Asymmetric Information

Rakesh Kumar

27 Sep, 2023

Asymmetric Information refers to situations in economic transactions where one party has more and better information than the other. This imbalance in information can lead to an imbalance of power in transactions, potentially resulting in inefficient transactions or, in extreme cases, market failures.

What Is Asymmetric Information?

Asymmetric Information means an information failure and deals with the study of economic decisions related to transactions when one party has more and better information than the other. It seems to happen if one party possesses more material knowledge during the economic transaction than the other. It can be demonstrated when a seller of any goods or services has more knowledge than its buyer of the same product or services. Moreover, a reverse situation can be possible accordingly. Every set of economic transactions consists of information as asymmetries to create an imbalance of power related to every transaction, resulting in inefficient transactions and market failure in the worst cases. 

Key Points on Asymmetric Information

• Asymmetric Information refers to economic-related transactions when one party has more and better information than the other.
• In every set of economic transactions, a seller possesses better knowledge than the buyers regarding selling goods, and the reverse of this process can be possible.
• Asymmetric information seems to be a healthy outcome of the economic market in terms of skilled labour. The workers in the market specialise in trade, giving more productivity and serving a greater value to those workers related to other markets. 

Understanding Asymmetric Information

• Asymmetric information seems to be possible under certain deals between a seller and a buyer, where one party among both has a good understanding of the sale product. It happens in the case where there is a sale of either goods or services.
• For example, suppose someone who wants to sell his house must understand the sale property well. In that case, in terms of the house getting cooler during the winter season and regarding its floor, the buyer of the property later feels the cost of the house paid more on the basis of information he perceived at the time of sale.
• Asymmetric information can be easily seen on the basis of various specializations and diversified knowledge if applied to any economic trade; thus, asymmetric information is perhaps beneficial for a growing economy and society, etc. 

Advantages and Disadvantages of Asymmetric Information

Advantage

• Asymmetric information, moreover, is not a bad part of the economy. However, spreading asymmetric information in society is a healthy outcome of the economic market in terms of skilled labour. The workers in the market specialise in trade, giving more productivity and serving a greater value to those workers related to other markets.
• An example stock market broker has more information and knowledge than a non-investment person, like a farmer interested in stock market trading and planning for retirement.
• The same condition might be possible with the stock broker itself, that he does not know how to grow crops, etc., instead of buying those goods from the farmer for a living.
• It seems within both economic transactions between the stock broker and farmer that each possesses more knowledge with respect to the other, and both benefited from the same economic trade and their various skills. 

Disadvantage

• It seems to be possible in certain conditions when asymmetric information leads to fraudulent results.
• For example, if the insured hide some fact like a chain smoker and thus engages further in dangerous acts, then such an asymmetric flow of information may cause an adverse consequence. It might increase the insurance premium for all insured person.

What is the Theory of Asymmetric Information

• This theory of Asymmetric Information came into existence between the 1970s and 1980s as a reasonable cause for the market failures. This theory describes that information which is imbalanced in nature and exists between the buyers and sellers results in the failure of the market.
• Accordingly, economist experts state that market failure refers to an irregular distribution of either goods or services in a free market, where the prices of said products depend upon the market forces, supply and demand.

Information asymmetry models

Usually, Asymmetric information models refer to when either one party have more knowledge than the other one but is not in use. It is quite possible that some asymmetric information can be used at a time when a single party can enforce or effectively act on breaches, either on specific parts of an agreement, where the opposite party cannot. Asymmetric models are classified as below-

Adverse Selection Model

• Akerlof suggested with the fact that asymmetric information can lead to adverse selection. In this method, the ignorant party within a contract usually must have different information at the time of negotiation and later agree with the information or the contract to the transaction. 
• An example in the real world is when people are at high risk due to purchasing more and more insurance policies, but the insurance company cannot discriminate against them on the basis of a deficiency of information regarding the specific insured person’s risks.
• Credence goods come under the category of adverse selection of information asymmetric. These goods refer to where the purchaser does not have proper information about the goods, but the goods are widely used or consumed by them. For example- medical procedures and automobile repairs, etc.

Moral Hazard Model

• A moral Hazard seems to happen when the ignorant party lacks the information regarding the performance of any agreed contract or is in deficiency to react upon those acts when there is a breach of the agreement.
•  Its consequences can be further results in such a situation where the ignorant party is more likely to take risks as the party is not fully responsible for the results of its own acts.
• An example of a Moral hazard is when people use to become more irresponsible or act the same way. This quite be possible because the insurer cannot either watch or react to their behaviours, such as their failure to renew their insurance, etc.

Monopolies of Knowledge Model

• In this type of asymmetry information model, the ignorant party are not allowed or not authorized to check out all the important information related to any situation in order to make any decision.
• This type of Asymmetric information model shows that one party have all the rights to access such information. Such type of asymmetric information can be seen in the government process.
• Take an example- where one party in terms of the enterprise’s sector poses some high level of management who is able to access the corporate information provided by any of the third parties. 

Warranty Model

• This warranty type of model is widely utilized in the real world in such a way as to verify or ensure the credibility of any product in terms of a guarantee provided by the seller who promised to change or take back its sale goods if the quality of goods is not sufficient.
• Warranties under product are usually required from the end of interested buyers, or either the financial lenders or it is used as a form of mediation between the parties.
• Warranties for products can be found in the form of insurance, whether they come from the buyer itself, from its own expenses, etc. Moreover, after the applicability of Lemon Laws has liquidated or eliminated the impact of asymmetric information upon those customers who have received faulty products. This process involves customers returning those faulty goods regardless of any circumstances within a specific period.

Mandatory Information Disclosure Model

• This asymmetric information model includes the voluntary disclosure of such important information when the party possesses more information and is more likely to disclose the same according to their personal benefits. And uses different measures to inform about the other party.
• Moreover, the disclosure of voluntary information sometimes not be beneficial for the party. Regulators of stock markets, therefore, take some active steps to spread such type of information in the market.
• Take an example- The Securities and Exchange Board initiated the measure to regulate fair disclosure in the market, which results in the stock market companies disclosing faithfully important information about the investment to those interested investors of the market. 

Specific Consideration

• In order to prevent customers or clients from abuse or exploitation by finance experts, financial markets often rely on reputation mechanisms.
• Financial advisors or experts who prove themselves to care about the client’s assets automatically get more and more clients, while those financial experts with dishonest intentions are losing their clients daily and face legal-based damages, etc.