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Economics of Asymmetric Information

1.0 Adverse Selection

Adverse selection is an economic concept that frequently appears in the literature for insurance and risk management. The main idea is that buyers and sellers have different or asymmetric information about goods, financial instruments or products, and those traders with better information about product quality will selectively participate in trades which benefit them the most—at the expense of their counterparts. The concept also exists in a more general sense of imperfect information between parties in any exchange and in any human action undertaken.

Many other studies in the insurance industry have been done that suggest that informational asymmetries are not a great problem in the insurance industry (de Meza & Webb 2001), and at times they tend to be mitigated by “propitious selection” (Hemenway 1990) so as to become “favorable selection” instead of adverse selection. Indeed, some scholars have concluded that the presences of small doses of asymmetric information is actually beneficial for the insurance market (Thomas 2008)—even generating a “welfare-enhancing effect of private information” as a “consequence of the fact that sellers’ price-setting behavior is in line with adverse selection theory” (Hoppe & Schmitz 2015).

This theory is connected by the wider, devastating critique of central planning, which cannot work simply because no single mind or committee possesses the “fragmented” and “dispersed” social or economic information needed to plan correctly (Hayek 1945; Sowell 1996; Holcombe 1995; Cobin 2009: 242-250). Some have thus been led to consider asymmetric information to be a “market failure.” The basic tenet of this premise is that since markets do not perfectly inform buyers and sellers about any transaction or good traded, they fail, with the presumption being that Pareto-efficient or Pareto-preferred public policy can be enacted to mitigate this malfunction.

1.1 Market for Lemons

The classic example of asymmetric information was presented in Akerlof's “Market for Lemons” paper (1970). He argues that the quality of goods can decline under conditions of information asymmetry between buyers and sellers, such that only “lemons” remain, e.g., a used car or other good that is found to be defective after it has been purchased. On the one hand, imperfectly informed buyers often cannot distinguish between a high-quality used car or other good and a “lemon,” nor can they easily know the history of the used good in question. Knowing this fact, they choose to pay a price for a car that is fixed between a good one and a lemon.

On the other hand, sellers know often whether the product for sale is a lemon, and will only sell it to those buyers with an intermediate price, never offering higher-quality goods at that discount. For instance, the owner of a carefully maintained, never-abused, good used car will be unable to get a high enough price to make selling that car worthwhile. However, the owner of the opposite quality used car will happily do so.

Eventually, as enough non-lemon sellers leave the market, the average willingness-to-pay of buyers also will decrease, given that the average quality of remaining goods in the market has decreased, such that the market quality continues its downward spiral. As a result, the pricing strategy by uninformed buyers creates an adverse selection problem that drives higher-quality goods from the market, perhaps resulting it is eventual collapse. The result is that in a market with asymmetric information with respect to quality, will have characteristics similar to those described by Gresham's Law: the bad drives out the good. In order to address this problem, firms adapt by varying prices according to different qualities (Phlips 1983: IV).

1.2 Imperfect Information as Market Failure

The knowledge problem provides a new critique of welfare economics. Indeed, “the sum total of knowledge available in an economy ‘never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess.’ It follows that nobody—and that obviously includes the government—is able to take a God's eye view of economic or social life” (Prowse 2014).

Ignorance or imperfect information—the very thing assumed away in static models—is precisely the object that allows entrepreneurial profit. “A state of market disequilibrium is characterized by wide-spread ignorance. Market participants are unaware of the real opportunities for beneficial exchange which are available to them in the market. The result of this state of ignorance is that countless opportunities are passed up” (Kirzner 1973: 69). So, are informational asymmetries really “failures?”

Consumer ignorance certainly leads them to make suboptimal choices at times. The market becomes the culprit for producing socially-unacceptable results, particularly when a firm or person deceives another to their hurt.

1.3 Framing Contracts

Along with strong property rights, the legal institution of contracting, which spells out the “rules of the game” for economic actors (North 1992), facilitates exchange and, when done well, dramatically reduces transactions costs. However, no contract eliminates informational asymmetry problems entirely, even though contracts have improved over time through legal trial and error. “In reality it is usually impossible to lay down each party's obligations completely and unambiguously in advance, and so most actual contracts are seriously incomplete” (Hart & Holmström 1987: 112).

The literature on contracting suggests that contractual forms have large effects on behaviour. Incentives matter. Curiously, the marketplace is full of “fairly simple contracts” (Chiappori & Salanie 2002: 34), that leave open the potential for greater transactions costs in the future. The field of law and economics has its core objective to incorporate economic concepts such as information asymmetry, moral hazard, and adaptation to changed circumstances, in the interpretation and analysis of contracts and disputes, as well as to develop a contract doctrine (Goldberg 2012).

