What Is Asymmetric Information?
Asymmetric information, also known as "information failure", occurs when one party to an economic transaction possesses greater material knowledge than the other party. This typically manifests when the seller of a good or service possesses greater knowledge than the buyer, however the reverse dynamic is also possible. Almost all economic transactions involve information asymmetries.
BREAKING DOWN Asymmetric Information
Asymmetric information is the specialization and division of knowledge, as applied to any economic trade. For example, doctors typically know more about medical practices than their patients. After all, physicians have extensive medical school educational backgrounds that their patients generally don't have. This principle equally applies to architects, teachers, police officers, attorneys, engineers, fitness instructors, and other trained professionals.
Economic Advantages of Asymmetric Information
Asymmetric information isn't necessarily a bad thing. In fact, growing asymmetrical information is a desired outcome of a healthy market economy. As workers strive to become increasingly specialized in their chosen fields, they become more productive, and can consequently provide greater value to workers in other fields. For example, a stockbroker's knowledge is more valuable to a non-investment professional, such as a farmer, who may be interested in confidently trading stocks, to prepare for retirement.
One alternative to ever-expanding asymmetric information is for workers to study all fields, rather than specialize in fields where they can provide the most value. However this is an impractical solution, with high opportunity costs and potentially lower aggregate outputs, which would lower standards of living.
Another alternative is to asymmetric information is to make information abundantly and inexpensively available through the the internet and other data sources.
Disadvantages of Asymmetric Information
In some circumstances, asymmetric information may have near fraudulent consequences, such as adverse selection, which describes a phenomenon where an insurance company encounters the probability of extreme loss due a risk that was not divulged at the time of a policy's sale. For example, if the insured hides the fact that he's a heavy smoker and frequently engages in dangerous recreational activities, this asymmetrical flow of information constitutes adverse selection, and could raise insurance premiums for all customers, forcing the healthy to withdraw. The solution is for life insurance providers is to perform thorough actuarial work and conduct detailed health screenings, and then charge different premiums to customers based on their honestly-disclosed risk profiles.
Information Asymmetry in Finance
To prevent abuse of customers or clients by finance 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, face legal damages, or both.