Information asymmetry

This is a condition in which at least some relevant information is known to some but not all parties
involved. Information asymmetry causes markets to become inefficient, since all the market participants
do not have access to the information they need for their decision making processes. Opposite of
information symmetry

Asymmetric Information

Information asymmetry a situation in which one party in a transaction has more or superior information
compared to another. This often happens in transactions where the seller knows more than the buyer,
although the reverse can happen as well. Potentially, this could be a harmful situation because one
party can take advantage of the other party's lack of knowledge.

Asymmetric information in Financial Markets

Asymmetric information is a problem in financial markets such as borrowing and lending. In these
markets the borrower has much better information about his financial state than the lender. The lender
has difficulty knowing whether it is likely the borrower will default. To some extent the lender will try to
overcome this by looking at past credit history and evidence of salary. However, this only gives a limited
information. The consequence is that lenders will charge higher rates to compensate for the risk. If there
was perfect information, banks wouldn’t need to charge this risk premium.

Accurate information is essential for sound economic decisions. When a market experiences an
imbalance it can lead to market failure.

Forms of Information Asymmetry: moral hazard and adverse selection

1. Adverse Selection

Adverse selection is the process by which the price and quantity of goods or services in a given market is
altered due to one party having information that the other party cannot have at reasonable cost.

It is a term used in economics that refers to a process in which undesired results occur when buyers and
sellers have access to different/imperfect information. The uneven knowledge causes the price and
quantity of goods or services in a market to shift. This results in "bad" products or services being
selected. For example, if a bank set one price for all of its checking account customers it runs the risk of
being adversely affected by its low-balance and high activity customers. The individual price would
generate a low profit for the bank.

Selecting whom to give more your money is a very important part of controlling risk. Give it to a crook,
and you lose your money. Give it to someone who is not good at handling money, and you could also
lose it. In fact, without information about those seeking funds, theory goes that you would have to
charge an average price for your money or sale item. But an average price would cause those who are
better risks or have better products to shun your offer, while those with higher risks will seek your offer,
resulting in adverse selection.

A good illustration of this principle was presented by George A. Akerlof in his article "The Market for
Lemons" for which he shared the Nobel Prize in economics in 2001. Suppose you have 2 people who

want to sell their car. The 1st person is a little old lady who rarely drove her car and kept it in good

condition. The 2nd person drove his car during his wild teenage years—speeding, drags racing, and
getting involved in a few fender benders, and to save on money, he changed the oil only once in a while.

They both come to a used car lot to sell their car, but if the car dealer or his customers couldn't
distinguish between the cars, then he would offer an average price for both cars, since a customer isn't
going to pay more than an average price without some guarantee that a higher priced car is better than
a lower-priced one. Well, the little old lady isn't suffering from dementia, so she won't accept less than
what her car is worth, while the young man, knowing a good price for his car considering its history,
gladly takes it. So what happens is that the car dealer stocks up on lemons because the lemon sellers
gladly accept his average price while the owners of sound cars don't.

The above scenario is not reality because there are ways of distinguishing the quality of cars, such as the
mileage and the year it was manufactured and the car can be inspected for dents and other damage. But
fund seekers will be harder to distinguish.

For instance, if you offer an average interest rate for your loans, the people who are better risks will go
elsewhere for their money, while the risky people will gladly take your money.
 2. Moral Hazards and Market Failure

Moral hazard is a situation where there is a tendency to take undue risks because the costs are not
borne by the party taking the risk.

In addition to adverse selection, moral hazards are also a result of asymmetric information. A moral
hazard is a situation where a party will take risks because the cost that could incur will not be felt by the
party taking the risk . A moral hazard can occur when the actions of one party may change to the
detriment of another after a financial transaction. In relation to asymmetric information, moral hazard
may occur if one party is insulated from risk and has more information about its actions and intentions
than the party paying for the negative consequences of the risk. For example, moral hazards occur in
employment relationships involving employees and management. When a firm cannot observe all of the
actions of employees and managers there is the chance that careless and selfish decision making will
occur.

An insured driver getting into a car accident is an example of a moral hazard. The driver will take risks
because the cost is not directly felt due to a transaction. The insurance company pays for the accident
and not the driver.

