Information asymmetry is a universal phenomenon in the trading market. The seller often knows more about the product’s quality than the buyer. In the labour market, the job applicant knows much more about how qualified they are than the potential employer. People who buy insurance often have a much better understanding of their risks than the insurance company which is selling them insurance. These kinds of cases lead to several kinds of problems. These problems “emerge in such markets when the information held by the two parties to the trade is not symmetric”. Relevant issues like adverse selection (hidden information) and moral hazard (hidden action) will be discussed, make examples in the sections below. On the other hand, why do insurance companies offer different insurance contracts to different policy-holders? Why do customers go to several shops only to compare the price of the same goods? Why do employers take the educational level as a significant factor when they choose a job applicant? What they do above are measures to mitigate the problems as the result of asymmetrical information. Specifically, some of these measures are called signaling and screening which will be discussed below with some examples.
Let us take the ideal market as a starter. Under the circumstances of an ideal market, we can have perfect competition. In this case, we have three main assumptions. One of those assumptions is that there are massive amounts of buyers and sellers. All of these economic entities have minimal effect on the aggregate supply and aggregate demand of the whole market. They have to accept the established price, and therefore they are called “price-takers”. The second assumption is the goods are exactly alike. Not only the quality, specification and trademark are all the same, but also it includes shopping environment, after-sale service, etc. We can buy any product from any seller without concern for the quality of the good. That further reinforces the idea that each economic entity is a price-taker. The last assumption is full information. This means each buyer and seller has their information of every aspects of economic decision-making.
However, there are many situations in which price cannot be utilized all the necessary information to complete the transaction. Furthermore, when the information is effective but it is disproportionally distributed, we call it information asymmetry. The asymmetrical nature of information in these cases can produce two main problems for the functioning of markets. The first is called adverse selection. Let us take as an example investing in a new apartment. The uninformed investors or shareholders regard the new sector as they are generally alike among most companies. However, the inside man knows much more about the information of the future profitability of the sector than the uninformed investor. The market would overestimate the value of those firms which are below the average rentability. Certainly, the unwitting investor will still trade. On the other hand, the higher valued firm which is above the average profitability will be underestimated. Thus “Under asymmetric information, the ‘low-quality’ firms (with low future profitability) thus tend to grow more rapidly than ‘high-quality’ firms, implying that the market will gradually be dominated by ‘lemons’. When uninitiated investors ultimately discover this, share prices fall”. From the example we can believe that the investor or shareholder may suffer huge losses. So this is the first problem of information asymmetry which is also called hidden information. Hidden information occurs beforehand, the private information is owned by one side before two parties conclude the transaction.
The other problem which has a big influence on the functioning of markets is hidden action. Hidden action leads to moral hazard. The situation in the insurance industry is obvious. Let us take property...