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The theory of asymmetric information was developed in the 1970s and 1980s as a plausible explanation for common phenomena that mainstream general equilibrium economics couldn't explain. In simple terms, the theory proposes that an imbalance of information between buyers and sellers can lead to inefficient outcomes in certain markets.

Rise of Asymmetric Information Theory

Three economists were particularly influential in developing and writing about the theory of asymmetric information: George Akerlof, Michael Spence and Joseph Stiglitz. All three shared the Nobel Prize in economics in 2001 for their earlier contributions.

Akerlof first argued about information asymmetry in a 1970 paper entitled "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism." Therein, Akerlof stated that car buyers see different information than sellers, giving sellers an incentive to sell goods of less than average market quality.

Akerlof uses the colloquial term "lemons" to refer to bad cars. He espouses a belief that buyers cannot effectively tell lemons apart from good cars. Thus, sellers of good cars cannot get better than average market prices.

This argument is similar to the since-challenged Gresham's law in money circulation, where poor quality drives out bad (though the driving mechanism is different).

Michael Spence added to the debate with the 1973 paper "Job Market Signaling." Spence models employees as uncertain investments for firms; the employer is unsure of productive capabilities when hiring. He then compares this situation to a lottery.

Spence identifies information asymmetries between employers and employees, leading to scenarios where low-paying jobs create a persistent equilibrium trap that discourages the bidding up of wages in certain markets.

It's with Stiglitz, though, that information asymmetry has reached mainstream acclaim. Using a theory of market screening, he authored or co-authored several papers, including significant work on asymmetry in insurance markets.

Through Stiglitz's work, asymmetric information was placed into contained general equilibrium models to describe negative externalities that price out the bottom of markets. For instance, the uncertain health insurance premium needed for high-risk individuals causes all premiums to rise, forcing low-risk individuals away from their preferred insurance policies.

Empirical Evidence and Challenges

Market research from economists Erik Bond (truck market, 1982), Cawley and Philipson (life insurance, 1999), Tabarrok (dating and employment, 1994), Ibrahimo and Barros (capital structure, 2010), and others have questioned the existence, evidence or practical duration of asymmetric information problems causing market failure.

Very little positive correlation between insurance and risk occurrence has been observed in real markets, for instance. One possible explanation for this is that individuals do not actually have more information about their risk type, while insurance companies have actuarial life tables and significantly more experience.

Other economists, such as Bryan Caplan at George Mason University, point out that everyone is not in the dark in real markets; insurance companies aggressively seek underwriting, for example. He also suggests that models based on two parties are flawed, as can be evidenced by information-broking third parties, such as Consumer Reports, Underwriters Laboratory, CARFAX and credit bureaus.

Economist Robert Murphy suggests that government intervention can prevent prices from accurately reflecting known information, which can cause market failure. For example, a car insurance company might have to raise all premiums if it cannot base its price decisions on an applicant's gender, age or driving history.

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