Asymmetric information starts the downward economic spiral for a firm. A lack of equal information
causes economic imbalances that result in adverse selection and moral hazards. All of these economic
weaknesses have the potential to lead to market failure. A market failure is any scenario where an
individual or firm's pursuit of pure self-interest leads to inefficient results.

Another type of moral hazard, sometimes called morale hazard, occurs most frequently with insurance,
where insurance coverage causes the insured to be less vigilant about controlling risk because they have
insurance to cover any losses.

What is the difference between moral hazard and adverse selection?

Adverse selection occurs when there's a lack of symmetric information prior to a deal between a buyer
and a seller, whereas moral hazard occurs when there is asymmetric information between two parties
and change in behavior of one party after a deal is struck. Moral hazard and adverse selection are two
terms used in economics, risk management and insurance to describe situations where one party is at a
disadvantage.

Adverse selection describes an undesired result due to the situation where one party of a deal has more
accurate and different information than the other party. The party with less information is at a
disadvantage to the party with more information. The asymmetry causes a lack of efficiency in the price
and quantity of goods and services.

For example, assume there are two sets of people in the population, those who smoke and do not
exercise and those who do not smoke and do exercise. It is common knowledge that those who smoke
and don't exercise have shorter life expectancies than those who don't smoke and do exercise. Suppose
there are two individuals who are looking to buy life insurance, one that smokes and does not exercise
and one that doesn't smoke and exercises daily. However, the insurance company cannot differentiate
between the individual who smokes and doesn't exercise and the other person.

The insurance company asks the individuals to fill out questionnaires to distinguish them. However, the
individual that smokes and doesn't exercise knows that answering truthfully means higher insurance
premiums, so he lies and says he doesn't smoke and exercises daily. This leads to adverse selection,
where the life insurance company is at a disadvantage and then charges the same premium to both
individuals. However, the insurance is more valuable to the non-exercising smoker than the exercising
nonsmoker because one party has more to gain.

Conversely, moral hazard occurs when a party provides misleading information and changes his
behavior when he does not have to face consequences of the risk he takes. For example, assume a
homeowner does not have home insurance or flood insurance and lives in a flood zone. The homeowner
is very careful and subscribes to a home security system that helps prevent burglaries. When there are
storms, he prepares for floods by clearing the drains and moving furniture to prevent damage.

However, the homeowner is tired of always having to worry about potential burglaries and preparing for
floods, so he buys home and flood insurance. After his house is insured, his behavior changes and he is
less attentive, leaves his doors unlocked, unsubscribes to the home security system and does not
prepare for floods. In this case, the insurance company is faced with the consequences and risks of
floods and burglaries, and the problem of moral hazard arises.
Theory of Information Asymmetry

The theory of asymmetric information was developed in the 1970s and 1980s as a plausible explanation
for common phenomena that mainstream general equilibrium economics couldn't explain. In simple
terms, the theory proposes that an imbalance of information between buyers and sellers can lead to
inefficient outcomes in certain markets.

Rise of Asymmetric Information Theory

Three economists were particularly influential in developing and writing about the theory of asymmetric
information: George Akerlof, Michael Spence and Joseph Stiglitz. All three shared the Nobel Prize in
economics in 2001 for their earlier contributions.

1. Akerlof first argued about information asymmetry in a 1970 paper entitled "The Market for
'Lemons': Quality Uncertainty and the Market Mechanism." Therein, Akerlof stated that car
buyers see different information than sellers, giving sellers an incentive to sell goods of less than
average market quality. Akerlof uses the colloquial term "lemons" to refer to bad cars. He
espouses a belief that buyers cannot effectively tell lemons apart from good cars. Thus, sellers of
good cars cannot get better than average market prices.This argument is similar to the since-
challenged Gresham's law in money circulation, where poor quality drives out bad (though the
driving mechanism is different).

2. Michael Spence added to the debate with the 1973 paper "Job Market Signaling." Spence
models employees as uncertain investments for firms; the employer is unsure of productive
capabilities when hiring. He then compares this situation to a lottery.Spence identifies
information asymmetries between employers and employees, leading to scenarios where low-
paying jobs create a persistent equilibrium trap that discourages the bidding up of wages in
certain markets.

