those selling high-quality cars. (This solution may face moral hazard problems, as mentioned above.) Likewise, a college degree need not prepare the student for her intended profession in order to be useful (Spence 1973a; Stiglitz 1975), as long as it is difficult to obtain for those students valued by potential employers. The degree could simply serve as a signal to employers that this student is bright or a hard worker, qualities that would otherwise be difficult for a potential employer to observe before hiring her. Further, the time and effort involved in courting a prospective spouse may also “signal” the love and commitment that would otherwise be difficult to observe before entering into marriage (Spence 1973b).
Another possible market solution is to provide the low-quality types an incentive to reveal themselves through the available contracts (Rothschild and Stiglitz 1976). In the case of health care, insurers provide contracts with lower deductibles that can be chosen by those less-healthy buyers willing to pay a higher premium. Healthy buyers pay lower premiums but a higher deductible, benefiting from their lower likelihood of illness.
SEE ALSO Adverse Selection; Collective Action; Free Rider; Market Economy; Markets; Moral Hazard; Regulation; Risk; Signals; Uncertainty
Akerlof, George A. 1970. The Market for “Lemons”: Quality Uncertainty and the Market Mechanism. The Quarterly Journal of Economics 84 (3): 488–500.
Rothschild, Michael, and Joseph Stiglitz. 1976. Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information. The Quarterly Journal of Economics 90 (4): 629–649.
Spence, Michael. 1973a. Job Market Signaling. The Quarterly Journal of Economics 87 (3): 355–374.
Spence, Michael. 1973b. Time and Communication in Economic and Social Interaction. The Quarterly Journal of Economics 87 (4): 651–660.
Stiglitz, Joseph E. 1975. The Theory of “Screening,” Education, and the Distribution of Income. The American Economic Review 65 (3): 283–300.
Christopher S. Ruebeck
"Information, Asymmetric." International Encyclopedia of the Social Sciences. . Encyclopedia.com. (October 20, 2017). http://www.encyclopedia.com/social-sciences/applied-and-social-sciences-magazines/information-asymmetric
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