REPORT ON

ASYMMETRICAL
INFORMATION

By: Charulata Das (15045)

Gurpreet Kaur (15058)

ABSTRACT
This report focuses on ASYMMETRICAL INFORMATION what it means,
how it works and its relevance in todays world. We present the theorys
implications for market behavior and the market institutions that are created to
mitigate the adverse effects implied by the theory.
The problem of asymmetric information occurs when one party of an economic
transaction has insufficient knowledge about the other party to make accurate
decisions. The moral hazard, on the other hand, is the risk that one party to a
contract can change their behavior to the detriment of the other party once the
contract has been concluded. In insurance market the moral hazard is tendency by
which people expend less effort protecting those goods which are insured against
theft or damage.
Key Words: Asymmetric Information, Moral Hazard, Insufficient knowledge,
Lemons market, Insurance markets, Signaling, Screening.

INTRODUCTION
Why are brand goods popular? Why does a McDonalds make more sales than a
local competitor next door? Why do some people prefer to buy used cars from a
used car salesman rather than from an individual? Of two job applicants with
similar skills, why does the one with higher qualification get the job? All of the
above, brands, used car salesmen, degrees and qualifications are examples of
market institutions set in place to level information asymmetries.
It is empirically clear that people possess different information. The information
they possess affects their behavior in many situations. Consider buying goods, for
example, the seller adjusts the price of an item based on her knowledge of the
prices of similar items on the market and the condition of the item among other
factors. The buyer similarly can have information about the prices of similar items
in the market. But what he probably does not have is the same depth of information
about the quality of the item as its seller. There is clearly an information
asymmetry between the two parties at issue.
The concept of information asymmetry was able to explain many common
phenomena that could not be otherwise explained when it was first introduced in
the early 1970s. Since then it has become a valuable tool in the field of economics
and it is used to explain a diverse set of phenomena. Its significance was
established well before the year 2001 when the original authors of the theory,
George Akerlof, Michael Spence and Joseph Stiglitz received the Nobel Prize in
Economic Sciences.
The purpose of this paper is to give the reader a good overview of the asymmetric
information theory and its significance to economics research. We will discuss the
theory and its applications based on economics literature.

The research problem set for this study can be characterized as follows:
First of all we aim to study and explain the theory of asymmetric
information and to study its implications. This includes explaining the key
concepts of the theory and also finding out the strengths and weaknesses of
the theory.
Secondly, we want to find out some useful applications of the theory. We
also want to see how well the theory holds in these instances.
Lastly we will try to find some real life examples and some new applications
where the theory can be utilized.

LITERATURE REVIEW
The study will be conducted in the form of a literature review. This theory first
introduced in economic context and, although it has also been applied to other
fields of study, there is more than enough subject material to discuss the theory in
this field.
The intended audience is mostly students wishing to familiarize themselves with
the concepts discussed. Other interested parties could include practitioners wanting
to understand the theory of their markets better.
The name asymmetric information theory is used throughout the report to refer to
the multi-disciplinary body of research based on the ideas presented in the
Novelists papers.
1. Following the seminal work of Akerlof (1970) and
Rothschild and Stiglitz (1976), a large theoretical
literature has stressed the key role of asymmetric
information in financial markets.

The concept of asymmetric information was first introduced in George A.

AKERLOFS 1970 paper The Market for "Lemons": Quality Uncertainty and the
Market Mechanism. In the paper, Akerlof develops asymmetric information with
the example case of automobile market. His basic argument is that in many
markets the buyer uses some market statistic to measure the value of a class of
goods.
MICHAEL SPENCE continues the ideas of George A. Akerlof in his
1973 paper Job Market Signaling. He divides markets into two
classes: those where there are few players in the market and they
can establish a reputation as signalers and those where the
players in the market are numerous and change frequently.
Spence concentrates on the latter market where signals need to
be interpreted without prior knowledge of the individual signaler.
He uses job market as an example in the paper. JOSEPH STIGLITZ
in his 1975 paper The Theory of Screening, Education, and the
Distribution of Income explore whether this could be used by the
seller (employer) to screen the applicants (potential employees)
into categories that reflect their productivity or some other
capability. Stiglitz states that there are many important
differences in the qualities of goods, individuals, brands and other
items. He defines screening as identifying these qualities. Further,
devices that perform screening activities are called screening
devices.
2. NARENDRA SINGH, STELIOS KAVADIAS, RAVI SUBRAMANIAN,
(2015):
Product Quality and the Value of Asymmetric Information Under
Supplier-Specified contracts.

