A Sour Predicament : Information Asymmetry
BY AADRIKA SHUKLA / JANUARY 8, 2022
The perfect knowledge assumption hardly holds true in real-world economics. Contrastingly, the imperfect knowledge equation proves to be a hazard for a number of individuals and institutions.
n today's day and age, information is essential to anything and everything we do. We are unlikely to arrive at the right decisions or, in some cases, any decision at all about a certain issue without having definite supporting information about that issue. Human beings are constantly looking for more and better data to identify opportunities for improvement. In fact, the possession and interchange of information is so vital to economic decisions that it has its own field of study termed ‘Information Economics’, a branch of microeconomic theory that is only concerned with information and information systems affecting an economy and economic decisions.
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As Robin Margon, American political theorist and activist strongly puts it, “Knowledge is power. Information is power. The secreting or hoarding of knowledge or information may be an act of tyranny camouflaged as humility.” While that is true, Margon's exposition of information hoarding as camouflaged tyranny has rarely deterred anyone since the dawn of time and this is what broadly constitutes information asymmetry. It is a scenario in which the distribution of knowledge between an individual or a group of individuals is inadequate. It occurs most frequently when one entity possesses information that the other does not or the extent of information is imbalanced. The concept might seem like conventional wisdom now but economists did not even give a thought to the role of information until 1970.
Pictured: Illustration unknown via Pinterest
Until the mid-1960s, most textbooks assumed that in the labour market, for example, employers knew their workers' productivity—or potential workers' productivity—and, owing to competition, paid them exactly what they produced. This was and still is to a large extent a false assumption since there is no mechanism to quantify productivity in a manner that those textbooks drew in their conclusions. You would expect that the research that brings light to this misconception would be hailed as a major advance right away. Yet, in the late 1960s, George Akerlof's study ‘The Market for Lemons’ which achieved just that and had earned its author a Nobel Prize many years later, was rejected by three major journals. The American Economic Review dismissed his findings as irrelevant. The Review of Economic Studies came to the same conclusion. The Journal of Political Economy, on the other hand, was nearly completely unconcerned by the paper's consequences. Mr. Akerlof, who is now an emeritus professor at the University of California, Berkeley, recalls the editor's complaint as, ‘If this is right, economics would be different.’
In a market economy, the majority of information is communicated through prices. Hence, inefficient price signals are likely to lead to adverse selection.
In his paper, Akerlof also discusses the manifestations of knowledge asymmetry, which emerges in two ways- adverse selection and moral hazard. The former occurs when one participant in a transaction has more accurate knowledge than the other. The party with less information is at a disadvantage as compared to the party with more. Because of this asymmetry, the price and amount of goods and services given are inefficient. In a market economy, the majority of information is communicated through prices. Hence, inefficient price signals are likely to lead to adverse selection. In Akerlof's paper, where he used the example of the market of used cars, he emphasized that a potential buyer cannot simply determine the vehicle's genuine value. As a result, buyers may be prepared to spend no more than the average price, which they consider to be halfway between a bargain and a premium price. At first glance, adopting such a structure may appear to provide some financial protection to the customer against the risk of purchasing a ‘lemon’ which is a bad product with low durability- a second rate used car in this example.
However, as Akerlof pointed out, this viewpoint actually benefits certain sellers, as an average price for a lemon would still be more than the seller could collect if the buyer knew the automobile was a lemon and not in fact a good car. Here, asymmetric information leads to an adverse selection problem: if consumers are unable to judge a product's quality and are ready to pay merely an average price for it. This price becomes more appealing to sellers with terrible items than to sellers with premium ones, who would not want to sell their products for less than what they are worth, hence the term adverse selection. As a result, there will be more lemons available than excellent products.
Pictured: George Akerlof via Google
If consumers are rational, they should foresee this adverse selection and believe that a randomly chosen product is more likely to be a lemon than a decent product at any given price. Naturally, these expectations indicate a decreased willingness to pay for things, resulting in a reduction in the proportion of good products actually supplied.
When a person or an institution does not carry the entire expense of a risk, they may feel compelled to raise their risk exposure.
