How to Fix the Problem of Asymmetric Information

Fact checked by Suzanne KvilhaugReviewed by Robert C. KellyFact checked by Suzanne KvilhaugReviewed by Robert C. Kelly

Asymmetric information is inherent in most (if not all) markets. Let’s say, a patient admitted to a hospital probably has less information about illness and recovery options than the doctor. Markets compensate for this by developing agency relationships where both parties are incentivized to produce an efficient outcome.

In this case, the doctor has the incentive to make an accurate diagnosis and prescribe the correct treatment, or else they may be sued for malpractice or otherwise have their reputation suffer. Since doctors and patients have repeat relationships, the law of repeat dealings also shows that both actors are better off in the long run if they deal fairly with one another.

Key Takeaways

• Asymmetric information arises when one party to an economic transaction has more or better information than another and uses that to its advantage.
• This causes market failures, including examples like adverse selection and the so-called lemons problem.
• Solutions include regulations, warranties or guarantees, insurance, and informing consumers about the quality and reputation of products and sellers.

The Market for Lemons

Free markets only work according to economic models if the information offered is perfectly understandable and all parties know all that is available. This is called symmetric information—buyers and sellers, producers and consumers, borrowers and lenders all have the same complete information. But, sellers typically know more than buyers about the products and producers know more about their goods than consumers.

The Lemons Problem

The lemons problem refers to issues that arise due to asymmetric information possessed by the buyer and the seller. The lemons problem was first put forward in a research paper, The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism, written in the late 1960s by George A. Akerlof, an economist and professor at the University of California, Berkeley.

The tag phrase identifying the problem came from the example of used cars Akerlof used to illustrate the concept of asymmetric information, as defective used cars are commonly referred to as lemons.

The lemons problem exists in the marketplace for both consumer and business products (and in investing) related to the disparity in the perceived value of investment between buyers and sellers. The lemons problem is also prevalent in the financial sector, including insurance and credit markets.

For example, in the realm of corporate finance, a lender has asymmetrical and less-than-ideal information regarding the actual creditworthiness of a borrower.

Important

The term lemon is slang and is commonly used to describe highly defective products that are worth much less than believed. Lemons are usually associated with vehicles.

Asymmetric Information and Adverse Selection

According to economic theory, asymmetric information is most problematic when it leads to adverse selection in a market. Consider life insurance where a customer may have information about their risk that the insurance company cannot easily obtain.

To compensate for a lack of information, the insurance company may increase all premiums to offset the risk of uncertainty. This means that the riskiest individuals (who ostensibly value insurance most highly) effectively price out some of the less risky individuals (who aren’t willing to pay as much).

Adverse selection theoretically leads to a sub-optimal market even when both parties in an exchange are dealing rationally. This sub-optimality, once understood, provides an incentive for entrepreneurs to assume risk and promote a more efficient outcome.

Methods for Addressing Adverse Selection

There are a few broad methods of addressing the adverse selection problem. We’ve listed some of the most common ones below.

Warranties, Guarantees, Refunds

One very clear solution is for producers to provide warranties, guarantees, and refunds. This is particularly notable in the used car market. In addition to seller-granted warranties, third-party companies can offer their own warranties in the form of insurance that comes at some cost to the consumer.

The government can also step in to regulate the quality of goods sold. In most states, there are “lemon laws” where a consumer can return a faulty used car to the dealer no questions asked within a certain initial period if it turns out to be a piece of junk.

Monitoring

Another intuitive and natural response is for consumers and competitors to act as monitors for each other. For instance:

• Consumer Reports, Underwriters Laboratory, notaries public, and online review services such as Yelp help bridge gaps in information.
• Seller ratings on eBay and Amazon.
• Uber driver reviews, and product ratings are all examples of crowdsourcing reputation in this way.

Online reputation management (ORM) software solutions allow companies to track what consumers say about a brand on review sites, social media, and search engines.

Mechanism Design Theory

The study of efficient market arrangements is known as mechanism design theory, which is a more flexible offshoot of game theory. Notable contributors include Leonid Hurwicz, Eric S. Maskin, and Roger B. Myerson.

What Is Asymmetric Information?

Asymmetric information happens when one party has more information or knowledge about a product, service, or transaction than the other party. This typically happens when a product seller or a company knows more about what they’re selling than the buyer. There are cases, though, where buyers may possess more knowledge about something they’re buying than the seller.

What Is a Lemon?

The term lemon is used in the financial world to describe a defective product whose worth is less than its value. It is commonly used in the automotive industry to describe defective vehicles that are sold for more than they are worth.

Which Ways Can Asymmetric Information Be Avoided?

While truly symmetric information tends to be an impossible feat to achieve, there are ways to mitigate the existence of asymmetric information. Introducing regulations and legislation where sellers must make full disclosures about the goods and services they sell is one way to ensure all parties are well-informed. Other methods include offering warranties and guarantees, and allowing consumers to return goods for refunds.

The Bottom Line

Information in a financial transaction tends to be asymmetric. This means that one party—usually the seller—has more information about the product or service than the buyer. Realistically, it isn’t possible to ensure that both parties have the same amount of knowledge. But, there are ways to ensure that transactions are fair for both parties. Legislators can enact regulations and sellers can offer guarantees, warranties, and refunds to remedy any problems consumers may encounter. This gives buyers recourse even if they may not be privy to information before they make a purchase.

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