Original equipment manufacturers (OEMs) sometimes face the

decision of whether to make a critical component for a product inhouse or to source it from a supplier. Though sourcing from a
supplier with a more favorable cost structure than the OEM would
be more efficient for the supply chain, the supplier could be in a
position to specify contract terms and thus leave a lower share of
the profit for the OEM.

They also investigated the impact of asymmetric information

regarding the cost structure of the OEMs in-house option. They
showed that, under certain conditions, asymmetric information
may be desirable not only for the OEM, but also for the supplier -the less-informed player.

3. ASHOK S. RAI, STEFAN KLONNER (2007):

Adverse Selection in Credit Markets: Evidence from a Policy
Experiment
They found evidence for adverse selection in credit markets:
risker borrowers are willing to pay higher interest rates than safer
borrowers are. The data are from an Indian Financial institution
where interest rates are determined by competitive bidding. The
government imposed an interest rate ceiling in 1993: They
examined changes in default patterns before and after this policy
change.. They isolated adverse selection from moral hazard and
to distinguish private information on riskiness from publicly
observed riskiness.

4. SANDIP MITRA, DILIP MUKHERJEE, MAXIMO TORERO

AND SUJATA VISARIA (2014)
Asymmetric Information and Middleman Margins: An
Experiment with Indian Potato Farmers
This was an experiment where potato farmers were randomly chosen in two Indian
districts and were provided information about prices at which middlemen resold
their output, found no significant average treatment effects on traded quantities or
revenues, but both became more responsive to market price variations. The results
were confirmed predictions of a model of ex post bargaining and sequential price
competition between village middlemen and external middlemen, where farmers

lack direct access to wholesale markets. Alternative explanations such as collusion,

simultaneous price competition and insurance via relational contracts between
middle men and farmers can be ruled out.

5.ANANT SUDARSHAN AND PRABHAT BARNWAL (2015)

Asymmetric information and the energy-efficiency of durable
goods
Liquid Petroleum Gas (LPG) is a modern cooking fuel, which is
convenient, reliable, and does not, like many traditional fuels,
pollute ones kitchen and lungs. The Government of India heavily
subsidizes LPG in order to induce households to switch from
dirtier fuels like kerosene and aims to raise adoption of LPG from
50% in 2009 to 75% by 2015 (Mo PNG, 2009).
One way to improve access while reducing cost is to increase the
efficiency of energy use. Many countries promote efficiency by
providing information on appliance efficiency, in order to reduce
the asymmetry of information between vendors and customers
and boost customer demand for efficiency. The study will innovate
by measuring the monetary cost of asymmetric information for
energy-using durables in a randomized-controlled trial.
6.FATEMEH ABBASI BENIAL, MOHSEN NAZARI AND HOMA
HADIAN(2014)
Does asymmetric information only threaten the insurers benefits?
In this article, the way asymmetric information emerges in
purchasing process has been investigated. The existence of
asymmetric information and the insurers and policy holders
benefits affected by which have been analyzed and tested
practically through interviews and participant observations. The
interviewees included 42 life insurance experts in Central

Insurance of Islamic republic of Iran. The interviews information

was extracted through content analysis and the results were
finally tested through participant observation in real market in 9
insurance companies branches (27 branches). The findings of
interviews analysis are indicative of the fact that asymmetry of
information in the process of purchasing life insurance in Iran is
very obvious and this asymmetry mainly stems from the insurers
not giving transparent and correct information to policy holders.
This affects policy holders choice of life insurance type and
insurance company and also policy holders future benefits.
Besides, this challenge has been recognized as the main reason of
complaints filed in Central insurance of Islamic Republic of Iran in
this realm.

OBJECTIVE
This report has only one objective, which is to
discuss the asymmetric information theory in
economics literature, its consequences and
solutions to the problem arising from it.

METHODOLOGY
Information failure is significant market failure and can occur in two basic
situations. Firstly, information failure exists when some, or all, of the participants
in an economic exchange do not have perfect knowledge. Secondly, information
failure exists when one participant in an economic exchange knows more than the
other, a situation referred to as the problem of asymmetric, or unbalanced,
information.
In both cases there is likely to be a misallocation of scarce resources, with
consumers paying too much or too little, and firms producing too much or too
little. Information failure is common and appears to exist in numerous market
exchanges.
It can be argued that markets work best, that is they are at their most efficient,
when knowledge is perfect and is evenly shared by all the parties in a transaction.
Hence, asymmetric knowledge is an economic problem because one party can
exploit their greater knowledge.
There are many examples of information failure associated with economic
transactions, including the following cases:
1. The job applicant, who fails to reveal at a job interview that they do not have
a particular skill for the job
2. The estate agent, who exploits the fact that a potential buyer of a property
has very little knowledge about the property, and any possible problems.
3. The cigarette manufacturer, who does not inform smokers of the true health
risk of smoking.
4. The buyer of a financial product, who is unaware of the true level of risk, as
in the case of derivative products.
5. The seller of a pension, who misleads purchasers about the financial value of
the pension. Indeed, widespread pension 'miss-selling' by large UK
insurance companies, occurred at the end of the 1990s.

