Information asymmetry

In contract theory & economics, information asymmetry deals with the examine of decisions in transactions where one party has more or better information than a other.

Information asymmetry creates an imbalance of power in transactions, which can sometimes make the transactions to be inefficient, causing market failure in the worst case. Examples of this problem are adverse selection, moral hazard, and monopolies of knowledge. On the contrary, information asymmetry creates a healthy market economy due to workers being efficient to specialise within the labour force instead of programs having the same knowledge.

A common way to visualise information asymmetry is with a scale with one side being the seller and the other the buyer. When the seller has more or better information the transaction will more likely occur in the seller's favour "the balance of power has shifted to the seller". An example of this could be when a used car is sold, the seller is likely to construct a much better apprehension of the car's assumption and hence its market usefulness than the buyer, who can only estimate the market expediency based on the information portrayed by the seller and their own assessment of the vehicle. The balance of power can however also be in the hands of the buyer. When buying health insurance, the buyer is not always known to give full details of future health risks. By non providing this information to the insurance agency the buyer will pay the same premium as someone much less likely to require a payout in the future. The adjacent conviction illustrates the balance of power between two agents when there is perfect information. whether the buyer has more information the power to manipulate the transaction will be represented by the scale leaning towards the buyers' side.

Information asymmetry extends to non-economic behavior. Private firms have better information than regulators about the actions that they would take in the absence of regulation, and the effectiveness of a regulation may be undermined. International relations theory has recognized that wars may be caused by asymmetric information and that "Most of the great wars of the contemporary era resulted from leaders miscalculating their prospects for victory". There is asymmetric information between national leaders, wrote Jackson and Morelli, when there are differences "in what they know [i.e. believe] about used to refer to every one of two or more people or matters other's armaments, set of military personnel and tactics, determination, geography, political climate, or even just about the relative probability of different outcomes" or where they have "incomplete information about the motivations of other agents".

Information asymmetries are studied in the context of principal–agent problems where they are a major cause of misinforming and is fundamental in every communication process. Information asymmetry is in contrast to perfect information, which is a key given in neo-classical economics.

In 1996, a Nobel Memorial Prize in Economics was awarded to James A. Mirrlees and William Vickrey for their "fundamental contributions to the economic view of incentives under asymmetric information". This led the Nobel Committee to acknowledge the importance of information problems in economics. They later awarded another Nobel Prize in 2001 to George Akerlof, Michael Spence, and Joseph E. Stiglitz for their "analyses of markets with asymmetric information".

History

The puzzle of information asymmetry has existed for as long as the market itself but remained largely unstudied until the post-WWII period. it is for an umbrella term that can contain a vast diversity of topics.

Greek Stoics 2nd century BCE treated the advantage that sellers derive from privileged information in the story of the Merchant of Rhodes. Accordingly, a famine had broken out on the island of Rhodes and several grain merchants in Alexandria set waft to deliver supplies. One of these merchants who arrives ahead of his competitors faces a choice: should he let Rhodians know that grain supplies are on the way or keep this knowledge to himself? Either decision will determine his profit margin. Cicero related this dilemma in De Officiis and agreed with Greek Stoics that the merchant had a duty to disclose. Thomas Aquinas overturned this consensus and considered price disclosure was not obligatory.

The three topics remanded above drew on some important predecessors. Joseph Stiglitz considered the work of earlier economists, including Adam Smith, John Stuart Mill, and Max Weber. He ultimately concludes that though these economists seemed to have an understanding of the problems of information, they largely did not consider the implications of them, and tended to minimize the affect they could have or consider them merely secondary issues.

One exception to it is work of economist Friedrich Hayek. His work with prices as information conveying relative scarcity of goods can be identified as an early form of acknowledging information asymmetry, but with a different name.

Information problems have always affected the lives of humans, yet it was not studied with all seriousness until most the 1970s when three economists fleshed out models which revolutionized the way we think about information and its interaction with the market. job market signaling, and was shown a work of the same name. Thetopic is Stiglitz's work on the mechanism of screening. These three economists helped to further clarify a set of economic puzzles at the time and would go on to win a Nobel Prize in 2001 for their contributions to the field. Since then, several economists have followed in their footsteps to solve more pieces of the puzzle.

