Asymmetric Information

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What is asymmetric information?

Asymmetric information, also known as “information failure”, occurs when one party to an economic transaction has greater material knowledge than the other. This usually manifests itself when the seller of a good or service has better knowledge than the buyer; however, reverse dynamics is also possible. Almost all economic transactions involve information asymmetries.

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Asymmetric information

Understanding asymmetric information

Asymmetric information is the specialization and division of knowledge, as it applies to any economic trade. For example, doctors generally know more about medical practices than their patients. After all, doctors have extensive academic training in medicine that their patients generally do not have. This principle also applies to architects, teachers, police officers, lawyers, engineers, fitness instructors and other trained professionals.

The economic benefits of asymmetric information

Asymmetric information is not necessarily a bad thing. In fact, increasing asymmetric information is the desired result of a healthy market economy. As workers strive to specialize more and more in the fields they choose, they become more productive and can therefore bring greater value to workers in other fields.

For example, the knowledge of a stock broker is more valuable to a non-investing professional, such as a farmer, who may be interested in trading stocks with confidence, to prepare for retirement.

An alternative to the ever-expanding asymmetric information is that workers study all areas, rather than specializing in the areas where they can provide the most value. However, it is an impractical solution, with high opportunity costs and potentially lower aggregate returns, which would lower living standards.

Another alternative to asymmetric information is to make information available in abundance and at low cost via the Internet and other data sources.

The disadvantages of asymmetric information

In certain circumstances, asymmetric information can have almost fraudulent consequences, such as adverse selection, which describes a phenomenon where an insurance company encounters the probability of an extreme loss due to an undisclosed risk. when a policy is sold.

For example, if the insured conceals that he is a heavy smoker and frequently engages in dangerous recreational activities, this asymmetrical flow of information constitutes an unfavorable selection and could increase insurance premiums for all customers, forcing healthy people to withdraw. The solution for life insurers is to do in-depth actuarial work and perform detailed health exams, and then charge clients different premiums based on their honestly disclosed risk profiles.

Key points to remember

  • Asymmetric information, also known as “information failure”, occurs when one party to an economic transaction has greater material knowledge than the other.
  • Asymmetric information generally appears when the seller of a good or service has better knowledge than the buyer; however, reverse dynamics is also possible. Almost all economic transactions involve information asymmetries.

Special Considerations: Information Asymmetry in Finance

To avoid abuse of clients or clients by financial specialists, the financial markets often rely on reputation mechanisms. Financial advisers and fund companies who prove to be the most honest and efficient custodians of their clients’ assets tend to gain clients, while dishonest or ineffective agents tend to lose clients, to suffer damage -interests, or both.

[Important: In certain asymmetric information models, one party can retaliate for contract breaches, while the other party cannot.]

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