Asymmetric information is where two people doing business together have different levels of information about something important to the transaction, meaning that one may be able to take advantage of the other. It is very common in economic life.
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Information is key to all business and financial transactions. In economic theory we often simplify drastically by assuming that there is perfect information, meaning everybody knows everything that is relevant to their decisions. This is clearly unrealistic, but that’s how theories work, by isolating one or more key aspects of a problem, to see if we can understand better what’s going on.
But economics has a lot to say about imperfect information too. This is in fact the normal situation, where people don’t have all the relevant information. They may be able to get more, but at a cost, which creates a dilemma: how much of my time or resources should I spend on getting more information, before deciding I have enough to make an informed decision?
A special case, but quite common one, of imperfect information is when two people are engaged in a possible transaction, and one of them knows more than the other. This is called asymmetric information, and it’s pretty pervasive in finance.
For example, I am trying to sell you something; you know what you’re willing to pay for it, but I don’t, so I have to try and figure it out. Or, I’m thinking of buying a second hand car from you. You assure me it’s in good shape, but I’m not sure, because you know the truth and I don’t.
The area where asymmetric information has been most studied is the insurance industry.
Consider car insurance. Let’s assume it’s not compulsory to have car insurance. People’s ability to drive safely, and therefore their risk of an accident, varies across the population. Each person has a pretty good idea what kind of driver they are (though male drivers tend to over-estimate their skill), but the insurance company doesn’t. Let’s say the insurance company has a rough idea of the average level of risk, meaning the average probability of a person having and accident and therefore making an insurance claim. So they set the price at a level that covers this risk, with a small profit margin.
The people who know they’re high risk drivers would see this as a good deal, and would be likely to sign up. But the better than average drivers, who know (or at least believe) they are less likely to have an accident, may think it’s overpriced and refuse to buy it.
This means that the pool of insured drivers is over-represented by the higher risk drivers. So the actual accident rate and the insurance company payout will be higher than expected. Since the price is not going to be high enough to make a profit, the insurance company will have to raise it.
But this risks driving out more of the lower risk drivers, with a further deterioration of the quality of the remaining pool of insured drivers. So the company raises prices again…
The upshot is that there is no profitable level of car insurance and so nobody can get it.
The problem is called adverse selection (*). The insurance is most likely to be taken up by those who most need it, not by the average driver. And it means there may be no profitable insurance industry.
There are two things needed to deal with this. One is to make car insurance mandatory, which is normal in most countries. So the pool of drivers is now all drivers; the lower risk drivers can’t opt out. But that still leaves each individual car insurance company at risk of attracting the highest risk drivers.
So the second thing they do is try to overcome the asymmetric information by getting drivers to signal how safe a driver they are. This is done by giving a discount (in the UK a “no claims bonus”) to drivers with a record of not having any accidents, which is a signal of their driver quality.
In practice this deals sufficiently with the adverse selection problem, and there are profitable car insurance markets.
There is a second aspect of asymmetric information that afflicts insurance, which is that being insured may change the way you behave. This is called moral hazard (**).
Imagine you are an average risk driver. You now have insurance. If the insurance fully covers you against the costs of an accident, perhaps you’ll be tempted to drive a little more carelessly? If so, the risk of you having an accident is higher, simply because you’re insured.
A standard way to deal with this is for the insurance contract to force you to pay the first say $100 of any accident costs. In the US this is called a deductible. In health insurance contracts it is called a co-payment. The goal is to ensure that the insured person still has some “skin in the game”, they still would prefer not to have an accident.
Moral hazard is also often seen as a problem with regulators of governments promising to bailout banks in a crisis. On the one hand, a failing bank can lead to contagion, where people withdraw their money from other banks, even perfectly sound ones, because of a general fear of failure. So regulators and governments may feel they have to step in to stop the contagion by rescuing a failing bank.
But if banks expect to be bailed out in future, they may act more recklessly, safe in the knowledge that the government will feel obliged to rescue them.
All these problems arise at least in part from asymmetric information, the inability to observe how other people are behaving. In general, strategies to deal with asymmetric information rest on either trying to overcome the asymmetry, by getting better information, or by changing the incentives of the person who has the greater information to encourage them to behave in the way that the other party wants.
We can observe both approaches in a particular example of asymmetric information found in finance, known as the agency problem, which we examine separately in this post.
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(*) Economists call this pre-contractual opportunism, meaning that rational (and unprincipled) agents take actions in their own interest before a contract is signed.
(**) Economists call this post-contractual opportunism, meaning that rational (and unprincipled) agents take action in their own interest after a contract is signed. In other words, the fact of having signed the contract alters their behaviour, which can undermine the assumptions made prior to signing the contract.
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