Information asymmetry
Information asymmetry is an economic phenomenon where one party in a transaction possesses more information than the other, potentially leading to an imbalance in decision-making. A classic example is the used-car market, in which sellers have a clearer understanding of the vehicle's condition compared to buyers, who may risk purchasing a faulty car, known as a "lemon." This situation can lead to adverse selection, where buyers are unable to distinguish between high- and low-quality vehicles, resulting in a market dominated by lower-quality products. Information asymmetry is also prevalent in health insurance, where applicants typically know more about their health than insurance companies, which can lead to issues like moral hazard, where insured individuals might engage in riskier behaviors.
Theories surrounding information asymmetry gained prominence in the 1970s, with economists like George Akerlof, Michael Spence, and Joseph Stiglitz contributing significantly to the discourse. While many economists acknowledge the implications of information asymmetry, opinions on its effects can vary. Various laws, such as "lemon laws," have been established to mitigate the negative impacts of information asymmetry in markets by promoting transparency and protecting consumers. Overall, while information asymmetry presents challenges, it can also create opportunities, such as revealing unexpectedly high qualifications in job candidates.
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Information asymmetry
Information asymmetry refers to an economic event in which one party has more information about an economic transaction than the other party. A famous example of asymmetric information is buying and selling used cars, as the person selling the car has much more information about the car than the person buying it, raising the possibility that a seller could take advantage of a customer's ignorance and sell them a broken or flawed car, known as a "lemon." Governments put laws into place, including laws referred to as "lemon laws," to reduce the number of economic transactions that involve information asymmetry. Information asymmetry, if left unchecked, can have negative consequences on a particular market. For example, when people purchase health insurance, they take part in an economic transaction with information asymmetry. People who are applying for insurance know more about their health than the companies they are buying the insurance from. Information asymmetry affects many different economic transactions.
Background
People first started to develop concrete theories about asymmetric information in the 1970s. Economists such as George Akerlof, Michael Spence, and Joseph Stiglitz were influential in the development of theories about the topic. In 2001, the three men shared a Nobel Prize in economics because of their contributions to the topic. In 1970, Akerlof published a paper called “The Market for 'Lemons': Quality Uncertainty and the Market Mechanism,” which helped develop the idea of information asymmetry as an important part of the used car market. Although these and other economics have been recognized for their contributions to theories of information asymmetry, some other economics throughout the 1980s, 1990s, and 2000s disagreed with some of their findings. Today economists mostly accept the theory of information asymmetry, but they do not always agree about its effects.
Overview
Information asymmetry happens when one party has more information about a transaction than another party, and one party might make a different decision in the transaction if that person had all the information. Transactions that include a buyer and a seller are the most common types of transactions that have asymmetric information.
Information asymmetry affects a number of different fields, though a few fields are famous for it. One of the most famous examples of asymmetric information problems is the used-car market. Different qualities of used cars exist, but only the seller of the car knows the quality of the vehicle up for sale. The buyer might not be able to tell the quality of the used car just by using it briefly and looking at it. Normally, the best used cars would be the most expensive used cars, and the worst used cars would be the least expensive used cars. However, if buyers are unsure about the quality of the vehicle they are buying, they will want to pay roughly the price of an average-quality used car. When the market price dips to the price of an average used car, the people who are selling the best used cars, those which should cost more than average used cars, will drop out of the market because they do not feel they are receiving a fair value for the quality of vehicle they are selling. In turn, the quality of the average in the overall used-car market decreases, so the price that buyers are willing to pay also drops. This action can precipitate what some economists call a death spiral, which causes the price to continue to lower as more of the higher-quality products are taken off the market. However, the United States has a thriving used-car market. This is because state governments have put laws into place that require inspections, punish bad actors, and more.
Another famous example is the health insurance market. People who apply for health insurance want the insurance company to pay for at least part of their medical expenses. People who have health conditions, diseases, or dangerous jobs are more likely to use medical services and cost the health insurance companies money. Therefore, health insurance companies are at a disadvantage. The information is asymmetric in this situation because the people who want insurance know more about the transaction than the insurance companies. Therefore, health insurance companies want people of all different levels of health to pay as much as a person with average health would pay. The information asymmetry in this situation is somewhat reduced in the United States because people applying for medical insurance sometimes have to complete questionnaires or release information about their health.
Adverse selection and moral hazards are outcomes that may occur because of information asymmetry. Adverse selection happens when the party that has less information makes a bad decision because they had too little information. For example, a health insurance company wants to charge its customers a different rate. The company wants to give the healthiest people the lowest rates because they will most likely cost the insurance company the least amount of money. The health insurance company also wants to charge people who are unhealthy the most money because they will most likely cost the company more money. However, the insurance company does not automatically know which potential customers are most and least healthy. The company could send potential customers questionnaires about their health. However, if people lie on the surveys, the insurance company might give the lower rate to all the people who apply for health insurance. Then, the company will have given the lower rate to all the people, not just the healthy ones. The insurance company will lose money because it allowed the unhealthy people to pay a lower rate. The insurance company could avoid this by mandating people who want insurance to take physicals or otherwise prove their health. Although this information gives the insurance company a better idea of people’s health, it is not necessarily a moral idea. Moral hazard is another outcome that happens because of information asymmetry. Moral hazards occur when a person decides to take on risk because they feel they are covered for the risk by having insurance. A healthy person deciding to smoke because that person’s medical bills are paid for is an example of a moral hazard.
Although information asymmetry can have negative outcomes, it can also be positive. For example, people in the job market have asymmetric information when they apply for jobs. Although people who apply for jobs write down their experience and education, only they truly know their expertise and skill level. A person who is hiring might be surprised that a person who has been hired for a job has such extensive experience and knowledge.
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