3. It's with Stiglitz, though, that information asymmetry has reached mainstream acclaim. Using a
theory of market screening, he authored or co-authored several papers, including significant
work on asymmetry in insurance markets.Through Stiglitz's work, asymmetric information was
 placed into contained general equilibrium models to describe negative externalities that price
out the bottom of markets. For instance, the uncertain health insurance premium needed for
high-risk individuals causes all premiums to rise, forcing low-risk individuals away from their
preferred insurance policies.

Empirical Evidence and Challenges

Market research from economists Erik Bond (truck market, 1982), Cawley and Philipson (life insurance,
1999), Tabarrok (dating and employment, 1994), Ibrahimo and Barros (capital structure, 2010), and
others have questioned the existence, evidence or practical duration of asymmetric information
problems causing market failure.

Very little positive correlation between insurance and risk occurrence has been observed in real
markets, for instance. One possible explanation for this is that individuals do not actually have more
information about their risk type, while insurance companies have actuarial life tables and significantly
more experience.

Other economists, such as Bryan Caplan at George Mason University, point out that everyone is not in
the dark in real markets; insurance companies aggressively seek underwriting, for example. He also
suggests that models based on two parties are flawed, as can be evidenced by information-broking third
parties, such as Consumer Reports, Underwriters Laboratory and credit bureaus.

Economist Robert Murphy suggests that government intervention can prevent prices from accurately
reflecting known information, which can cause market failure. For example, a car insurance company
might have to raise all premiums if it cannot base its price decisions on an applicant's gender, age or
driving history.

Jaffee and Russell (1976) develop a theoretical model in which imperfect information and uncertainty
can lead to rationing in loan markets, where some agents do not receive the loan they applied for. Their
paper analyses the behavior of a loan market in which borrowers have more information than lenders
about the likelihood of default. The key feature in the model is the relationship between default
proportions and contract sizes. There is some minimum loan size at which no default is observed,
beyond that, the proportion of individuals who do not default is declining with the contract size.
Since borrowers are identical ex ante, the market interest rate incorporates a premium to take account
of the aggregate probability of default. Consequently, borrowers with low default probability pay a
premium to support low quality borrowers and credit rationing in the form of the supply of smaller-sized
loans than those demanded by the borrowers at a quoted rate may result. High quality borrowers will
prefer some rationing if the smaller loan sizes lower the market average default probabilities, thus
reducing the premium.

Stiglitz and Weiss (1981) develop a model of credit rationing, where some borrowers receive loans and
others do not. They assume that the interest rate directly affects the quality of loans because of an
adverse selection effect or moral hazard effect. Banks making loans are concerned about the interest
rate they receive on a loan, and the riskiness of the loan. For a given loan rate, lenders earn a lower
expected return on loans to borrowers with riskier projects than to good quality borrowers.

The interest rate a bank charges can affect the riskiness of the loans by either sorting prospective
borrowers (the adverse selection effect), or by affecting the actions of borrowers (the moral hazard
effect). When the price (interest rate) affects the transaction, it may not clear the market. The adverse
selection effect of interest rates is a consequence of different borrowers having different probabilities of
repaying their loans. The interest rate an individual is willing to pay may act as a screening device. Those
who are willing to pay high interest rates may, on average, be worse risks. They are willing to borrow at
high interest rates because they perceive their probability of repaying the loan to be low. As a result
there exists an interest rate that maximizes the expected return to the bank and beyond which the bank
will be unwilling to supply funds, making the supply of loans curve bend backwards.

A change in interest rates can affect the bank’s expected return from loans through the moral hazard
effect by changing the behavior of borrowers. Higher interest rates induce firms to undertake projects
with lower probabilities of success but higher payoffs when successful. Increasing the rate of interest
increases the relative attractiveness of riskier projects, for which the return to the bank may be lower.
As the interest rate rises, the average riskiness of those who borrow increases and the moral hazard
effect reinforces the adverse selection problem. Banks therefore have an incentive, in some
circumstances, to ration credit rather than to raise interest rates when there is excess demand for
loanable funds.

Williamson (1986) develops a model of credit rationing where borrowers are subject to a moral hazard
problem. Borrowers are identical ex ante, but some receive loans and others do not. A borrower and
lender are asymmetrically informed ex post about the return on the borrower’s investment project, and
the borrower will have an incentive to falsely default on the loan. Costly monitoring by lenders of
borrowers together with large-scale investment projects imply that there exist increasing returns to
scale in lending and borrowing which can be exploited by financial intermediaries. The optimal contract
between a lender and a borrower is a debt contract and the lender only monitors in the event of
default.

