Asymmetric information is inherent in most, if not all, markets. To take a basic example, a patient admitted to a hospital probably has less information about illness and recovery options than the doctor does. Markets compensate for this by developing agency relationships where both parties are incentivized to produce an efficient outcome.

In the hospital case, the doctor has an incentive to diagnose accurately and prescribe treatments correctly, or else he might be sued for malpractice or otherwise have his reputation suffer. Since it is likely that doctors and patients have repeat relationships, the law of repeat dealings also shows that both actors are better off in the long run if they deal fairly with one another.

Key Takeaways

  • Asymmetric information arises when one party to an economic transaction has more or better information than another, and uses that to their advantage.
  • This causes market failures, including examples like adverse selection and the so-called lemons problem.
  • Solutions include the introduction of regulations, offering warranties or guarantees on items sold, insurance, and bottom-up efforts to inform consumers of products' and sellers' quality and reputation.

The Market for Lemons

Free markets only work according to economic models if information is "perfectly" (i.e. completely) knowable in a way where all parties know all that is available. This is called symmetric information - buyers and sellers, producers and consumers, borrowers and lenders, all have exactly the same complete information.

In reality, this is not the case and sellers know more than buyers, producers more about their goods than consumers. The "lemons problem" refers to issues that arise due to asymmetric information possessed by the buyer and the seller. The lemons problem was first put forward in a research paper, "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism," written in the late 1960s by George A. Akerlof, an economist and professor at the University of California, Berkeley. The tag phrase identifying the problem came from the example of used cars Akerlof used to illustrate the concept of asymmetric information, as defective used cars are commonly referred to as lemons.

The lemons problem exists in the marketplace for both consumer and business products, and also in the arena of investing, related to the disparity in the perceived value of an investment between buyers and sellers. The lemons problem is also prevalent in financial sector areas, including insurance and credit markets. For example, in the realm of corporate finance, a lender has asymmetrical and less-than-ideal information regarding the actual creditworthiness of a borrower.

Asymmetric Information and Adverse Selection

According to economic theory, asymmetric information is most problematic when it leads to adverse selection in a market. Consider life insurance: A customer might have information about his risk that the insurance company cannot easily obtain.

To compensate for a lack of information, the insurance company might increase all premiums to offset the risk of uncertainty. This means that the riskiest individuals (who ostensibly value insurance most highly) effectively price out some of the less risky individuals (who aren't willing to pay as much).

Adverse selection theoretically leads to a sub-optimal market even when both parties in an exchange are dealing rationally. This sub-optimality, once understood, provides an incentive for entrepreneurs to assume risk and promote a more efficient outcome.

Market Responses to Adverse Selection

There are a few broad methods of addressing the adverse selection problem. One very clear solution is for producers to provide warranties, guarantees, and refunds. This is particularly notable in the used car market. In addition to seller-granted warranties, third-party companies can offer their own warranties in the form of insurance that comes at some cost to the consumer. In addition, the government can step in to regulate the quality of good sold. In most states, there are "lemon laws" where a consumer can return a faulty used car back to the dealer no questions asked within a certain initial time period if it turns out to be a piece of junk.

Another intuitive and natural response is for consumers and competitors to act as monitors for each other. Consumer Reports, Underwriters Laboratory, notaries public, and online review services such as Yelp help bridge gaps in information. eBay and Amazon seller ratings, Uber driver reviews, and product ratings are all examples of crowd-sourcing reputation in this way.

Finally, the study of efficient market arrangements is known as mechanism design theory, which is a more flexible offshoot of game theory. Notable contributors include Leonid Hurwicz and David Friedman, son of Milton Friedman.