The concept of information asymmetry was developed by George A. Kerlof during the year 1970. Information asymmetry is a situation in which one party in a trading transaction possess valuable information while the other party involved in the same trading transaction do not have the information. Information is said to be asymmetric when one trader knows something that the other trader does not know.
Information asymmetry affects traders’ behaviour in many economic situations, for example:
- A company knows better about the benefits of the business project and the rewards that can be earned from this business project than a bank that is providing finance for the business project.
- The owner of the credit card knows very well about his repayment capacity and the bank who is issuing the card to the holder.
- A seller of a used computer knows better than the buyer of this computer
- A consumer knows her taste better in garments purchasing than the firm who is supplying various kinds of garments to consumers.
- A person knows more about her health than a company that provides life insurance and medical insurance to various consumers.
- A person is more familiar with his driving habits than a company providing the facility of auto insurance.
- An employee knows very well about his work ethic and working capability than the company who is hiring the person for the job.
Thus, these were the various situations where information asymmetry occurs. It also has two effects on economic behaviour: adverse selection and moral hazard.
Adverse Selection:
Adverse selection is being used in economics, insurance and risk management. Adverse selection is a situation where sellers have information that buyers don’t have about some aspect of product quality.
The situation of adverse selection arises when a better-informed trader uses his various knowledge and skills before signing the agreement with the trader having less information.
The concept of adverse selection can be explained with the help of the following examples:
- A seller of a used computer will accept a lower price for his computer only when he knows that the computer is in bad condition and is of poor quality.
- A person will buy extra life insurance policies when he knows that his life will deteriorate fast.
- A consumer is very much aware of his solvency position, so he will accept the credit card at a very high interest rate. Also, because he knows very well, in the near future, he will be a defaulter on the card debt.
Adverse selection in information asymmetry can be reduced by the following mechanisms:
1. Regulation: This means that the government regulates the prices of food products in the economy. If prices are being lowered down in the market, the consumers and marketers will not be much affected as the government is regulating the prices.
2. Goodwill: Goodwill also plays an important role in the market. Big business houses will not sell their products at very low prices to earn extra profit in future because their reputation will be affected by adopting this policy.
3. Assurance: In assurance, the less informed party can go for an expert opinion. For example, it is better to hire an engineer to inspect a used computer and to check the details of the computer.
4. Warranty: For example, if the seller of a used computer who claims that it is of top quality, then the better-informed party will pay for the repair charges of the computer.
Conveying information from a better-informed party to a less-informed party in case of warranty and goodwill is also known as signalling. In the case of assurance, the less informed party itself tries to collect information, and then this activity is known as screening.
Moral Hazard:
Moral hazard arises when one trader with more information takes some hidden steps after signing the contract with a trader with less information. This can be explained with the help of the following examples.
- A person will develop a change in his driving skills after purchasing full auto insurance.
- A person can use a company laptop for his personal purposes.
Sometimes in order to gain more and more profit, the person having more information may also use fraudulent methods and can also rely on lying and cheating.
A famous quotation on information by Machiavelli on information asymmetry is very famous: “A wise ruler therefore cannot and should not keep his word when such an observance of faith would be to his disadvantage and when the reasons which made him promise are removed” (The Prince, 2006).
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