Asymmetric Information: Subject Matter and Implications

Let us study about Asymmetric Information. After reading this article you will learn about: 1. Subject Matter of Asymmetric Information 2. Implications of Asymmetric Information.

Subject Matter of Asymmetric Information:

The model of perfect competition is based on the assumption of perfect information. But, in reality, no economic participant can have full, efficient, and perfect information. This means that consumers and producers make decisions under uncertainty.

In other words, mistakes and errors in business decisions appear if information is incomplete and imperfect. Earlier market failures were ascribed to public goods and externalities. Today a new theory, known as “Economics of Information” has been developed that relates market failure to imperfect and costly information.

As uncertainty is the permanent feature of an economic system, economic participants may at least develop imperfect information. By ‘imperfect information’ we mean absence of certain knowledge about the probability of an outcome.

On the other hand, information is asymmetric when one participant, say, a seller, has better information than others, say, a buyer, about the probability of an outcome. However, asymmetric information is closely related to the concept of incomplete information. The idea of asymmetric information is at the core of “Economics of Information”.

Informational asymmetry arises when economic agents to a transaction have different information about the transactions. It may happen that the suppliers may have better information than the buyers about the quality of the product. Here, as the buyers have little or no knowledge about the quality of the product, informed agents (i.e., sellers) have the tendency to exploit the uninformed or under-informed buyers.

The most frequently cited example of asymmetric information is the market of automobiles where both defective and second­-hand cars and good or brand-new cars are sold. In the case of second-hand cars, an asymmetry of information arises between buyers and sellers since the seller has the full information about the quality of the car than the prospective buyers.

Since information is a ‘costly commodity’, sellers usually do not give all kinds of information to the buyers. Authors of this theory have demonstrated that bad cars tend to drive the good cars out of the market. The man who popularized this new branch of economics in 1970 was the Nobel Prize winning economist George Akerlof.

Implications of Asymmetric Information: Adverse Selection and Moral Hazard:

The problems of adverse selection and moral hazard may arise in the case of incomplete and imperfect information such as old car market, insurance market, and health market.

Market participants, i.e., buyers and sellers, may have different levels of information. One party may have more information about the hidden or unobservable qualities of the product than other participants. For instance, in the second-hand car market, a seller is more informed about the true quality of his car.

He does not like to communicate the true quality of the car to the uninformed or less informed buyers. Sellers have the tendency to exploit the uninformed buyers and, in the process, the buyer draws a selection of goods with relatively less attractive features.

Thus, adverse selection arises in market transactions when one party knows more about the quality of the product than the second party, and, as a result, low quality goods are sold in large numbers than high- quality goods. In other words, adverse selection is a tendency of an informed agent to gain more from trading with less informed agent. Adverse selection may, thus, be called a “hidden information” problem.

Let us consider the example of the health insurance market. Unhealthy people have the tendency to buy health insurance against any illness. Insurance companies may not have full knowledge about the state of health of the party concerned. Unhealthy people are eager to insure more than the healthy people.

Insurance companies go on insuring the health of these people to enlarge their business, Low-risk healthy persons are not anxious to have this kind of transaction with the insurance companies. This is called adverse selection in the insurance market.

Moral hazard is something different from adverse selection. Moral hazard exists when an individual alters his or her behaviour after buying the product. People who purchase health or car or fire insurance face the problem of moral hazard.

Everybody knows that ‘Smoking is injurious to health’. An insured person may be induced to go on smoking more cigarettes in a day since in case of any eventuality he knows that his costs of treatment will be borne by the insurance company.

Because of moral hazard, people act less carefully since they do not have to bear the cost for their carelessness. Moral hazard refers to situations where one of the parties cannot observe the actions of the other party because of incomplete information. Moral hazard may thus be called a “hidden action” problem.

It is impossible to know everything about the behaviour of the party concerned as well as the true quality of the product. Under the circumstance, market exchanges are not efficient. Cheating and fraudulent practices take place. Ultimately, this leads to inefficient resource allocation in the market.