Asymmetric Information

Definition

Asymmetric information refers to a situation where one party in a transaction has more or better information than the other party. This information imbalance can lead to market inefficiencies and undesirable outcomes, as the party with more information may use it to their advantage at the expense of the less informed party.

5 Must Know Facts For Your Next Test

1. Asymmetric information can lead to market failures, where resources are not allocated efficiently.
2. Adverse selection can occur when the party with more information selects transactions that are more favorable to them, but less favorable to the other party.
3. Moral hazard can arise when the party with more information changes their behavior in a way that increases the risk or cost for the other party.
4. Signaling is a strategy used to reduce information asymmetry, where the party with less information tries to convey information to the party with more information.
5. Asymmetric information is a key concept in the field of economics, as it helps explain various market inefficiencies and the need for government intervention or other mechanisms to address these issues.

Review Questions

• Explain how asymmetric information can lead to adverse selection in the context of the economic approach.
  • Asymmetric information can lead to adverse selection when the party with more information, such as a seller, selects transactions that are more favorable to them but less favorable to the other party, such as the buyer. For example, in the used car market, the seller may have more information about the car's condition than the buyer, and can use this information to sell lemons (cars with hidden defects) at the same price as good cars. This results in a higher proportion of lemons being sold, as buyers cannot distinguish them from good cars, leading to an inefficient allocation of resources.
• Describe how asymmetric information can create moral hazard in the context of insurance and imperfect information.
  • Asymmetric information can lead to moral hazard in the insurance market, where the insured party has more information about their own risk and behavior than the insurance provider. This can result in the insured party engaging in riskier behavior, knowing that the insurance provider will bear the cost of any losses. For example, a person with health insurance may be less likely to take preventive measures or make healthy lifestyle choices, as they know the insurance provider will cover the cost of any medical expenses. This increases the overall cost of providing insurance and can lead to higher premiums or a reduction in coverage for all policyholders.
• Evaluate how signaling can be used to mitigate the effects of asymmetric information in the context of imperfect information.
  • Signaling is a strategy that can be used to reduce the effects of asymmetric information by conveying information from the party with less information to the party with more information. For example, in the job market, job applicants may use educational credentials or work experience as signals to convey their abilities to potential employers, who have less information about the applicant's true capabilities. Similarly, in the insurance market, individuals may use their driving record or health history to signal their risk profile to insurance providers, allowing them to obtain more appropriate coverage. By using these signals, the party with less information can reduce the information asymmetry and potentially improve the efficiency of the market.

Related terms

Adverse Selection: A situation where the party with more information takes advantage of the party with less information, leading to a higher proportion of undesirable transactions.

Moral Hazard: A situation where the party with more information changes their behavior in a way that increases the risk or cost for the other party, who has less information.

Signaling: A strategy used by the party with less information to convey information to the party with more information, in order to reduce the information asymmetry.