Information asymmetry
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In economics, information asymmetry occurs when one party to a transaction has more or better information than the other party. (It has also been called asymmetrical information). Typically it is the seller that knows more about the product than the buyer, however, it is possible for the reverse to be true: for the buyer to know more than the seller.
Information asymmetry models assume that at least one party to a transaction has relevant information whereas the other(s) do not. Some asymmetric information models can also be used in situations where at least one party can enforce, or effectively retaliate for breaches of, certain parts of an agreement whereas the other(s) cannot. In adverse selection models the ignorant party lacks information while negotiating an agreed understanding of or contract to the transaction, whereas in moral hazard the ignorant party lacks information about performance of the agreed-upon transaction or lacks the ability to retaliate for a breach of the agreement. An example of moral hazard is when people are more likely to behave recklessly if insured, either because the insurer cannot observe this behavior or cannot effectively retaliate against it, for example by failing to renew the insurance. An example of adverse selection is when people who are high risk are more likely to buy insurance, because the insurance company cannot effectively discriminate against them, usually due to lack of information about the particular individual's risk but also sometimes by force of law or other constraints.
Examples of situations where the seller usually has better information than the buyer are numerous but include used-car salespeople, mortgage brokers and loan originators, stockbrokers, real estate agents, and life insurance transactions.
Examples of situations where the buyer usually has better information than the seller include estate sales as specified in a last will and testament, sales of old art pieces without prior professional assessment of their value, or health insurance consumers of various risk levels.
This situation was first described by Kenneth J. Arrow in a seminal article on health care in 1963 entitled "Uncertainty and the Welfare Economics of Medical Care," in the American Economic Review.
George Akerlof later used the term asymmetric information in his 1970 work The Market for Lemons. He also noticed that, in such a market, the average value of the commodity tends to go down, even for those of perfectly good quality. Because of information asymmetry, unscrupulous sellers can "spoof" items (like software or computer games) and defraud the buyer. As a result, many people not willing to risk getting ripped off will avoid certain types of purchases, or will not spend as much for a given item. It is even possible for the market to decay to the point of nonexistence.
Although information asymmetry has recently been noted to be on the decline thanks to the Internet, which allows unknowledgeable users to acquire heretofore unavailable information such as the costs of competing insurance policies, used cars, etc. (See Freakonomics.) it is still heavily applied to human resource and personnel economics regarding incentive schemes when the employer cannot continually observe worker effort.