  1. Signalling

Sellers beleaguered by adverse selection will try to protect themselves by screening customers or by identifying credible quality “signals.” In contract theory, signalling means that an agent credibly conveys information about himself to a principal. For example, prospective employees send signals to potential employers about their ability levels by obtaining education credentials (Spence 1973; Weiss 1995; Hungerford & Solon 1987). The value of doing so resides in the fact that employers believe that such education is positively correlated with greater ability, since it is difficult for lower-quality employees to attain. Thus, it enables employers to reliably distinguish lower-ability workers from higher-ability ones.

Signalling blossomed alongside the theory of asymmetric information within economic transactions. Inequalities of access to information twists “normal” market exchange. However, parties involved in trade can circumvent asymmetry problems if one party sends a signal that reveals a bit of relevant information to the other (Spence 1973). That party interprets the signal and adjusts purchasing decisions accordingly—perhaps bidding up the pre-signal price, and thus resulting in many ancillary problems.

The amount of time, energy and money that the sender (or agent) should spend on sending a signal will depend on how much the receiver (or principal, usually the buyer) can trust the signal to be an honest revelation of information. In many cases, equilibrium conditions will arise, until such time that trust breaks down.

  1. Moral Hazard

In economics, a moral hazard occurs when one person takes greater risk (e.g., does not lock his doors) because someone else (usually an insurer) bears the cost of the increased risk. Moral hazard situations are most frequently seen after financial or insurance transactions are completed, wherein the actions of one party change to the detriment of another (e.g., a claim must be paid).

Moral hazard arises especially when information asymmetries between buyers and sellers occur, where the soon-to-be risk-taking party to a transaction knows more about his intentions than the party paying the consequences for his behaviour. In such situations, the party with more information about intended actions has an incentive to behave inappropriately from the perspective of the party with less information.

Moral hazard also arises within the principal-agent problem, where the agent (or manager), acts on behalf of another (the principal). The agent usually has greater information about his actions and intentions than the principal does, since it is difficult for him to monitor the agent (Laffont & Martimort 2002: 147-148). Accordingly, the agent may have an incentive to act inappropriately (from the viewpoint of the principal) if the interests of both are not aligned.

2.0 Law and Economics

Economists study human action aiming at consistent ends by efficient means, including the use of institutions that minimize costs and uncertainty, such as the law. Judges and lawyers are expected to act rationally, and will be criticized otherwise. Economic models are thus useful in explaining law, legislation, and legal institutions.

2.1 Law Versus Legislation

There is a difference between law and legislation, each of which has distinct origins. On the one hand, legislation is subject to inefficiencies due to lack of knowledge and public choice problems, and is thus more distortive to human action by injecting inefficient transaction costs into the market process. Ideological-driven divorce policy which caters to special interest groups that profit from it (e.g., lawyers, judges, feminist activists, forensic psychologists and social workers) is perhaps the most glaring example of a legislative social distortion (Baskerville 2007; 2008). On the other hand, law reduces information costs, facilitating cooperation.

2.2 The Injection of Economics into Law

In terms of production, companies have two interesting costs to consider in terms of potential legal sanctions: product safety (i.e., design costs), plus the present value of implicit costs of awards made to clients who will be injured by using their products, which is largely unknown if it is a function of activist legislation. Such damages are determined in the judicial process. Consequently, firms compare the expected costs of production with the expected benefits in order to maximize profits. This result is attained by the producer when he adjusts the level of safety until the real cost of additional product safety is equal to the implicit price of the added accidents that will occur by increasing production and, by implication, consumption (Cobin 2009). Thus, economic theory predicts how people will respond to changes in law or legislation. If law and legislation can be utilized to achieve social goals, economics can predict public policy’s effect on efficiency, and improve the efficiency of contracts (Cooter & Ulen 1997: 3, 5).

2.4 The Coase Theorem and Its Use to Justify Judicial Activism or Interventionism

The Theorem says that where the costs of concluding a contract are low, the rule of law will not affect the level of negative externalities like pollution because people will have already found cooperative, efficient solutions. Thus, when there is low transactions cost bargaining between parties, judges will not be able to change the level of negative externality. The Coase Theorem says that the individual actions in the market will allocate property rights to their highest valued or most efficient use. Efficient allocation occurs automatically, no matter how property rights are initially assigned by a court. The activity of judges in such cases, therefore, creates a negative external cost to others, amounting to a superfluous cost to society in general.

However, when transactions costs are high enough to impede private bargaining, which is often the case, judicial activism with the goal of finding the efficient solution become necessary. Thus, many judges now study economic modes in order to make more efficient rulings. The inverse use of the Coase Theorem thus suggests that under conditions of high transactions costs and/or barriers to free market exchange, court can improve property rights allocations.

Fortunately, there are several real-world examples that demonstrate both Coasean bargaining and spontaneously-emerged market grading institutions. The rare coin grading industry provides perhaps the most important, pure market example of how buyers and sellers eliminate information asymmetries by using market-based (rather than government) regulation.

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