What is Asymmetric Information?
Asymmetric Information is a situation whereby there is unequal knowledge between the parties of a transaction resulting in an unusual advantage to the party with additional knowledge. This occurs primarily before the transaction/pre-contractual problem. Adverse selection and Moral hazard can result from severe cases of asymmetric information problem.
- For example, used car owners possess more asymmetric information than they disclose while selling their cars. This can create an element of suspicion for the buyers and make it difficult for sellers who want to sell good quality second-hand cars. Sellers of high-quality goods would gradually exit the market, leaving only an adverse selection of low-quality goods. Gradually, the market of second-hand cars will disappear.
- Another instance can be while opting for health insurance, the insured party may not disclose information pertaining to past health ailments (if any) which causes a gap in the information between the insurer and the insured. This causes asymmetric information problem in the contract.
Types of Asymmetric Information Problems
The types of Asymmetric information problem can be classified as follows:
#1 – Adverse Selection
Refers to the process whereby undesired results occur when buyers and sellers have access to different or asymmetric information. This leads to an imbalance in the price and quantity of goods and services in the market. For e.g., if a bank sets a fixed price for all its checking account, the low balance and high activity customers would be severely impacted and may shift to another option.
#2 – Moral Hazards
A situation in which a party will take risks because the cost incurred will not be felt by the party taking the risk. The hazard can occur when the actions of one party may change to the detriment of another after a financial transaction. In respect of asymmetric information, moral hazards may occur if one party is insulated from risk and holds more asymmetric information about its actions and intentions than the party paying for negative consequences of risk. For e.g. moral hazards occur in employment relationships between employees and management in which there is a strong possibility of selfish decision making taking place.
These imbalances can further cause market failures due to inefficient results.
How to Solve the Asymmetric Information Problem?
Below are the Solutions to the Asymmetric Information Problem.
#1 – Availability of Information
This solution is of paramount importance which involves creating opportunities for greater access to information to consumers. It is almost impossible to provide all the information at a time, but sufficient information should be available for the user to make an educated decision. As a result, along with improved customer satisfaction, the overall quality of the product of the commodity can be improved. This paves way for seamless communication and resolves many problems before they arise.
#2 – Guarantees & Warranties
These benefits offer a cushion to consumers against faulty products. It offers them the security that a particular product is of superior quality and in case of any defects, the option of return/replacement to the seller is available for a given period of time. This is useful in negotiating the prices as well.
#3 – Taxes & Subsidies
Government intervention through policies is very common in case of market imperfection. For e.g. the healthcare market is not fully competitive as someone may be more beneficial and someone can be worse off. The doctor (principle) stands to benefit the most due to asymmetric information by them thereby controlling the health care labor market. Through monopolistic practices, many doctors or health specialists become better off by taking additional payments from the patients. The government complete the market or strike a balance between the gainers and losers. Normally, this is executed by imposing higher taxes on the doctor and subsidies to receivers of the healthcare.
#4 – Industrial Standards
Industries may set a few pre-conditions to be met for providing the goods and services. This ensures offering high-quality products and services in the market. Information asymmetry can be more harmful in case of adverse selection in the market. For instance, a person with good health conditions is less likely to opt for life insurance as compared to someone who does not have optimum health conditions. A person can do immoral behaviour prior to the transaction due to the asymmetric information problem. For compensating on the unavailable information and to offset the risk of uncertainty, the health insurance company is empowered to increase all their premiums. It means the riskiest people price out the less risky customers. Since health care markets involve asymmetric information, it’s essential to provide complete and true information to patients and vice-versa.
#5 – Monitoring & Controlling
Sufficient controlling and monitoring are other big challenges for the government. The government should assume responsibilities for intervening all of the aspects in sectors which have information gap problems. Without proper monitoring and controlling, firms may be impacted through various problems executed by illegal beneficiaries. The government regulations have to be structured and updated in ways through which gaps are minimized and one party is not taking advantage over the other. It has to be combined with strict monitoring and controlling processes.
#6 – Licensing & Liability Laws
These are part of consumer protection regulations whereby certain licenses/permits are required to sell certain goods and services. Firms can be subject to severe penalties if minimum industry standards are not set. This law has to be carefully set and regularly monitored because if licenses are not procured or it’s causing an unacceptable increase in prices, it may give rise to hoarding or black marketing practices.
The problem of asymmetric information is a long-standing phenomenon which is expected to prevail due to a difference in perception and also lack of smooth communication. There requires a two-way dialogue between interested parties and the availability of sufficient information to ensure correct decisions are taken. Government intervention can also be required as this situation can have an impact on the economic scenario as well but it can be restricted if some of the above-mentioned solutions are successfully implemented.
This has been a guide to What is Asymmetric Information?. Here we discuss Asymmetric Information including its definition, examples, and how to solve an asymmetric information problem. You may also have a look at the following articles –