Asymmetric Information

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.

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 S_H and S_L of high-quality smartphones and low-quality smartphones respectively. Similarly, D_H denotes the demand for high-quality smartphones, and D_L denotes the demand for low-quality smartphones. D_H is higher than D_L 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 D_M 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.

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.

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.

Asymmetric Information Market Failure

Asymmetric information can be a possible reason for market failure.

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.

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.