An increase in the loan interest rate raises the expected return to the lender, but also results in an
increase in the probability that the borrower defaults, thus increasing the expected cost of monitoring
to the lender. This, in turn, generates an asymmetry in the borrowers’ and lenders’ payoff functions,
which can lead to credit rationing. Because of the asymmetry in the payoff functions it may not be
possible for the loan interest rate to adjust to clear the market, so that some borrowers do not receive a
loan in equilibrium.

The role of Information Asymmetry and consequences for financial markets

Governments around the world try to level the information playing field among investors by regulating
the disclosure of corporate information. But what is the cost of unequal access to information?

Theoretical arguments for and against leveling the information playing field

On the one hand, uninformed investors may demand a return premium to invest in companies where
they have an information disadvantage. This return premium compensates them for their expected
losses from trading against informed investors in these companies’ stocks (Easley and O’Hara 2004). By
raising companies’ cost of capital, information asymmetry could inhibit investment and hence long-run
economic growth.

On the other hand, Hughes, Liu, and Liu (2007) argue that in a large market, uninformed investors can
diversify away such information risk, rendering information asymmetry irrelevant for the cost of capital.
Manne (1966) and Carlton and Fischel (1983) argue that allowing informed insiders to trade on their
private information causes stock prices to more accurately reflect fundamental value, increasing
welfare. Perhaps motivated by this latter view, insider trading was legal in most European countries in
the early 1990s (Posen 1991).

Kelly and Ljunqvist argue that analyst coverage of a company decreases information asymmetry; they
show that bid-ask spreads, illiquidity, and return volatility around earnings announcements which
should be positively correlated with information asymmetry increase following unrelated coverage
terminations. They also show that earnings in the quarter following an unrelated termination are no
different between companies that did and did not suffer an unrelated termination, suggesting that the
coverage terminations they study are in fact unrelated to economic fundamentals.

Because there is no evidence that future company cash flows are affected by unrelated coverage
changes, stock price decreases around unrelated coverage changes are equivalent to increases in the
cost of capital. Kelly and Ljunqvist report that merger-induced coverage terminations cause a stock’s
price to drop by about 2% and terminations induced by 9/11 cause a stock’s price to drop by about
0.6%. In contrast, merger-induced coverage initiations cause a stock’s price to increase by about 1%.

Impact on the Financial Market:

Three results of the Asymmetric Information syndrome on the financial or more precisely the credit
market are best reflected in the sourcing of external funds by the corporate. The transaction between
the borrowers offers the best example to study their practical implications.

Every firm has to inevitable take recourse to the external source of financing while preparing the mix of
owners fund and the borrowed funds. The borrowed funds come with some conditions, to be complied
by parties to these transactions. Both the parties to this financial transaction have to have exchange the
relevant information between each other. Do, both the parties pass on the symmetric information is a
moot question. It is proved by several examples in the domestic and the global finance symmetric
information is theoretical and whereas the asymmetric information is a reality.

The borrowers voluntarily or per force take recourse to concealing of the information for making their
case as a strong candidature for obtaining the external finance. In this, the efforts are done to hide
uncomfortable economic information on the real risk involved in the project. It, therefore, reduces the
ability of the lending institution to foresee the hazards inherent to the project. The feasibility and the
viability of the proposed project are miscalculated due to the imperfect information received from the
borrower. The imperfect decision made on the on the basis of imperfect information has a cascading
effect on the financial market legitimately resulting in economic crisis.

The starting point of this economic downturn due to financial mess occurring on account of this less
than perfect decision is the shifting of the priority in the utilization of the borrowed funds. The basic
purpose of the borrowing funds remains hungry or gets starved for the adequate funds in order to get
the predetermined rate of return on investment. This further increases the cost of the external finance
and retention of owners’ earnings. At times this forces crossing of the safe limits of project viability.
Subsequently, there is an unwarranted rise in the costing due to ever increasing cost component i.e.
compounding of interest. The vicious cycle of diminishing the value of assets is sets in; further leading to
the non-performing assets on one hand and the mounting bad debts on the other. It sets in the dead
burden of bad financing at micro and macro levels. The problem gets compounded due to the
monitoring cost involved in the salvaging the emerging financial crisis trading the path of downturn.

