Information asymmetry is a situation whereby one party in a transaction has got more or superior information compared to another. Such situations often exist in transactions where the seller is more knowledgeable than the buyer, although the reverse can also happen as well. Information asymmetry situation could be very harmful owing to the fact that one party can take advantage of another’s ignorance to undertake certain undesirable practices or measures.
The advancement in technology has today been helpful in lowering information asymmetry. In fact, it has been on the decline since a significant number of people are being able to easily gain access to all types of information. However, there are two main problems that are likely to result from information asymmetry that you should take note of. These problems are adverse selection and moral hazard. Adverse selection is an immoral behavior that takes advantage of asymmetric information before a transaction. Moral hazard on the other hand, refers to an immoral behavior that takes advantage of asymmetric information after a transaction.
Moral hazard and adverse selection are the two models of information asymmetry. In adverse selection, the ignorant party lacks information while negotiating an agreed understanding of or contact to the transaction. However, in moral hazard, the ignorant party lacks information about performance of the transaction agreed upon or lacks the ability for retaliation in case the agreement is breached. An example of adverse selection is when people who are at high risk of certain conditions are more likely to purchase insurance, since the insurance company is unable to effectively discriminate against them, usually as a result of lack of information about the particular risk of the individual and also sometimes by law or other constraints.
An example of moral hazard is when people have higher chances of behaving recklessly after becoming insured, either because the insurance company cannot observe their behaviors or unable to effectively retaliate against it, for instance through failing to renew the insurance.
In George Akerlof’s classic paper on adverse selection titled, ‘The Market of Lemons’ (1970), he discussed two primary solutions to the problem of information asymmetry. These solutions are signaling and screening. Signaling was an idea primarily proposed by Michael Spence. He proposed that in a situation of information asymmetry, it is possible for people to signal their type, thus, believably transferring information to the other party and resolving the bias in information.
Screening was pioneered by Joseph E. Stiglitz. According to him, the less informed party can induce the other party to reveal the information. They can offer a variety of choices in such a way that the choice depends on the private information on the other party. Some of the situations where the seller usually has sufficient information than the buyer include mortgage brokers, used car salespeople, stock brokers, and real estate agents among others. Buyers on the other hand, can also have adequate information than sellers in situations like estate sales, life insurance, sale or old art pieces without prior assessment of their value by a professional.
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