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 normally manifests when the seller of a good or service has greater knowledge than the buyer, although the reverse 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 typically know more about medical practice than their patients. After all, through extensive education and training, doctors specialize in medicine, whereas most patients do not. The same principle applies to architects, teachers, police officers, attorneys, engineers, fitness instructors, and other specially trained professionals.
Economic Advantages of Asymmetric Information
Growing asymmetrical information is a desired outcome of a market economy. As workers specialize and become more productive in their fields, they can provide greater value to workers in other fields. For example, a stockbroker’s services are more valuable to customers who do not know enough to buy or sell their own stocks with confidence.
One alternative to ever-expanding asymmetric information is for workers to study in all fields, rather than specialize in fields where they can provide the most value. Associated with this alternative are large opportunity costs and possibly a lower aggregate output, which would lower standards of living.
Another alternative is to make information abundantly available and inexpensive, such as through the internet. It is important to note that this does not replace asymmetric information. It only has the effect of moving information asymmetries away from simpler areas and into more complex areas.
Disadvantages of Asymmetric Information
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. High-risk 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 healthy to withdraw. The solution is to perform actuarial work and insurance screening and then charge different premiums to customers based on their associated potential risks.
Information Asymmetry in Finance
Information asymmetries tend to be greatest in areas where information is complex, difficult to obtain, or both. For instance, it is relatively difficult to obtain exclusive information when trading baseball cards, but it is relatively easy in fields such as law, medicine, technology, or 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 or face legal damages.