Asymmetric Information

What is Asymmetric Information?

Definition: Asymmetric information, also known as “information failure“, occurs when one party to an economic transaction possesses greater material knowledge than the other party. This typically manifests when the seller of a good or service possesses greater knowledge than the buyer; however, the reverse dynamic is also possible. Almost all economic transactions involve information asymmetries.

What Does Asymmetric Information Mean?

It is usually present when the seller of a good or a service knows more about the product or the service than the buyer. For instance, a car retailer has full knowledge of the capabilities of a particular model than a buyer. So, the buyer has to trust the car seller in order to know all the details about the vehicle he is interested in buying.

In capital markets, information asymmetry occurs because the borrowers have a full knowledge of their financial situation. Therefore, before approving a loan, a financial institution should perform due diligence to make sure that the borrower is reliable and unlikely to default on the loan. However, a credit history check or a salary verification provides limited information about the borrower’s financial state. Hence, there is information asymmetry, and the bank charges a risk premium in case the borrower defaults.

Asymmetric information in insurance refers to a market situation in which one party in a transaction has insufficient information about the other party which leads to market failure. The problem of asymmetric information is common to all insurance markets. However, most markets function adequately given the range of tactics used by insurance companies to overcome these information asymmetries. Many of these remedies have developed over time in response to experience and result in the well-functioning insurance markets we see today.

Example

Mary wants to buy 500 shares of Company ABC, a leading construction company. Mark has 500 shares of Company ABC that he wants to sell because he has inside information that the company is about to go bankrupt. Since Mark has more information on the company’s true financial situation, there is information asymmetry, and he can capitalize on this information to avoid losses. On the other hand, Mary, who is not aware of the possibility of the company’s bankruptcy, is more likely to lose her money on the stocks.

If Mark does not sell his shares, and the company’s financial problems become public, he will lose more money because the stock price will decline sharply, causing all stockholders of Company ABC to lose their money. Therefore, Mark, should take advantage of the inside information and sell his shares before the entire market acquires a full knowledge of the company’s financial situation.

Asymmetric Information in the Financial World

Asymmetric information examples are everywhere. In the financial world, consider a situation where a lending institution enters into an agreement with a borrower. The lender establishes the terms and agreements that the borrower must stipulate to, and usually, background checks are done.

However, the borrower may not accurately explain what they are borrowing the money for and may use it in a way that involves a level of risk that – had the lender been aware of it – would likely have led the lender to decline making the loan. The lender may end up with a loan that isn’t repaid on time or isn’t paid back at all. Such a situation can result in far-reaching consequences if the loss is so great that the lender is forced to charge higher interest rates to other borrowers to make up for the loss.

The ideal situation for any agreement or deal is one of perfectly symmetrical information, where each party has the same information, and both parties have all the information relevant to the transaction. That way, both parties can enter into the deal with confidence and reap from it what they expect.

Asymmetric information exists virtually everywhere, making flawless business agreements and transactions almost impossible to come by. In the best cases, asymmetric information causes some hurdles but leaves both parties relatively unscathed. At its worst, asymmetric information can cause severe financial hardship to one party and lead to broken agreements and failed deals.

Information Asymmetry Outside of Economics

Asymmetric information exists outside of economics as well. Disproportional information can exist in all facets of life, but one common place where it can be found is within international relations and politics.

The leaders of countries consistently meet to make trade agreements and to establish allegiances,. Asymmetric information in such situations can lead to an unfair benefit for one nation over another. In extreme cases, war can ultimately break out because of asymmetric knowledge by one party or another. And in such cases, the winning side or the side that gains the right to dictate the terms of surrender is the side that holds more information or better information about their own troops and the strategies of the opposing side.

The Economic Advantages of Asymmetric Information

Asymmetric information isn’t necessarily a bad thing. In fact, growing asymmetrical information is the desired outcome of a healthy market economy. As workers strive to become increasingly specialized in their chosen fields, they become more productive, and can consequently provide greater value to workers in other fields.

For example, a stockbroker’s knowledge is more valuable to a non-investment professional, such as a farmer, who may be interested in confidently trading stocks, to prepare for retirement.

One alternative to ever-expanding asymmetric information is for workers to study all fields, rather than specialize in fields where they can provide the most value. However, this is an impractical solution, with high opportunity costs and potentially lower aggregate outputs, which would lower standards of living.

Another alternative to asymmetric information is to make information abundantly and inexpensively available through the internet and other data sources.

The Disadvantages of Asymmetric Information

In some circumstances, asymmetric information may have near fraudulent consequences, such as adverse selection, which describes a phenomenon where an insurance company encounters the probability of extreme loss due to a risk that was not divulged at the time of a policy’s sale.

For example, if the insured hides the fact that he’s a heavy smoker and frequently engages in dangerous recreational activities, this asymmetrical flow of information constitutes adverse selection and could raise insurance premiums for all customers, forcing the healthy to withdraw. The solution is for life insurance providers is to perform thorough actuarial work and conduct detailed health screenings, and then charge different premiums to customers based on their honestly-disclosed risk profiles.

Summary

  • Asymmetric information, also known as “information failure,” occurs when one party to an economic transaction possesses greater material knowledge than the other party.
  • Asymmetric information typically manifests when the seller of a good or service possesses greater knowledge than the buyer; however, the reverse dynamic is also possible. Almost all economic transactions involve information asymmetries.

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