Asymmetric Information, Essay Example

The concept of asymmetric information is important in understanding many of the sectors and transactions in the economy. The basis of asymmetric information is the following: there are two parties engaged in a transaction, one party holds more information than the other, and thus one side is at a disadvantage in understanding the true value and costs of the transaction. One might (perceptibly) notice that this concept runs counter to a principal precept of neoclassical economics: the idea of “perfect information.” In almost all neoclassical economic models, individuals are assumed to have “perfect information” (that is, they know all the options and the advantages and disadvantages) when making decisions, and then act rationally in order to maximize personal utility based on this information.

While there is certainly pedagogical value in models where the assumption of full information is embedded, this assumption prevents more realistic modeling at the micro level of how consumers and businesses actually behave in the real world. Three noted economists, Joseph Stiglitz, George Akerloff, and Michael Spence, won the Swedish Bank Prize (also referred to as the “Economics Nobel Peace Prize”) in 2001 for their work on asymmetric models- their contributions on specific subjects will be detailed as the paper goes on.

George Akerloff first posited the theory of “adverse selection” in a seminal 1971 paper entitled “The market for “lemons”: quality uncertainty and the market mechanism.”. Akerloff used the common transaction between a car buyer and car seller to illustrate the problem of adverse selection: When an individual visits a used car dealership to purchase an automobile, he/she has no idea regarding the ultimate quality of the car; the only information is contained in the price of a car. The car dealer, however, knows which car is of good and bad quality; that difference is not (adequately) expressed in the price between good and poor quality used cars. Because price is an unreliable signal in the used car market, individuals take advantage of this to sell “lemons” or poor quality cars for higher prices rather than sell higher quality goods. The consumer, after repeated transactions in buying lemons, finds this out and the market essentially closes because the quality of these markets declines to such a state where consumers are unwilling to participate due to fear of purchasing a “lemon.” This is a problem where buyers have more information than sellers and market imperfections cause the market to function improperly.

Adverse selection is also at play in insurance markets, particularly in car and health insurance markets. The main difference in adverse selection between the car market and the insurance market is that consumers have more information than the providers in the insurance market. For example, although health insurers force potential beneficiaries to undergo various medical tests, perhaps an individual lives a more dangerous lifestyle (e.g, drug abuse) or has a genetic proclivity for a certain disease that is not adequately documented in health records. In this case, the individual (and others) may become beneficiaries, but once admitted, the insurance market will quickly fail to function properly as individuals with claims will not be offset with individuals paying into the pool to offset the claims. Thus, adverse selection in the case of insurance ends in a similar result to the car market: the market fails to function.

Another main issue in asymmetric information is the “principal-agent” problem. The principal agent problem revolves around the relationship between the owner (or principal) and the principal (or worker of the principal). In the world there are many different permutations of this problem: the stockholders of a company (principals) and the agent (CEO); a lawyer (principal) and the client (agent); a politician (principal) and a constituent (agent). The problem comes in that the principal often times cannot fully supervise the agent, and thus in order to incentivize good performance, the principal increases pay or creates a licensure system in order to ensure that performance incentives are aligned.

Stock options is one way to bridge the principal-agent problem. The agent incentivizes top executives and managers to maximize profits, rather than personal glory or expense accounts, through giving part of their compensation in stock options- or options to sell company stock after a certain lock-up period havs ended. The rationale behind this remuneration strategy is simple: if the executive is given compensation linked to the stock price, they will work harder to ensure a higher stock price, which will also benefit the agent. The problem comes in, however, that often times maximizing stock prices is not only difficult to do, but also may give perverse incentives to executives to follow short-term strategy that may harm the firm over the long-term.

Another way to ensure performance is through regulations involved in franchising a brand name and licensing doctors. Restaurant firms that want to expand into new geographic areas may “franchise” the brand to different proprietors who then sign a contract to maintain certain standards and regulations in the operation. Otherwise, they may be tempted to buy a brand name and “free ride” on the often times heavy investment needed to maintain the brand and quality of the product. The asymmetric information in medicine is a bit different: Doctors and other medical personnel know much more than patients about potential health problems. In order to make sure that doctors act ethically in treating patients, rather than take advantage of the gap in information between producer and consumer, a licensing structure was formed. Kenneth Arrow produced a famous article in 1963 that posited licensure is a function of this asymmetry of information.

“Signaling” is one of the mechanisms proposed to solve the problem of asymettric information. Michael Spence in a 1973 paper proposed that individuals acquired educational credentials in order to make up for the employer not knowing whether an employee is good or bad. That is, employees can “signal” to an employer that they are a good employee worthy of a higher salary by acquiring certain educational qualifications that tells the employee that they are better.

Overall, asymettric information challenges the neoeconomic assumption of “perfect information” in understanding why certain markets fail to function properly.

References

Akerloff, G. (1970). The market for “lemons”: quality uncertainty and the market mechanism. The Quarterly Journal of Economics. 84(3). 488-500.

Arrow, K. (1963). Uncertainty and the welfare economics of medical care. The American Economic Review. 53(5), 941-973.

Snyder, C. & Nicholson, W. Intermediate Microeconomics and Its Applications. Cengage Learning.

Spence, M. (1973). Job market signaling. Quarterly Journal of Economics. 87(3), 355-374.