Decision-making bias
Anchoring
Behavioural economists argue that individuals may be subject to anchoring bias
when making simple and complex decisions, which acts as a constraint on the
exercise of rational choice. Anchors can be visual images or sounds that
individuals become focused on and use to compare options and make decisions.
They may create a bias in favor of a particular decision, and perhaps against the
best interests of the individual. For example, research by Warwick University
discovered that credit card users focused more on the minimum payment required
when looking at their credit card statement than the total sum owed, and this might
cause them to run up higher debts that they would do without this low fee anchor.
The Lemons Problem

When parties to a transaction are ignorant of certain aspects of the transaction,

such as the quality of the product they are buying, they are forced to make
assumptions, often based on price. For example, a buyer may assume that goods
are of poor quality if their price is low and that goods are of high quality if their
price is high.
In some markets, only low quality products will be sold - the so-called lemons
problem. The lemons problem was first analyzed by American economist George
Akerlof in 1970. Akerlof explored the problem associated with pricing second hand
cars in the USA, which he called a lemons market a lemon is a derogatory term
for a poor quality second-hand car. However, the lemon's problem has many wider
implications in terms of understanding information failure in general.
For example, in terms of second hand cars, buyers may be suspicious of the
motives of seller, and wonder whether the car is a lemon. If an individual buys a
new car for 30,000 and tries to sell on the second-hand market shortly after, they
may be forced to accept a much lower price, given that buyers will be suspicious of

the seller's motive. Not having all the facts, potential buyers are likely to assume
the worst and expect the car to have a problem - in other words, it is a lemon.
Therefore, given that second hand cars will generally attract a low price, only those
sellers who actually have poor quality cars will use this market. After a short
period, it can be predicted that all cars sold on the second hand car market will be
lemons.
When applying this concept to other markets it can be suggested that, whenever
there is information failure, there is the possibility that markets will become
lemons markets. If so, the supply of good quality products will fall and the supply
of poor quality will products rise.
The principal-agent problem
Asymmetric information is also associated with the principal-agent problem. In an
increasingly complex world, individual decision making often relies on the advice
given by experts, and a potential principal-agent problem can occur whenever
decision makers rely on advice from others with more knowledge than they have.
For example, the shareholders of firms, the principals, usually delegate
responsibility for day-to-day decision making to appointed managers, the agents.
This creates a situation of asymmetric knowledge, with managers knowing much
more than the shareholders, and raises the possibility of inefficiencies, especially
when shareholders and managers have different objectives.
Examples of these inefficiencies include situations when managers decide to take
the easy life, knowing that shareholders will not find out, and managers deciding
to cheat and not reveal information to shareholders. This may occur in situations
involving insider dealing, where managers can exploit their knowledge of a
businesss prospects to buy or sell shares and make a personal gain.

Extra costs
From a firms perspective, the principal-agent problem can increase costs, and
make the firm less efficient than it could be. These inefficiencies include the costs
associated with monitoring the performance of the managers and having to pay a
premium to attract the best managers.

Moral hazard
Moral hazard occurs when peoples behavior is less careful than it could be, either
because they believe that their carelessness will not be found out, or because they
are encouraged to behave carelessly. This occurs because there is insurance
protecting them from the adverse effects of their careless decision. For example, a
pupil at school can idle along because they believe, either that their parents will
provide insurance against their idling, or that the State will provide them with an
income if they fail to get a job.
There are many other examples of information failure, including the following
situations:
1. Consumers may under-estimate the net private and external benefit of merit
goods.
2. Consumers may over-estimate the net private and external cost of demerit
goods.
3. Fishermen may not know the size of fish stocks and, as a result, over-fishing
current stocks.
4. Firms may provide misleading information about products, such as
producers of cosmetics claiming to make people beautiful, holiday brochures
making resorts appear more attractive, and car drivers not knowing how
much pollution they are creating.

