Concept of Information Asymmetry

The concept of information asymmetry was developed by George A. Kerlof during the year 1970. Information asymmetry is a situation in which one party in a trading transaction possess valuable information while the other party involved in the same trading transaction do not have the information. Information is said to be asymmetric when one trader knows something that the other trader does not know.

Information asymmetry affects traders’ behaviour in many economic situations, for example:

• A company knows better about the benefits of the business project and the rewards that can be earned from this business project than a bank that is providing finance for the business project.
• The owner of the credit card knows very well about his repayment capacity and the bank who is issuing the card to the holder.
• A seller of a used computer knows better than the buyer of this computer
• A consumer knows her taste better in garments purchasing than the firm who is supplying various kinds of garments to consumers.
• A person knows more about her health than a company that provides life insurance and medical insurance to various consumers.
• A person is more familiar with his driving habits than a company providing the facility of auto insurance.
• An employee knows very well about his work ethic and working capability than the company who is hiring the person for the job.

Thus, these were the various situations where information asymmetry occurs. It also has two effects on economic behaviour: adverse selection and moral hazard.

Adverse Selection:

Adverse selection is being used in economics, insurance and risk management. Adverse selection is a situation where sellers have information that buyers don’t have about some aspect of product quality.

The situation of adverse selection arises when a better-informed trader uses his various knowledge and skills before signing the agreement with the trader having less information.

The concept of adverse selection can be explained with the help of the following examples:

• A seller of a used computer will accept a lower price for his computer only when he knows that the computer is in bad condition and is of poor quality.
• A person will buy extra life insurance policies when he knows that his life will deteriorate fast.
• A consumer is very much aware of his solvency position, so he will accept the credit card at a very high interest rate. Also, because he knows very well, in the near future, he will be a defaulter on the card debt.

Adverse selection in information asymmetry can be reduced by the following mechanisms:

1. Regulation: This means that the government regulates the prices of food products in the economy. If prices are being lowered down in the market, the consumers and marketers will not be much affected as the government is regulating the prices.

2. Goodwill: Goodwill also plays an important role in the market. Big business houses will not sell their products at very low prices to earn extra profit in future because their reputation will be affected by adopting this policy.

3. Assurance: In assurance, the less informed party can go for an expert opinion. For example, it is better to hire an engineer to inspect a used computer and to check the details of the computer.

4. Warranty: For example, if the seller of a used computer who claims that it is of top quality, then the better-informed party will pay for the repair charges of the computer.

Conveying information from a better-informed party to a less-informed party in case of warranty and goodwill is also known as signalling. In the case of assurance, the less informed party itself tries to collect information, and then this activity is known as screening.

Moral Hazard:

Moral hazard arises when one trader with more information takes some hidden steps after signing the contract with a trader with less information. This can be explained with the help of the following examples.

• A person will develop a change in his driving skills after purchasing full auto insurance.
• A person can use a company laptop for his personal purposes.

Sometimes in order to gain more and more profit, the person having more information may also use fraudulent methods and can also rely on lying and cheating.

A famous quotation on information by Machiavelli on information asymmetry is very famous: “A wise ruler therefore cannot and should not keep his word when such an observance of faith would be to his disadvantage and when the reasons which made him promise are removed” (The Prince, 2006).

Read More in: Theory of Public Finance

1. Public Finance: Meaning, Nature & Scope
2. Role of Government in Economy
3. Role of Government in Mixed Economy: Public & Private Sector
4. Role of Government under Cooperation and Competition
5. Role of Government in Economic Development and Planning
6. Concept of Public Goods, Private Goods, and Merit Goods
7. Concept of Market Failure and Functions of Government
8. Market Failure and Functions of Government: Decreasing Costs
9. Market Failure and Functions of Government: Externalities
10. Market Failure and Functions of Government: Public Goods
11. Future Market: Meaning, Role & Uncertainty
12. Concept of Information Asymmetry
13. Theory of Second Best: Concept & Explanation
14. Problem of Allocation of Resources: Public & Private Mechanisms
15. Preferences: Meaning, Types & Problems of Preference Revelation
16. Preference Aggregation & Its Mechanism
17. Voting Systems, Direct Democracy, Representative Democracy, Leviathan Hypothesis & Arrow’s Impossibility Theorem
18. Economic Theory of Democracy: Concept & Explanation
19. Politico Eco Bureaucracy: Concept & Explanation
20. Rent-Seeking and Directly Unproductive Profit-Seeking Activities
21. Rationale for Public Goods: Concept & Explanation
22. Benefit Theory or Voluntary Exchange Theory
23. Lindahl Model: Concept, Equilibrium & Limitations
24. Bowen Model: Concept, Advantages & Limitations
25. Samuelson’s Model of Public Expenditure
26. Musgrave’s Model of Public Expenditures
27. Demand Revealing Schemes for Public Goods
28. Vickery-Clarke-Groves Mechanism
29. Groves-Ledyard Mechanism
30. Tiebout Model: Concept, Assumptions Equilibrium & Simple Tiebout Model
31. Theory of Club Goods
32. Keynesian Principles of Stabilization Policy
33. Difference Between Keynesian Economic Thought and Others
34. Role of Expectations and Uncertainty in Formulating Stabilization Policy
35. Intertemporal Markets Efficiency & Failure
36. Liquidity Preference Theory
37. Diamond-Dybvig Banking Model
38. Preference Shocks, Adverse Selection & Central Bank
39. Equilibrium Deposit Contract
40. Social Goods and Its Effect on Stabilization Policy
41. Effect of Infrastructural Facilities on Stabilization Policy
42. Effect of Distributional Inequality on Stabilization Policy
43. Effect of Regional Imbalances on Stabilization Policy
44. Wagner’s Law of Increasing State Activities: Explanation, Graph & Criticism
45. Peacock-Wiseman Hypothesis: Explanation, Graph & Criticism
46. Public Expenditure: Concept, Objectives, & Public vs Private Expenditure
47. Pure Theory of Public Expenditure
48. Structure & Growth of Public Expenditure in India
49. Trends, Lessons & Priorities in Public Expenditure in India
50. Social Cost-Benefit Analysis: Project Evaluation, Estimation of Costs & Discount Rate
51. Performance Based Budgeting and Zero Based Budgeting
52. Theories of Tax Incidence: Concentration Theory, Diffusion Theory & Modern Theory
53. Tax System and Its Principles
54. Equity Principle and Efficiency Principle of Taxation: Meaning, Explanation & Examples
55. Ability to Pay and Benefits Received Principle of Taxation
56. Theory of Optimal Taxation: Excess Burden & Distortions of Taxation
57. Deadweight Loss of Taxation: Causes, Measurement & Example
58. Concept of Equity & Efficiency in Economics
59. Trade-Off Between Equity and Efficiency: Meaning & Example
60. Theory of Measurement of Dead Weight Loss
61. Double Taxation: Meaning, Desirability, Forms & Solution
62. Solution to Problem of Double Taxation: Intra-Country & International
63. Double Taxation Avoidance Agreement (DTAA) and Indian Policy
64. Classical View on Public Debt
65. Compensatory Aspect of Public Debt Policy
66. Public Debt or Borrowings: Concept, Need, Sources & Types
67. Concept of Public Debt or Public Borrowings
68. Need for Public Debt or Public Borrowing
69. Sources of Public Debt
70. Classification of Public Debt
71. Burden of Public Debt: Meaning, Types & Explanation
72. Debt Through Created Money or Deficit Financing
73. Public Debt (Public Borrowings) and Inflation (Price Level)
74. Crowding Out of Private Investment and Activity
75. Principle of Public Debt Management and Debt Repayment