Information asymmetry

Information asymmetry

Information asymmetry is a situation in which there is imperfect knowledge, usually when one party has more information than the other. 

Adverse selection

When information asymmetries distort the market before a transaction takes place. 

e.g. In the used car market, the seller of the car has more information than the buyer, and the buyer knows this. Therefore, the buyer is less likely to trust the seller and will offer less to the buyer. The buyer may think the car is worth £3000, whereas the seller may know it is actually worth £2000. 

This can lead to adverse selection, which is a distortion of the usual market process. If a seller had a car that was worth more than £3000, they would not put it up for sale, as they would know that no-one would buy it as no-one would trust them enough - the highest quality cars exit the market. This means the average quality of cars on the market would be lowered, so buyers would lose even more trust in the market, so would buy at lower prices, and next highest quality cars would be taken off the market, so slowly the market would be skewed as the value of cars gradually goes down. This is often known as a death spiral, which results in the market collapsing. 

Solutions to adverse selection

The market has developed solutions, such as inspections, reports and programs that offer guarantees, which ensure buyers' trust in the market. 

Signalling 

When the potential customer/agent undertakes an action to provide more information to the producer/principal. The side with more information tries to signal to the side with less, reducing the asymmetry. 
e.g. entering essay competitions, CVs, politicians making public speeches 

Screening

This is when the producer/principal undertakes an to find out more information about the consumer/agent. The side with less information tries to find out more about the side with more information. 

e.g. job interviews, credit ratings 

Moral Hazard 

When information asymmetries distort the market after a transaction has taken place. 
This is a case of information asymmetry where one party uses information that the other party doesn't have to exploit the other party. 

e.g. A Taxi driver knows more about his route than the tourist in the back seat, so takes a detour to get a higher fare at the expense of the customer. 

Or a plumber charges you for parts you do not need. 

The potential that you are being 'ripped-off' often reduces the likelihood of the transaction happening in the first place. You may not trust the plumber enough to call her, and instead allow your pipes to deteriorate until they break. 

Principal-agent problem - conflicting incentives between the principal and the agent. The agent pursues self interest rather than the aims of the principal, which are often profit maximisation. This creates a conflict between the two. 

Solutions to moral hazard:

- Make information less asymmetric - if both parties have equal information, it is very hard for exploitation to occur

- Reduce the incentive of a party to exploit their informational advantage - laws may change incentives. Splitting the diagnosis of an issue from the cure of it eliminates the incentive for the person giving the diagnosis (e.g. doctor) to overstate it and try to sell you add-ons like drugs. 

- Penalise exploitation of parties - punishments make it less likely for the party to breach laws again. 

User ratings/reviews 

Yelp, TripAdvisor, etc. reviews make signalling/screening more easy/accessible. Also a solution to adverse selection. 

These close the gap between the information the consumer and producer have. They also change the incentives of the producer - instead of simply making profit, they may want to boost their reviews in order to increase revenue. 

However, some may try to manipulate reviews/ratings (like getting friends to do review your product). It is also hard to exclude people from information - it is a public good. Therefore, third parties that provide reviews can have people that free-ride (i.e. use the information without paying for it).This results in an under-provision of information by third-parties, as it is hard to make profit. 

Observation 

If the principal can observe the behaviour of the agent then this provides the principal with full information, resolving the asymmetry. They can then threaten to punish an agent who doesn't do what they are supposed to. 
e.g. teachers making you hand in homework to check how you are doing, an employer having an open floor where she can see all employees' computer screens. 

However, this is quite costly/time-consuming and could go against trust/people's right to privacy. 

Payment structure 

if the principal changes the payoff structure so that how much the agent gets paid depends on how hard they work. 
e.g. bonuses, commissions 

However, this only works when it is easy to quantify individuals' performance, like in investment banking, where it depends on how much money you generate. With football players, you can't tell which players are causing the success of the team, so it is harder to offer bonuses.