Analysis
Remedies for Information Asymmetry
Clearly, government has a considerable role in trying to ensure that some of these
information failures are reduced or eliminated. The two basic strategies are to
increase both the supply of, and demand for, information.
Increasing the supply of information:
Options to increase the supply of knowledge include:

1. Government may force producers to provide accurate information about

products through accurate labeling. For example, requiring that the alcoholic
content of drinks is printed on alcoholic drinks, and stating the E numbers
found in a product E numbers are the European system for indicating
chemical additives in food and drink.
2. Public broadcasts to improve knowledge may also be made, such as
informing smokers and drinkers of the true cost of their habit. To help
inform the public, a government can subsidize public service TV and radio
broadcasting, as in the case of BBC TV and radio.
3. Laws may be passed to force public limited companies to be more
transparent, and publish their financial accounts, as well as have them
audited to ensure accuracy.
4. Government may also regulate advertising standards to make advertising
more informative, and less persuasive.
5. Employers may be forced to request that job applicants disclose information
about themselves, such as whether they have a criminal record.
6. Government may force car owners to have their vehicles regularly checked
by a Ministry of Transport (MOT) test, which provides some basic
information to potential buyers. All cars over 3 years old must be tested each
year, and this gives some assurance to potential buyers that the car is road
worthy.
Increasing the demand for information
1. Market theory suggests that demand for knowledge will increase if it is
provided freely, or at low cost, hence consumers should not have to pay for
information. However, consumers may become overwhelmed with
information and fail to take it into account.
2. Government may also promote the formation of pressure groups such as
anti-smoking groups, which campaign for more knowledge to be made
available by producers.

3. In addition, promoting literacy, numeracy, and IT skills may help increase

the demand for information. Having the skills to acquire knowledge can
create an increase in demand for knowledge, and a greater appreciation of
the value of information in making rational choices.

SCREENING

Screening in economics refers to a strategy of combating adverse selection, one of

the potential decision-making complications in cases of asymmetric information.
The concept of screening was first developed by Michael Spence (1973), and
should be distinguished from signaling, which implies that the informed agent
moves first.
For purposes of screening, asymmetric information cases assume two economic
agentswhich we call, for example, Abel and Cainwhere Abel knows more
about himself than Cain knows about Abel. The agents are attempting to engage in
some sort of transaction, often involving a long-term relationship, though that
qualifier is not necessary. The "screener" (the one with less information, in this
case, Cain) attempts to rectify this asymmetry by learning as much as he can about
Abel.
The actual screening process depends on the nature of the scenario, but is usually
closely connected with the future relationship.
In education economics, screening models are commonly contrasted with human
capital theory. In a screening model used to determine an applicant's ability to
learn, giving preference to applicants who have earned academic degrees reduces
the employer's risk of hiring someone with a diminished capacity for learning.

Examples

 Second degree price discrimination is an example of screening whereby a

seller offers a menu of options and the buyer's choice reveals his private
information. For example, a business traveler that refuses a weekend stay
over reveals to the airline that he is in fact a business traveler and therefore
has a higher willingness to pay than a leisure traveler. As another example, a
consumer with a high willingness to pay for quality may choose to purchase
a more expensive iPod with 128GB of memory to a cheaper version with
less memory.
An employer seeking a salesperson may offer a contract with a low base
salary supplemented with a commission when sales are made. A potential
employee who privately knows he is bad at sales will self-select away from
this firm while a potential employee who privately knows he is good at sales
would accept such a contract.

Contract theory
In contract theory, the terms "screening models" and "adverse selection models"
are often used interchangeably. An agent has private information about his type
(e.g., his costs or his valuation of a good) before the principal makes a contract
offer. The principal will then offer a menu of contracts in order to separate the
different types. Typically, the best type will trade the same amount as in the firstbest benchmark solution (which would be attained under complete information), a
property known as "no distortion at the top". All other types typically trade less
than in the first-best solution (i.e., there is a "downward distortion" of the trade
level).Optimal auction design (more generally known as Bayesian mechanism
design) can be seen as a multi-agent version of the basic screening mode. Contracttheoretic screening models have been pioneered by Roger Myerson and Eric
Maskin. They have been extended in various directions, e.g. it has been shown that
in the context of patent licensing optimal screening contracts may actually yield
too much trade compared to the first-best solution. Applications of screening
models include regulation, public procurement, and monopolistic price
discrimination. Contract-theoretic screening models have been successfully tested
in laboratory experiments and using field data.

