What is asymmetric information?

Asymmetric information, also known as “information failure”, occurs when one party to an economic transaction has greater material knowledge than the other party. This usually manifests itself when the seller of a good or service possesses greater knowledge than the buyer; however, the opposite dynamic is also possible. Almost all economic transactions involve information asymmetries.

Understanding Asymmetric Information

Asymmetric information exists in certain transactions with a seller and a buyer, whereby one party can take advantage of another. This is usually the case when selling an item. For example, if a homeowner wanted to sell his house, he would have more information about the house than the buyer. They may know that some floors creak, the house gets too cold in the winter, or the neighbors are too loud; information that the buyer will only know after buying the house. The buyer could then feel that he paid too much for the house or that he would not have bought it at all if he had had this information in advance.

Asymmetric information can also be considered as the specialization and division of knowledge, applied to any economic trade. For example, doctors generally know more about medical practices than their patients. After all, doctors have extensive medical training that their patients usually don’t have. This principle also applies to architects, teacherspolice officers, Lawyers, engineers, fitness instructors and other qualified professionals. Asymmetric information is therefore most often beneficial to an economy and a society by increasing efficiency.

Advantages and disadvantages of asymmetric information

Advantages

Asymmetric information is not necessarily a bad thing. In fact, growing information asymmetry is the desired outcome of a healthy market economy. As workers strive to become more and more specialized in their chosen fields, they become more productive and can therefore provide greater value to workers in other fields.

For example, the knowledge of a stockbroker is more valuable to a non-investment professional, such as a farmer, who may be interested in trading stocks with confidence to prepare for retirement. On the other hand, the stockbroker does not need to know how to grow crops or care for livestock for food, but can instead purchase items from a grocery store that are provided by the farmer.

In each of their respective trades, the farmer and the stockbroker both hold superior knowledge to the other, but both benefit from the trade and from the division of labor.

An alternative to ever-expanding asymmetric information is for workers to study all areas, rather than specializing in areas where they can provide the most value. However, this is an impractical solution, with opportunity costs and potentially lower overall production, which would lower the standard of living.

Disadvantages

Under certain circumstances, asymmetric information can have quasi-fraudulent consequences, such as Adverse selectionwhich describes a phenomenon where an insurance company encounters the probability of extreme loss due to risk that was not disclosed at the time of selling a policy.

For example, if the insured hides the fact that he is a heavy smoker and frequently engages in dangerous recreational activities, this asymmetric flow of information constitutes adverse selection and could increase insurance premiums for all customers, forcing the sane to withdraw. The solution is for life insurers to carry out actuarial work and perform detailed health examinations and then charge different premiums to clients based on their honestly disclosed risk profiles.

Special Considerations

To prevent abuse of clients or clients by finance specialists, financial markets often rely on reputation mechanisms. Financial advisers and fund companies that prove to be the most honest and effective managers of their clients’ assets tend to gain clients, while dishonest or ineffective agents tend to lose clients, suffer damages, or both.