Question

What is asymmetric information? What are some common situations in which it occurs? What are some of the problems it can cause? What are some way to overcome these problems?

Please write one page answering these questions

Answer 1

What Is Asymmetric Information?

Asymmetric information, also known as "information failure," occurs when one party to an economic transaction possesses greater material knowledge than the other party. This typically manifests when the seller of a good or service possesses greater knowledge than the buyer; however, the reverse dynamic is also possible. Almost all economic transactions involve information asymmetries.

Understanding Asymmetric Information

Asymmetric information is the specialization and division of knowledge, as applied to any economic trade. For example, doctors typically know more about medical practices than their patients. After all, physicians have extensive medical school educational backgrounds that their patients generally don't have. This principle equally applies to architects, teachers, police officers, attorneys, engineers, fitness instructors, and other trained professionals.

The Economic Advantages of Asymmetric Information

Asymmetric information isn't necessarily a bad thing. In fact, growing asymmetrical information is the desired outcome of a healthy market economy. As workers strive to become increasingly specialized in their chosen fields, they become more productive, and can consequently provide greater value to workers in other fields.

For example, a stockbroker's knowledge is more valuable to a non-investment professional, such as a farmer, who may be interested in confidently trading stocks, to prepare for retirement.

One alternative to ever-expanding asymmetric information is for workers to study all fields, rather than specialize in fields where they can provide the most value. However, this is an impractical solution, with high opportunity costs and potentially lower aggregate outputs, which would lower standards of living.

Another alternative to asymmetric information is to make information abundantly and inexpensively available through the internet and other data sources.

The Disadvantages of Asymmetric Information

In some circumstances, asymmetric information may have near fraudulent consequences, such as adverse selection, which describes a phenomenon where an insurance company encounters the probability of extreme loss due to a risk that was not divulged at the time of a policy's sale.

For example, if the insured hides the fact that he's a heavy smoker and frequently engages in dangerous recreational activities, this asymmetrical flow of information constitutes adverse selection and could raise insurance premiums for all customers, forcing the healthy to withdraw. The solution is for life insurance providers is to perform thorough actuarial work and conduct detailed health screenings, and then charge different premiums to customers based on their honestly-disclosed risk profiles.

Overcoming Asymmetric information

• Invest in the business – give signals. With second-hand car markets, if you were buying from a one-off private buyer, you would have reasons to be suspicious about the quality of the car. However, if a second-hand car dealer invests in a large property and advertising, it is a signal that the firm intends to stay in the long-term. In this case, the firm has a greater incentive to sell reliable cars and avoid costs to its reputation. This is why the price of a second-hand car from big dealers is higher than from private seller.
• Give warranties. Another way to avoid asymmetric information is for second-hand car salesmen to give warranties for the reliability of their car.
• Employ a mechanic to test car. If you are going to buy a second-hand car for $7,000, it would be worth paying $100 to a qualified mechanic to run the car through independent tests. This would give you more information. Also, the car dealer would be wary of trying to sell ‘duds’ if you were bringing a qualified mechanic to test.
• No claims bonuses. To overcome asymmetric information in insurance, insurers will give big discounts for ‘no claims bonuses’ this is the best way of gaining better information about ‘careful’ and ‘unlucky’ consumers.