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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!

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Asymmetric Information

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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.

Asymmetric Information Market for smartphones StudySmarterFig. 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.

Frequently Asked Questions about Asymmetric Information

For example, Liam (seller) possesses more information about the product/service than Ariana (buyer) involved in the economic transaction. This is a situation of asymmetric information.

Asymmetric information can lead to implications such as adverse selection, moral hazard, and signaling.

The situation when one party in an economic transaction possesses more information about the product/service involved than the other party is known as asymmetric information. It is a problem because the information bias between the seller and the buyer of the product can be a possible reason for the market failure.

As asymmetric information can cause the high-quality high-priced product to disappear from the market, it causes an imbalance in the product distribution. Hence, it causes market failure.

Basically, the theory of asymmetric information concerns a market in which the buyers and sellers possess different levels of information. This theory has implications for many markets.

Final Asymmetric Information Quiz

Asymmetric Information Quiz - Teste dein Wissen

Question

What is a moral hazard?

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Answer

A moral hazard occurs when one individual can alter their actions in an undesirable way, knowing that this can't be observed.

Show question

Question

What is an agent?

Show answer

Answer

An agent is someone that performs a certain task.

Show question

Question

What is a principal?

Show answer

Answer

principal is someone who receives the service from the agent.

Show question

Question

What is a market failure in the context of moral hazard?

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Answer

Market Failure occurs when the pursuit of one's self-interest makes society worse off.

Show question

Question

For a moral hazard to occur, the principal needs to have more information about their actions than the agent.

Show answer

Answer

False.

Show question

Question

Moral hazards are bad, but they do not cause market failures.

Show answer

Answer

False.

Show question

Question

The moral hazard becomes worse when multiple people are participating in the moral hazard.

Show answer

Answer

True.

Show question

Question

The insurance industry is particularly good at avoiding moral hazards.

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Answer

False.

Show question

Question

Driving more recklessly after getting car insurance is considered a _______.

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Answer

free rider problem.

Show question

Question

Not paying taxes and using public roads is an example of a moral hazard.

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Answer

True.

Show question

Question

A(n) _________ needs to perform a task that is in their self-interest which disregards the ________.

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Answer

agent; principal.

Show question

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TARP relief is considered a moral hazard for financial institutions.

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Answer

True.

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While moral hazards are problematic, they are easy to solve.

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Answer

False.

Show question

Question

Moral hazards can cause market _______.

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Answer

failures.

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Question

If the principal knows about the agent's actions, then the moral hazard cannot occur.

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Answer

True.

Show question

Question

What is asymmetric information?

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Answer

The situation when one party in an economic transaction possesses more information about the product/service involved than the other party.

Show question

Question

What is market failure?

Show answer

Answer

Market failure is a situation where goods and services are not distributed efficiently in the free market. 

Show question

Question

The information bias between the seller and the buyer of the product can be a possible reason for __________.

Show answer

Answer

Market Failure.

Show question

Question

What is a mechanism by which buyers and sellers deal with asymmetric information?

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Answer

Adverse Selection.

Show question

Question

What is signaling?

Show answer

Answer

The concept of market signalling was developed by Michael Spence, who stated that, sellers send signals to the buyers which helps them determine the quality of the product.

Show question

Question

__________ is one of the most effective ways of helping buyers distinguish between high-quality products and low-quality products. 

Show answer

Answer

Signaling.

Show question

Question

What is economic inefficiency?

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Answer

The situation when the allocation of resources is not the best (efficient).

Show question

Question

What is moral hazard?

Show answer

Answer

The situation when an individual alters his/her behavior knowing that their actions are unobserved is known as Moral Hazard.

Show question

Question

When does the problem of adverse selection occur?

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Answer

Adverse selection occurs when the products of different qualities are sold at a same price due to the information asymmetry between buyers and the sellers. 

Show question

Question

The asymmetric information theory was developed in the __________

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Answer

1970s.

Show question

Question

What is asymmetric information theory?

Show answer

Answer

The theory of asymmetric information states that, high-quality products and low-quality products can be sold at the same price, considering the fact that buyers don't have enough information about the products. 

Show question

Question

Adverse selection becomes a problem when products of different qualities are sold _____ in the market.

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Answer

at the same price.

Show question

Question

What is an adverse selection?

Show answer

Answer

Adverse selection is a phenomenon when products of different qualities are sold at the same price due to the information asymmetry between buyers and sellers. 

Show question

Question

Moral hazard can lead to economic inefficiency.

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Answer

True.

Show question

Question

Which phenomenon causes a problem to determine the true quality of the product/service while purchasing it?

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Answer

Adverse Selection.

Show question

Question

What is adverse selection?

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Answer

Adverse selection occurs when two entities engage in an agreement where one entity has more information than the other, and the entity with less information incurs large costs.

Show question

Question

What is a moral hazard?

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Answer

A moral hazard occurs when one individual knows more about their actions and is willing to alter their behavior at the expense of another individual after an agreement. 

Show question

Question

Adverse selection can lead to market ______.

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Answer

Failures.

Show question

Question

Adverse selection and moral hazard only differ in the time that the agreement is made.

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Answer

True.

Show question

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The insurance industry is good at avoiding adverse selection problems.

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Answer

False.

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Question

In adverse selection, the entity with more information will incur ______ costs.

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Answer

Less.

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In adverse selection, the entity with less information will incur ______ costs.

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Answer

More.

Show question

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Adverse selection is a problem that can impede market equilibrium.

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Answer

True.

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Question

Adverse selection occurs _____ the agreement, moral hazard occurs ______ the agreement.

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Answer

before; after.

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Moral hazard occurs before the agreement, whereas adverse selection occurs after the agreement.

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Answer

False.

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Adverse selection ONLY occurs in the insurance market.

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Answer

False.

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Adverse selection can lead to a moral hazard.

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Answer

True.

Show question

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Economic problems can occur when ______ occurs.

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Answer

Moral hazard.

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Adverse selection can restore market equilibrium.

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Answer

False.

Show question

Question

Adverse selection occurs with _______ information.

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Answer

asymmetric.

Show question

Question

What is Asymmetric Information?

Show answer

Answer

Asymmetric information is known as the information gap between buyers and sellers in an economic transaction, which can lead to market failure in the long run.

Show question

Question

What is Moral Hazard?

Show answer

Answer

A situation when one party changes their behavior knowing that it cannot be monitored by another party is known as a moral hazard.

Show question

Question

Moral hazard does not only alter the behavior of the agent, but it might also lead to _________?

Show answer

Answer

Market Inefficiency.

Show question

Question

What is a principal-agent problem?

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Answer

The principal-agent problem is a situation that develops when agents start pursuing their objectives rather than that of the principal.

Show question

Question

If an employee tries to pursue their personal goal over the firm's goal, the __________ problem arises.

Show answer

Answer

Principal-agent.

Show question

Test your knowledge with multiple choice flashcards

For a moral hazard to occur, the principal needs to have more information about their actions than the agent.

Moral hazards are bad, but they do not cause market failures.

The moral hazard becomes worse when multiple people are participating in the moral hazard.

Next

Flashcards in Asymmetric Information118

Start learning

What is a moral hazard?

A moral hazard occurs when one individual can alter their actions in an undesirable way, knowing that this can't be observed.

What is an agent?

An agent is someone that performs a certain task.

What is a principal?

principal is someone who receives the service from the agent.

What is a market failure in the context of moral hazard?

Market Failure occurs when the pursuit of one's self-interest makes society worse off.

For a moral hazard to occur, the principal needs to have more information about their actions than the agent.

False.

Moral hazards are bad, but they do not cause market failures.

False.

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