The situation is not different in the case of the capital market too. The transactions at a stock
market provide the classic example of Asymmetric information and the effects thereof. The
beneficiaries, the underwriters and the project owners, parties to the transactions, wisely use
this practice of imperfect information to their advantage at the time of stock-issue or while raising
debts, through the chosen issuance of stocks or bonds. This offers good example to prove the
proposition of signaling (Michael Spence) and the screening mechanism (Joseph Stiglitz).

Impact on the Capital Market:

Equity market works on the forward looking statements and published financial and other data made
available by the company as public information. This forms the base information on which price of
equity is determined. There are several tools available in public domain to accurately calculate the price
of equity under the given scenario. In an ideal case of perfect symmetric information being available to
all the parties in the market using the same tools, everybody will come at the same price for the equity.
Assuming a rational investor expecting rational returns and evaluating the equity as an independent
asset class, when everybody is at the same price for the equity, there isn’t a sufficient incentive for
transaction of equity. However, in practicality there is never perfect symmetric information available
about the equity. Parties with some additional information about the equity which is concealed from
others will come up with a new estimate for price of equity, and hence there will be a trade of equity.
Equity market functionality is thus based on assumption that there is asymmetric information in market
and hence every investor will have different views about price of equity. This is normal and expected
behavior because the parameters and variables defining the price of equity are huge and it is difficult for
each individual to have same amount of perfect symmetric information.

This gets ratified when we compare the rate of returns in developed and evolving markets. Daily
fluctuations in equity prices in developed markets hardly cross 1% mark as the statutory requirements in
these markets are stringent and also strictly enforced, reducing the information asymmetry to large
extent. However in developing markets; because of the inbuilt flux of a developing economy information
asymmetry is higher; and hence the getting a daily return of over 5% if very normal in these markets. So
often or not do we get to hear the case of insider trading resulting into abnormal returns. This is a
classical case of adverse selection resulting out of asymmetric information in equity markets.

Resolving the financial asymmetry problem

Until recently and even now depending on the market, there has been an unbalanced distribution of
information between buyers and sellers. Merchants have long held the advantage. With full information
over consumers, they've had the power to set prices and hide crucial information about products and
services, leaving buyers at the mercy of sellers. Consumers had few resources for unbiased information,
where they could go to find average prices for goods and services across any market from real estate
and autos to careers and travel.

This information asymmetry was negatively affecting consumers, businesses and the competitive market
in general. Consumers had to make decisions based on partial information. Too often, the only
information consumers had access to was the information provided by the same merchants who were
trying to make the sale biased and incomplete information. It wasn't too long ago when buying a car
involved going to a dealer and asking the price and specs of car with no third party information to
reference as a base point. Consumers would often end up paying far above the true value of the
automobile. Worse, some hopeless buyers ended up with "lemons," a term coined to describe cars
found to be defective only after they had been purchased.

At the same time, honest businesses that sold quality products at reasonable prices would often lose out
to their manipulative counterparts who masked subpar products with big-budget marketing ploys and
slick salespeople. All this resulted in rewarding companies whose products and services weren't actually
competitive on a level playing field, a decrease in the quality of products and a market that wasn't
efficient after all, an efficient market depends on consumers making rational decisions, and consumers
can only make rational decisions when they have full and equal access to the same information that
their seller counterparts do.

But today, a growing number of companies are emerging that shift this asymmetry of information back
to balance arming consumers with the same information that businesses have long had. This shift
toward a more balanced distribution of information benefits consumers and quality businesses alike.
With full information, consumers are able to see through marketing schemes, overpriced products and
inferior goods and services. They can then offer their business to the companies that offer the highest
quality offerings for the most reasonable price.

The market for companies that are providing consumers with this information is just beginning to
emerge, with companies like Edmunds providing information on auto specs and pricing, sites like Redfin
and Glassdoor arming consumers with information around real estate and careers respectively, and
companies like Find The Best and its network of sites offering a broad range of information on highly
considered products and services from familiar markets like cars and smartphones to newer verticals
like colleges and dog breeds. By increasing transparency and trust between buyers and sellers through
equal access to information, these companies are helping to create more efficient markets.

