Using Asymmetric Information To Understand How Markets Work

If you have a sneaking suspicion that business deals may benefit one party more than the other, you’re entirely right. Although this may not be anything new, there is a term you can ascribe to some of those sneaky business deals. It’s called asymmetric information.

Asymmetric information is what happens when one party has more knowledge than another regarding a business agreement or deal. Almost all organizations use asymmetric information when they hire employees, price products, acquire capital, and more.

This significantly impacts how the market works and using it, we can better understand how.

Signaling and Screening

In 2001, economist George Akerlof received the Nobel Prize for his 1970 paper “The Market for Lemons.” In his paper, he looked into the used-car market to analyze the asymmetric information between buyers and sellers. He noted that the most profound effect of asymmetric information is adverse selection. Adverse selection is when a seller exploits the buyer’s lack of information during a transaction. The buyer, in this case, tends to make dangerous purchase decisions.

In contrast to Akerlof’s pre-owned car market, most markets can handle information asymmetry because they have ways of informing the uninformed, allowing transactions to proceed smoothly. Two of the most effective methods they may use are signaling and screening.

Signaling: when the informed party readily provides private information to the less-informed party.
Screening: when the uninformed party offers an incentive to get the informed party to disclosure information.

Let’s take a look at examples of these two concepts.

Signaling

In this case, we’re looking at the employer-potential employee dynamic. We are assuming that the employer is the one with less knowledge about the employment deal. The potential employee will have to disclose more information about themselves as a productive worker to the employer.

Highly-productive workers have several methods of signaling or demonstrating their attributes. One way is to enroll in classes, for example, to improve their work-related abilities. On the other hand, lower-productivity workers may steer clear of such a challenge and settle for lower-paying work. Here, the two types of workers show, or signal, their true qualities according to their education.

Screening

Picture an insurance firm selling the same exact policy to customers because it cannot differentiate customer risk levels. This makes the policy extremely competitive, with customers of varying risk receiving exactly the same benefits. Yet ultimately, the policy is more profitable for those who are of higher risk. The result is adverse selection, with policyholders being riskier than the general public, leading to a loss for the insurance provider.

Another option for the insurance firm is to create different contracts for customers to choose from based on their assessed level of risk through a process called screening. When screening does not or cannot exist, no company will offer insurance of any kind.

The Benefits of Asymmetric Information to the Economy

Asymmetric information isn’t all bad. More asymmetrical information means a healthier market economy. As people work more to specialize in certain fields, they increase their productivity and offer more value to their employers and the market. For instance, a banker’s expertise will be appreciated more by high-paying professionals who may be looking for stock trading opportunities ahead of retirement.

With constantly expanding asymmetric information, workers can widen their knowledge base by studying different fields. However, this is not a very practical way of handling the situation. It can be expensive and inevitably pulls down standards of living. Another option for asymmetric information is to keep info flowing through convenient and inexpensive channels such as the Internet.

All in all, asymmetric information helps create better employees. Better, more productive employees make a better business and therefore, a better market.

The Morality Component

Whether you consider asymmetric information an asset or a liability to the economy, its moral dimension is of particular concern to economists and the general market. By nature, this moral hazard is basic to asymmetric information.

A moral hazard scenario involves one party agreeing to some arrangement (usually related to finance or insurance), having no interest in or complete disregard to the risk attached to the situation. Why? Because they know they will not suffer in any way, regardless of the consequences.

Multi-Market Impact of Asymmetric Information

Scenarios involving asymmetric information are common and have different effects on various sectors.

Finance

Imagine a lender signing a contract with a borrower. The company lays down the terms and conditions of the agreement and performs background checks as per the standard operating procedure.

However, the borrower may not provide details about their real intention for borrowing the money. They could be using it for something that would have stopped the lender from entering into the agreement in the first place — not being paid back in time, for instance. This situation can get out of hand quickly. If the lender’s loss is big enough, they could increase interest rates on other loans as a compensatory measure.

Clearly, the best environment for any agreement is one where there is perfectly symmetrical information. In this case, each side of the deal holds exactly the same information as the other in relation to the transaction. Both ends can handle the deal with confidence and will be satisfied with the results.

Insurance

A company insuring a good is technically unsure about the insured’s ability to take care of it. For instance, if a homeowner didn’t care enough to install CCTV cameras around his property, the insurer would steer clear of insuring it. This issue can create an adverse selection problem.

Labour

When an employer hires an individual, they have no idea how productive the new employee will be. While a job seeker can impress HR with a stellar resume and references, it is no guarantee that the person will be an asset to the employer.

Companies know their wealth and whether they are over-valued or under-valued against the market price of their shares. This is why we do not accept insider trading as an ethical practice. With insider trading, managers can take advantage of their market and company knowledge to gain an edge over unsuspecting share traders.

Wrapping Up

Asymmetric information exists practically everywhere, making it almost impossible for business agreements and transactions to proceed flawlessly. At best, asymmetric information can create issues without actually causing significant damage to either party. At worst, it can financially cripple one party and lead to a failure of agreements. Either way, it will always exist. And because it affects our decisions in business transactions, it directly affects the market.