Have you ever purchased a product and felt as if the seller was concealing certain information about it? Often, the seller knows more about the product than the buyers. This phenomenon is known as asymmetric information. Want to learn more about asymmetric information theory, how asymmetric information can lead to market failure, and possible solutions to mitigate the problem? Let's jump right into it!
Asymmetric Information Theory
The asymmetric information theory was developed in the 1970s, which states that the information bias between the seller and the buyer of the product can be a possible reason for market failure.
Asymmetric Information Definition
Let's get straight into the definition of asymmetric information.
Asymmetric information is the situation when one party in an economic transaction possesses more information about the product/service involved than the other party.
Now, we will take a look into what happens when one party (seller) possesses more information than another party (buyer) involved in the economic transaction.
Asymmetric Information Graph
The asymmetric information theory states that high-quality products and low-quality products can be sold at the same price because buyers don't have enough information about the products.
Fig. 1 - The Market for Smartphones
Let us suppose there are two types of smartphones available in the market, i.e., High-quality smartphones and Low-quality smartphones which can be distinguished by the buyer by just having a look at them. From Figure 1 above, we can illustrate that there are two markets for both qualities of products.
The supply curve is denoted by SH and SL of high-quality smartphones and low-quality smartphones respectively. Similarly, DH denotes the demand for high-quality smartphones, and DL denotes the demand for low-quality smartphones. DH is higher than DL because the buyers are willing to pay a higher amount for high-quality smartphones. The market price for a high-quality smartphone is $900 and the market price of a low-quality smartphone is $500 while both are selling 20,000 units at the given price point.
The sellers of smartphones of both qualities know more about the quality of their products than the buyers. As the same quantity of both of the products is sold, the buyers expect that the product they get will be medium-quality. The demand curve for medium-quality smartphones is DM in Figure 1. We can see that medium-quality smartphones are sold for $700 each but this time the quantities sold of high-quality smartphones have decreased to 10,000 units. However, the quantity sold of the low-quality smartphone has increased to 30,000 units.
We can see that 3/4th of the smartphones sold now are of low quality. Therefore, smartphone buyers now expect that they are more likely to get a low-quality than a high-quality phone. This causes the perceived demand to shift further to the left. The price and quantity sold of high-quality products decrease as the quantity sold of low-quality products increases.
This process will continue and shift the mix of products more toward low-quality smartphones. Slowly, in the long run, the price of any product will be very low, and no high-quality smartphones will be sold. The low-quality product has driven the high-quality product out of the market.
This is an extreme case where the low-quality product drives the high-quality one out of the market. We can have a market equilibrium that allows a mix of both varieties to be sold, but the quantity sold of the low-quality product will be higher than the quantity sold of the high-quality one.
Asymmetric Information Types
By now, you already know about asymmetric information and its effects on the market, but there are various types of situations that involve asymmetric information. Let's talk about these.
Asymmetric Information: Adverse Selection
The example of smartphones of different qualities sold at the same price point is the perfect example of adverse selection. Adverse selection occurs when products of different qualities are sold at the same price due to the information asymmetry between buyers and sellers.
This causes a problem to determine the true quality of the product while purchasing it. Hence, it causes a higher quantity of low-quality products and less quantity of high-quality products being sold in the market.
Adverse selection is also a problem for the insurance market. Let's consider an example in the health insurance market.
People who purchase insurance are far more informed about their health than the insurance company. Even if the insurance company runs many screening tests, they may not be able to identify all of the health problems. In this case, there is an information asymmetry between the insurance buyers and the insurance company. Knowing that less healthy people are more likely to get insurance, insurance companies raise the price of their premiums. This forces more relatively healthy people to drop out, leaving the insurance pool with even less healthy people. You can see why this can turn into a problematic cycle for the insurance market.
Asymmetric Information: Moral Hazard
The situation when an individual alters his/her behavior knowing that their actions are unobserved is known as a moral hazard.
Let us suppose that Emily gets full insurance on her house against theft. Now, her behavior might alter. She might not be as careful as before while locking the doors, and she might choose to not get an alarm system. The change in her behavior as she is insured is an example of a moral hazard.
Moral hazard does not only alter the behavior of an individual, it leads to economic inefficiency. Economic inefficiency arises because, in comparison to actual cost and benefits, the insured person perceives the cost and benefits differently.
A moral hazard is a situation where an individual alters his/her behavior knowing that their actions are unobserved.
We have covered these topics in detail. Check out the following explanations:
- Adverse Selection
- Moral Hazard
Asymmetric Information Market Failure
Asymmetric information can be a possible reason for market failure.
Market failure is when the free market leads to an inefficient distribution of goods and services.
For example, in the market for smartphones, consumers must be able to choose between high-quality smartphones and low-quality smartphones as per their preferences. Some people might not want to spend much on a smartphone and might select a low-quality smartphone for a lower cost, but some people might spend more because they prefer a higher-quality product.
However, if the quality of a smartphone can only be known by the buyer after they purchase it, the majority of people would choose the lower quality product as they cost less and buyers have less to lose even if the smartphone is not of the desired quality. This decreases the demand for high-quality smartphones, and the sellers start to decrease the price of their products. Slowly, high-quality smartphones disappear from the market even though some people would prefer high-quality smartphones. Hence, market failure arises.
Asymmetric Information Problem
Asymmetric information problems are eminent in almost every market. Each market is unique and different types of problems might arise depending on the type of market. Now we will look into the mechanism that can be used by sellers and buyers to deal with the problem of asymmetric information.
Signaling
One of the widely used mechanisms to reduce the problem of asymmetric information is signaling. The concept of market signaling was developed by Michael Spence, who stated that sellers send signals to the buyers which help them determine the quality of the product. Depending on the type of product, sellers use different signaling mechanisms.
Alex is a seller of high-quality electronic goods. The market of electronic goods is very fragmented and various types of sellers are in the market selling both high-quality and low-quality products. How will Alex stand out in such a market and convince the buyers that his product is of higher quality than his competitors?
He will start using warranties and guarantees while selling his products. As warranties and guarantees are given mainly by high-quality product sellers, it effectively signals the quality of a product. Low-quality product sellers are reluctant to provide warranties and guarantees, as they would have to repair the damages at their own cost. Hence, the buyers of products sold by Alex will view warranties and guarantees as a signal of a high-quality product.
Therefore, signaling is one of the most effective ways of helping buyers distinguish between the different qualities of products. Hence, this mechanism helps in reducing the problem of asymmetric information.
Signaling also plays a big role in the labor market. If you want to learn more about it, see our explanation: Signaling.
For more topics related to asymmetric information, check out these explanations:
- Screening
- Contract Theory
- Principal-agent Problem
- Efficiency Wages
Asymmetric Information - Key Takeaways
- Asymmetric information is the situation when one party in an economic transaction possesses more information about the product/service involved than the other party.
- Asymmetric information can be a possible reason for market failure.
- Adverse selection occurs when products of different qualities are sold at the same price due to the information asymmetry between buyers and sellers.
- A moral hazard is a situation when an individual alters his/her behavior knowing that his/her actions are unobserved. Moral hazard alters the behavior of an individual and leads to economic inefficiency.
- Sellers can send signals to the buyers that help them determine the quality of the product.
Explanations 
Exams 
Magazine 
