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In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry. Examples of this problem are adverse selection and moral hazard. Most commonly, information asymmetries are studied in the context of principal-agent problems.

In 2001, the Nobel Prize in Economics was awarded to George Akerlof, Michael Spence, and Joseph E. Stiglitz "for their analyses of markets with asymmetric information."[1]

Contents

Information asymmetry models

Information asymmetry models assume that at least one party to a transaction has relevant information whereas the other(s) do not. Some asymmetric information models can also be used in situations where at least one party can enforce, or effectively retaliate for breaches of, certain parts of an agreement whereas the other(s) cannot.

In adverse selection models, the ignorant party lacks information while negotiating an agreed understanding of or contract to the transaction, whereas in moral hazard the ignorant party lacks information about performance of the agreed-upon transaction or lacks the ability to retaliate for a breach of the agreement. An example of adverse selection is when people who are high risk are more likely to buy insurance, because the insurance company cannot effectively discriminate against them, usually due to lack of information about the particular individual's risk but also sometimes by force of law or other constraints. An example of moral hazard is when people are more likely to behave recklessly after becoming insured, either because the insurer cannot observe this behavior or cannot effectively retaliate against it, for example by failing to renew the insurance.

Adverse Selection

A classic paper on adverse selection is George Akerlof's "The Market for Lemons", which defines two primary solutions to this problem, signaling and screening.

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Signaling

Michael Spence originally proposed the idea of signaling. He proposed that in a situation with information asymmetry, it is possible for people to signal their type, thus believably transferring information to the other party and resolving the asymmetry.

This idea was originally studied in the context of looking for a job. An employer is interested in hiring a new employee who is skilled in learning. Of course, all prospective employees will claim to be skilled at learning, but only they know if they really are. This is an information asymmetry.

Spence proposes, for example, that going to college can function as a credible signal of an ability to learn. Assuming that people who are skilled in learning can finish college more easily than people who are unskilled, then by finishing college the skilled people signal their skill to prospective employers. No matter how much or how little they may have learned in college, finishing functions as a signal of their capacity for learning.

Screening

Joseph E. Stiglitz pioneered the theory of screening. In this way the underinformed party can induce the other party to reveal their information. They can provide a menu of choices in such a way that the choice depends on the private information of the other party.

Examples of situations where the seller usually has better information than the buyer are numerous but include used-car salespeople, mortgage brokers and loan originators, stockbrokers, Realtors, real estate agents, and life insurance transactions.

Examples of situations where the buyer usually has better information than the seller include estate sales as specified in a last will and testament, sales of old art pieces without prior professional assessment of their value, or health insurance consumers of various risk levels. This situation was first described by Kenneth J. Arrow in an article on health care in 1963.[2]

George Akerlof used the term asymmetric information later, in his 1970 work The Market for Lemons. He also noticed that, in such a market, the average value of the commodity tends to go down, even for those of perfectly good quality. Because of information asymmetry, unscrupulous sellers can "spoof" items (like software or computer games) and defraud the buyer. As a result, many people not willing to risk getting ripped off will avoid certain types of purchases, or will not spend as much for a given item. It is even possible for the market to decay to the point of nonexistence.

Although information asymmetry has recently been noted to be on the decline thanks to the Internet, which allows ignorant users to acquire hitherto unavailable information such as the costs of competing insurance policies, used cars, etc. (See Freakonomics.) it is still heavily applied to human resource and personnel economics regarding incentive schemes when the employer cannot continually observe worker effort.

Application of Information Asymmetry in Research

Since the seminal contributions of Akerlof, Spence, and Stiglitz, the pervasive effects of information asymmetry in markets have been documented and studied in numerous contexts. In particular, a substantial portion of research in the field of accounting can be framed in terms of information asymmetry, since accounting involves the transmission of enterprise's information from those who have it to those who need it for decision-making. Likewise, financial economists apply information asymmetry in studies of differentially informed financial market participants (insiders, stock analysts, investors, etc).

Notes

  1. ^ "The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2001: Information for the Public", press release from the Royal Swedish Academy of Sciences, Nobel Foundation, nobelprize.org, October 2001, accessed November 12, 2007.
  2. ^ Arrow, Kenneth J. (1963). "Uncertainty and the Welfare Economics of Medical Care". American Economic Review 53 (5): 941–973. doi:10.2307/1812044.  

References

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