In a moral hazard situation, on the other hand, one of the parties involved in an agreement presents misleading information or changes their behaviour after the agreement is signed because they feel they will not face any consequences. When a person or an institution does not carry the entire expense of a risk, they may feel compelled to raise their risk exposure. This selection is based on what will bring the greatest advantage to them. There is always the possibility that one party entered into a contract in bad faith, which they could do by lying about their assets, liabilities, or credit ability. A lesson of moral hazard can be derived from the Global Financial Crisis of 2008, when the US federal government stepped in with the ​​Troubled Asset Relief Program (TARP) to bail out many of the largest banks of the US after having lost billions of dollars in asset value. Because of these events, many banks are under the assumption that if they ever go bankrupt, the government will bail them out as a result of that line of events. Now, rather than implementing effective measures to prevent future overexposure, banks are more likely to continue providing riskier loans if doing so provides them with short-term advantages. This situation is a prime example of one party (the bank) profiting at the expense of another (the federal government, and eventually, the taxpayers).
Knowledge gaps are expensive, as the person with the least information can never be certain of what is being traded.
Pictured: To have and have not by Barry Falls via Pinterest
Knowledge gaps are expensive, as the person with the least information can never be certain of what is being traded. For instance, the lemons analogy assists in elucidating the employment of minorities too: employers are sometimes known to refuse employment to members of certain minority groups, not accruing to bias but simply because of the motive of profit maximization as an individual’s socio-religious identity may serve as an indicator of their background, educational attainment, and overall work aptitude. The socially non-marginalised groups usually have better access to quality education facilities as opposed to the marginalized as institutions made solely for the latter are often not credible enough, thus decreasing the employment possibilities for its students. The absence of understanding this might cost the marginalized a good amount in terms of their economic prospects.
To quote from Arkelof’s paper,“This lack may be particularly disadvantageous to members of already disadvantaged minority groups. For an employer may make a rational decision not to hire any members of these groups in responsible positions - because it is difficult to distinguish those with good job qualifications from those with bad qualifications.”
Michael Spence and Joseph Stiglitz, the two joint Nobel laureates for the 2001 prize, were acknowledged for their research on how people distinguish between gems and lemons in a number of industries. Spence inquired on how better-informed people in a market might legitimately ‘signal’ their knowledge to less-informed people, avoiding some of the issues associated with adverse selection. Signalling makes it essential for economic agents to take observable and expensive means to persuade other economic agents of their competence or, more broadly, of the worth or quality of their products. Spence's contribution consisted of developing and formalizing this concept as well as demonstrating its consequences. While Stiglitz demonstrated that via ‘screening’ which is the process of providing incentives in exchange of information, an uneducated agent may occasionally collect the knowledge of a better-informed agent.
Pictured: by Bill Mayer via Pinterest
Similarly, strong statistics help in alleviating feelings of doubt and ambiguity about the information for less informed people but more importantly, the lack of that very information or data leads to the creation of fear, fear that then lays the base for an array of adverse selection hazards.
Keywords
Information Economics, The Market for Lemons, Nobel Prize, Global Financial Crisis, adverse selection, moral hazard
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References
Steven Nicholas (2021, June 27). Understanding the Difference Between Moral Hazard and Adverse Selection. Investopedia.
The Economist (2016, July 23). Secrets and Agents. The Economist.
https://www.economist.com/schools-brief/2016/07/23/secrets-and-agents
The Economist (2016, September 5). What is Information Asymmetry? The Economist.
https://www.economist.com/the-economist-explains/2016/09/04/what-is-information-asymmetry
Sean Ross (2020, July 26). The Theory of Asymmetric Information in Economics. Investopedia.
https://www.investopedia.com/ask/answers/042415/what-theory-asymmetric-information-economics.asp
Sean Ross (2020, July 26). How to Fix the Problem of Asymmetric Information? Investopedia.
Akerlof, G. A. (1970). The Market for “Lemons”: Quality Uncertainty and the Market Mechanism. The Quarterly Journal of Economics, 84(3), 488–500. https://doi.org/10.2307/1879431
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