Information Asymmetry

Information Asymmetry

Information asymmetry — a situation where one party to a transaction knows more than the other. This leads to "market failures": adverse selection and moral hazard.

Adverse Selection
Definition: before the transaction — the informed party has an advantage, which leads to "adverse selection".

"Market for Lemons" (Akerlof):

• Sellers know the quality of the cars, buyers do not
• Buyers offer the average price
• Owners of good cars leave the market
• Only "lemons" remain — the market may collapse

Examples:

• Insurance: the sick buy more
• Loans: risky borrowers seek credit more actively

Solutions: signaling (education as a signal of quality), screening (deductibles in insurance), guarantees, reputation.

Moral Hazard
Definition: after the transaction — one party changes behavior, knowing that the other bears the risks.

Examples:

• Insurance: the insured person becomes less cautious
• Managers: they risk shareholders’ money
• Banks: "too big to fail" — know that they will be bailed out

Solutions: monitoring, incentive alignment (stock options), deductibles, co-payments.

Principal-Agent Problem
Principal: hires the agent to perform a task.
Agent: has his own interests and informational advantage.

Problem: interests may diverge; the principal cannot fully control.

Examples:

• Shareholders vs managers
• Patients vs doctors
• Clients vs financial advisors

Solutions: contracts, incentives, monitoring, reputation.

For the investor
Due diligence: reducing information asymmetry.
Corporate governance: mechanisms for controlling management moral hazard.
Disclosure: requirements for information disclosure — an instrument against asymmetry.