SIGNALLING

Michael Spence originally proposed the idea of signaling. He proposed that in a

situation with information asymmetry, it is possible for people to signal their type,
thus believably transferring information to the other party and resolving the
asymmetry.
JOB-MARKET SIGNALLING
In the job market, potential employees seek to sell their services to employers for
some wage, or price. Generally, employers are willing to pay higher wages to
employ better workers. While the individual may know his or her own level of
ability, the hiring firm is not (usually) able to observe such an intangible trait
thus there is an asymmetry of information between the two parties. Education
credentials can be used as a signal to the firm, indicating a certain level of ability
that the individual may possess; thereby narrowing the informational gap. This is
beneficial to both parties as long as the signal indicates a desirable attributea
signal such as a criminal record may not be so desirable.
SPENCE 1973 "JOB MARKET SIGNALING" PAPER
ASSUMPTIONS AND GROUNDWORK
Michael Spence considers hiring as investment under uncertainty, analogous to
buying a lottery ticket. Of the observable attributes on an applicant, the observable
attributes are called indices, while the signal refers to attributes that are
manipulable by the applicant. Applicant age is thus an index, since it does not
change at the discretion of the applicant. On the basis of previous experience of the
market the employer is supposed to have conditional probability assessments over
productive capacity given a certain combination of indices and signals. The
employer updates his beliefs regarding his upon observing the employee
characteristics.

The paper is concerned with a risk-neutral employer. The offered wage is the
expected marginal product. Signals may be acquired by sustaining signaling costs
(monetary and not). If everyone invest in the signal in the exactly the same way,
then the signal can't use as discriminatory, therefore a critical assumption is made:
the costs of signaling are negatively correlated with productivity. This situation as
described is a feedback loop: the employer updates his beliefs upon new market
information and updates the wage schedule, applicants react by signaling and
recruitment takes place.
Michael Spence studies the signaling equilibrium that may result from such a
situation, he began his 1973 model with an hypothetical example: suppose that
there are two types of employeesgood and badand that employers are willing
to pay a higher wage to the good type than the bad type. Spence assumes that for
employers, there's no real way to tell in advance which employees will be of the
good or bad type. Bad employees aren't upset about this, because they get a free
ride from the hard work of the good employees. But good employees know that
they deserve to be paid more for their higher productivity, so they desire to invest
in the signalin this case, some amount of education. But he does make one key
assumption: good-type employees pay less for one unit of education than bad-type
employees. The cost he refers to is not necessarily the cost of tuition and living
expenses, sometimes called out of pocket expenses, as one could make the
argument that higher ability persons tend to enroll in "better" (i.e. more expensive)
institutions. Rather, the cost Spence is referring to is the opportunity cost. This is a
combination of 'costs', monetary and otherwise, including psychological, time,
effort and so on. Of key importance to the value of the signal is the differing cost
structure between "good" and "bad" workers. The cost of obtaining identical
credentials is strictly lower for the "good" employee than it is for the "bad"
employee.
THE RESULT
Spence discovered that even if education did not contribute anything to an
employee's productivity, it could still have value to both the employer and
employee. If the appropriate cost/benefit structure exists (or is created), "good"
employees will buy more education in order to signal their higher productivity.

The increase in wages associated with obtaining a higher credential is sometimes

referred to as the sheepskin effect, since sheepskin informally denotes a
diploma. It is important to note that this is not the same as the returns from an
additional year of education. The "sheepskin" effect is actually the wage increase
above what would normally be attributed to the extra year of education. This can
be observed empirically in the wage differences between 'drop-outs' vs.
'completers' with an equal number of years of education. It is also important that
one does not equate the fact that higher wages are paid to more educated
individuals entirely to signalling or the 'sheepskin' effects. In reality education
serves many different purposes to individuals and society as a whole. Only when
all of these aspects, as well as all the many factors affecting wages, are controlled
for, does the effect of the "sheepskin" approach its true value. The debate is not so
much about whether there should be any public funding at all; but what the correct
level of funding should be. In purely economic terms, the optimal level of public
funding would equal the total public benefits from the educated populationthe
private value of the signal would be excluded.

Conclusion
A lot of economic theories about asymmetric information, while logically correct,
have been rendered empirically obsolete. We are not suggesting that this new world
is perfect in every way, and indeed privacy is one of the major concerns. Still, the
passing of many information asymmetries will lead easier trade, higher
productivity, and better matches of people to jobs and to each other.
These changes also cast new light on the costs of a political system that produces
many new regulations but repeals very few old ones. The American regulatory
apparatus is increasingly out of date. It is geared to problems that peaked in the
previous generation or even earlier. We should revisit the topic of regulatory
reform, with an eye toward making more regulations temporary, or having
automatic sunset provisions, unless they are consciously and intentionally renewed
for reasons of their continuing usefulness.

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