What is 'Asymmetric Information'
Asymmetric information, sometimes referred to as information failure, is present whenever one party to an economic transaction possesses greater material knowledge than the other party. This normally manifests itself when the seller of a good or service has greater knowledge than the buyer, although the opposite is possible. Almost all economic transactions involve information asymmetries.
BREAKING DOWN 'Asymmetric Information'Asymmetric information is the specialization and division of knowledge in society as applied to economic trade. For example, medical doctors tend to know more about medical treatment than their patients; after all, those doctors specialize in medicine, while their patients do not. The same principle applies to manufacturers, teachers, police officers, attorneys, restaurant operators and yoga instructors, or any other specialized profession.
Growing asymmetrical information is a desirable outcome of a market economy. As workers specialize and become more productive in their fields of expertise, they can provide greater levels of value to workers in other fields. For example, a stockbroker’s services are less valuable to customers who already know enough to buy and sell their own stocks with confidence.
One alternative to ever-expanding asymmetric information is for workers to study in all fields, rather than specializing in those fields where they can provide the most value. This comes with large opportunity costs and would likely result in a lower level of aggregate output, lowering standards of living.
Another alternative is to make information abundantly and cheaply available, such as through the internet. This does not replace asymmetric information, however. It only has the effect of moving information asymmetries away from simpler areas and into more complex areas.
In certain circumstances, asymmetric information may lead to adverse selection or moral hazard. These are situations where individual economic decisions are hypothetically worse than they would have been had all parties possessed more symmetrical information. Most of the time, the solutions to adverse selection and moral hazard are not complicated.
Consider adverse selection in life insurance or fire insurance. Higher-risk insurance customers, such as smokers, the elderly or those living in dry environments, may be more likely to purchase insurance. This could raise insurance premiums for all customers, forcing the healthiest to drop out. The solution is to perform actuarial work and insurance screening, then charge different premiums to different customers based on potential risk.
Information Asymmetry in Finance
Information asymmetries tend to be greatest in those areas where information is complex, difficult to obtain or both. For instance, it is relatively difficult to obtain large information asymmetries when trading baseball cards, but it is relatively easier in fields such as law, medicine, technology or finance.
To prevent abuse of customers or clients by specialists, financial markets often rely on reputation mechanisms. Financial advisors and fund companies that prove to be the most honest and effective stewards of their clients' assets tend to gain clients, while dishonest or ineffective agents tend to lose clients or face legal damages.