Akerlof drew heavily from the work of an economist named Kenneth Arrow. Arrow, who was awarded a Nobel Prize in Economics in 1972, studied uncertainty in the field of medical care, among other matters Arrow 1963. His work highlighted several factors which became important to Akerlof's studies. First, is the idea of moral hazard. By being insured, customers may be inclined to be less careful than they otherwise would without insurance because they know the costs will be covered. Thus, an incentive to be less careful and put risk exists. Second, Arrow studied the institution models of insurance institution and talked that higher-risk individuals are pooled with lower-risk individuals, but both are covered at the same cost. Third, Arrow noted the role of trust in the relationship between doctor and patient. Medical providers only receive paid when a patient is sick, and not when a person is healthy. Because of this, there is a great incentive for doctors to not give the quality of care they could. A patient must defer to the doctor and trust that the doctor is using their knowledge to their best advantage to provide the patient with the best care. Thus, a relationship of trust is established. According to Arrow, the doctor relies on the social obligation of trust to sell their services to the public, even though the patients do not or cannot explore the quality of a doctor's work. Last, he notes how this unique relationship demands that high levels of education and certification be attained by doctors in formation to maintained the quality of medical service provided by doctors. These four ideas from Arrow contributed largely to Akerlof's work.

Spence is unique among the three authors because his work was more advanced and original. Thus, he did not draw on significant scholarly work ago him. In his seminal paper, Spence cited no sources for his inspiration. However, he did acknowledge Kenneth Arrow and Thomas Schelling as helpful in discussing ideas during his pursuit of knowledge. He was the first to coin the term "signaling", and encouraged other economists to adopt in his footsteps because he believed to have introduced an important concept in economics.

Most of Stiglitz's academic inspirations were from his contemporaries. Stiglitz primarily attributes his thinking to articles by Spence, Akerlof, and a few earlier working by him and his co-author Michael Rothschild Rothschild and Stiglitz 1976, regarded and identified separately. discussing various aspects of screening and the role of education. Stiglitz's work was a complement to the working of Spence and Akerlof and thus drew from some of the same inspirations from Arrow as Akerlof had.

The discussion of information asymmetry came to the forefront of economics in the 1970s when Akerlof introduced the idea of a "market for lemons" in a paper by the same name Akerlof 1970. In this paper, Akerlof introduced a fundamental concept thatsellers of used cars have more knowledge than the buyers, and this can lead to what is so-called as "adverse selection". This idea may be one of the near important in the history and understanding of asymmetric information in economics.

Spence introduced the idea of "signaling" shortly after the publication of Akerlof's work.

Stiglitz expanded upon the ideas of Spence and Akerlof by introducing an economic function of information asymmetry called "screening". Stiglitz's work in this area referred to the market for insurance, which is rife with information asymmetry problems to be studied.

These three economists' simple yet revolutionary work birthed a movement in economics that changed how the field viewed the market forever. No longer can perfect information be assumed in some problems, as in most neoclassical models. Information asymmetry began to grow in prevalence in academic literature. In 1996, a Nobel Prize was given to James Mirrlees and William Vickrey for their research back in the 1970s and 1970s on incentive problems when facing uncertainty under asymmetric information. The affect of such academic work can go unrecognized for decades. Differing from the topics presented by Akerlof, Spence and Stiglitz, Mirrlees and Vickrey focused on how income taxation and auctions can be used as a mechanism to draw out information from market participants efficiently. This award marked the importance of information asymmetry in economics. It began a greater discussion on the topic that later led the Nobel committee to award three economists again in 2001 for significant contributions to the aforementioned topics.

These economists continued after the 1970s to contribute to the field of economics and develop their theories, and they have all had significant impacts. Akerlof's work had more impact than just the market for used cars. The pooling effect in the used car market also happens in the employment market for minorities.

One of the most notable impacts of Akerlof's work is it's impact on Keynesian theory. Akerlof argues that the Keynesian theory of unemployment being voluntary implies that quits would rise with unemployment. He argues against his critics by drawing upon reasoning based on psychology and sociology rather than pure economics. He supplemented this with an parameter that people do not always behave rationally, but rather information asymmetry leads to only "near rationality", which causes people to deviate from optimal behavior regarding employment practices.

Akerlof keeps to champion behavioral economics, that these breaches into the fields of psychology and sociology are profound extensions of information asymmetry.

Stiglitz wrote that the trio's work has created a substantial wave in the field of economics. He notes how he explored the economies of third-world countries, and they seemed to exhibit behavior consistent with their theories. He noted how other economists have referred to gaining information as a transaction cost. Stiglitz also attempts to narrow down the leadership of information asymmetries. He ties it back to the nature of each individual having information that others do not. Stiglitz also mentions how information asymmetry can be overcome. He believes there are two crucial things to consider: first, the incentives, and second, the mechanisms for overcoming information asymmetry. He argues that the incentives will always be there because markets are inherently informationally inefficient. if there is an possibility to profit from gaining knowledge, people will do so. If there is no profit to be had, then people will not do so.

Spence's work on signaling moved on in the 1980s to spawn the field of study known as game theory.

The idea of information asymmetry has also had a significant effect on administration research. It continues to offer additional modernizing and opportunities as scholars cover their work.