DeepakBhalla

Information Asymmetry

By Deepak Bhalla Sat 07 May 2016 7 min read

Introduction

Let's talk about Information asymmetry - a term used to describe a situation where two parties engage in a transaction where one or both parties have unique information unknown to the other party. Often this type of asymmetry is one sided (one side has information and the other does not) and often it is the seller that has unique information unbeknownst to the seller. Unique information is everywhere and it creates a unique dynamic that shapes markets. First let us look at what a system with perfect symmetry would look like.

Information Assymetry

Information Imperfection

In a perfect system the seller would give all the information needed (called perfect signalling) for the buyer to screen for risks (perfect screening). According to general equilibrium economics:

A perfectly competitive market is one where all parties have perfect information about all transactions in the marketplace.

But this is out of the reach of most markets due to cost and complexity. In terms of the equities markets companies do not reveal all the information they need to to allow perfect screening, Secondly, it would be too costly to ensure everyone that wanted to trade equities was exposed to similar information before being allowed to trade. Not to mention there are complexities underlying asset pricing which make a lack of full understanding a reason to participate. The equities market is an example of a market where people benefit and lose from information asymmetry.

The effects of asymmetry occur at the transaction level. Let's look at two situations, the case where sellers have more information than buyers and the case where buyers have more information than sellers.

Sellers with more information than buyers

The most common case of information asymmetry is a seller having more information than their buyers. In a one sided transaction like a sale it is the buyer that is reliant on the seller to provide information, the seller benefits from the buyer revealing information and the seller gains comparatively little benefit from being exposed to information from the buyer. Because sales are a common form of transaction it is easy to see why sellers having more information than buyers is the most common case.

This type of information asymmetry can often lead to adverse selection, a situation where the party with more knowledge (the seller) only engages in transactions which benefit them - sometimes at the cost of the other party or the whole marketplace.

The Market for Lemons

George Akerlof detailed the consequences of adverse selection using his analogy “The Market for Lemons”. In this analogy there is fictional marketplace with high quality cars (which come at a high cost) and low quality cars (which come at a lower cost) are sold in one market where information asymmetry is evident. Buyers are unaware of the quality of a cars before buying but sellers have an understanding of the quality of their product.

Buyers, accounting for the "known-unknowns" consider all cars to be “medium quality” 1 or an average of the quality of all the cars in the market. Demands shift appropriately and buyers seek to only pay a medium cost or less for their cars - due to their inability to distinguish between qualities.

In this situation sellers will logically only sell low quality cars as there is no market for high end cars. Sellers engage in transactions where their profits are maximised and flood the market with low quality cars - so creating the “market for lemons”. The seller ultimately benefits at the cost of reducing the quality of the whole market. Sellers in this position can falsy signal quality to earn a higher return.

One solution Akerlof noted is warranties, sellers who are willing to offer the warranty are those who are confident that they are not selling a low quality car.

False signalling & Market Manipulation

In a sale it is the buyer that is reliant on the seller. It would be perfectly logical (although unethical) for the seller to falsely signal quality to inflate the perceived quality of their good. Artificial scarcity, false information and price fixing are a common forms of signal manipulation. These can be considered market manipulations and come at the cost of buyers who are unable to gauge quality due to information asymmetry.

The logical thing for buyers to do is to fall to reputation and word of mouth, buying from sellers they see as reputable as a form of screening. A seller who perceives their goods as better than their competition can standardise and brand their products to build reputation and make buyer screening easier.

Buyers with more information than Sellers

It is not always the case that sellers have more information than buyers. In the case of health insurance it is the quite the opposite. A person knows much more about their health than the company they buy insurance from. As insurers have to take on more risk it is often the case that insurance policies rise.

The fictional insurance market is a popular analogy for information asymmetry, joyfuly, it is often extrapolated in to a theoretical insurance end game where adverse selection has come in to play has caused insurance policies to rise to a point at which only people who are ill buy insurance and those who are healthy do not see insurance as cost effective or useful.

In the case of an employer and their employee (Often called the principal and their agent) asymmetry can lead to moral hazards. An employee may take risks where they do not suffer consequences but which fall on to their employer. The employee often has greater knowledge of their own intentions compared to their employer causing their employer to experience excess risk at the employees benefit. This is not strictly a buyer seller relationship, but I couldn't help bring up moral hazards when talking about asymmetry.

To summarise, information asymmetry between a buyer with more information than a seller can lead to increased prices. Information asymmetry between a principal and their agent leads to moral hazards and an increased need for trust.

Information Asymmetry, not on the decline

Signalling in a competitive marketplace is often achieved through advertising, effectively reducing the asymmetry between a buyer and seller. A competitive marketplace makes signalling the correct information key and the reputation of a firm is strongly tied to company brand and future profits - factors which act to reduce asymmetry. You can also make the case that new technological revolutions increase symmetry and are able to increase information sharing to near perfect levels in some markets. That is slowly becoming the case in the auto industry. Buying a car can be now reduced down to an internet search for list prices and negotiations with one or many retailers.

I would hesitate say information asymmetry will stop, I would not even say it will decline to low levels. The most obvious argument showing why information asymmetry will never end is bounded rationality. People are limited by the information they have, the cognitive limitations of their minds, and the finite amount of time they have to make a decision. The limiting factor to many transactions is not the ability to find information, but the ability to process it. As a technology becomes more complex it becomes increasingly difficult understand and more effort needs to be exerted by the buyer to understand the transaction.

The modern consumer has access to a lot of codified knowledge but is limited by their ability to utilise it.

  1. This quality is entirely dependent on the ratio of high quality cars to lower quality cars, the more low quality cars the lower the average perceived quality
Deepak Bhalla