Minimizing Adverse Selection and Moral Hazard Risk

1. The risks of adverse selection and moral hazard makes direct financing expensive, especially for
small firms, since people are unwilling to lend or invest money in unknown entities. With their
expertise in gathering reliable information at reduced cost, financial intermediaries can extend
financing to many firms or individuals who would otherwise not get it.

2. The cure for information asymmetry is more information about potential fund receivers. The
best predictor of future creditworthiness is past creditworthiness. Checking the history of the
fund applicant reduces both adverse selection and moral hazard. There are many databases on
individuals and businesses that can be consulted to check their history. News sources can be
consulted about many businesses.

3. For lending to individuals, lenders can check the loan applicant's credit files and credit scores,
their employment history, and with the permission of the borrowers, lenders can even verify
their income with the Internal Revenue Service.

4. For lending to businesses, lenders can check any credit ratings issued by the credit rating
agencies for businesses, such as CRB's IN Kenya, as well as credit reporting agencies for
businesses, such as Dun & Bradstreet. More information is available on businesses that seek
direct financing through the issuance of stocks and bonds, because they are required by law to
 report significant financial information before offering their securities for sale, and to update
that information periodically.

5. For individuals applying for insurance, insurers can consult credit reports, and other databases.
Medical records can be check for health and life insurance applicants.

6. Requiring collateral can also reduce information asymmetry risks. Collateral reduces adverse
selection by requiring a specific value of collateral, such as 20% down payment on a house, for
instance. Collateral also lowers moral hazard risk because the borrowers stand to lose their
collateral if they do not make the required payments.

7. Requiring a minimum net worth also reduces adverse selection because only those individuals
or businesses with sufficient assets over liabilities will be considered for a loan. Moral hazard is
reduced because the borrower can be sued if they fail to make timely payments on their loans.

Reducing Moral Hazard

There are additional methods of reducing moral hazard.

1. One method for equity finance, which is financing through the issuance of stock, is to require
the managers to own a certain percentage of the company, which is often achieved through the
granting of stock options as part of the compensation package.

2. Another method for debt finance through the issuance of bonds is to require restrictive
covenants that prevent the bond issuer from taking too many risks or to restrict the amount of

debt that can be added later. By law, all bonds are required to have a 3 rd party trustee who
ensures that the bond issuer will comply with the terms of the bond.

Reducing the Cost of External Financing

Both individuals and companies generally do not like to reveal too much information, put up collateral,
or be restricted in what they can do. But the more information they are willing to divulge, the more
collateral they are willing to put up, and the more they are willing to restrict their behavior to maintain
creditworthiness, the cheaper will be their external financing.

The problems caused by asymmetric information can be lessened through signalling and screening.
Signaling: This is the provision of small bits of information that is intended to indicate other more
complete information. Sellers, for example, knowing that buyers have less information about their
products might pass along signals about product quality. Guarantees and warranties are common
signals. Brand names established over long periods of customer satisfaction and/or advertising are
another method of signalling. Of course, the signals might not be accurate and those with less quality
products might deceptively mimic the signals of the higher quality goods.

Screening: This is the attempt by those with limited information to identify indicators suggesting more
complete information. Employers, for example, commonly use grade point averages, aptitude tests, or
school quality as a means of screening out high quality from low quality prospective employees. Of
course, screening can also be inaccurate. A good student, from a good school, with a high grade point
average, might be a lousy worker.

Remedies for information failure

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.

7. In addition to direct intervention, government may establish organisations to act as regulators

and watchdogs, such as the Office of Fair Trading, which tries to ensure that firms compete
fairly, and the Competition Commission, which investigates abuse of market dominance by
firms with monopoly power. The Advertising Standards Authority (ASA) also promotes ‘ethical’
advertising and regulates the advertising industry in an attempt to improve the accuracy of
information available to consumers. The ASA is a self-regulatory body established in 1962, and
insists that adverts should be ‘..honest, decent and truthful..’ ‘.. and in line with the principles of
fair competition generally accepted in business..’.

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.

4. Nudging towards more effective decisions

5. Behavioural economists argue that small nudges can be used to counteract the effect of
misleading or overly complex information.
One problem is that in certain situations individuals may not be able to exert self-control, and select less
than healthy choices. For example, food packaging will clearly portray food in its most appealing light,
but this may reduce an individual’s self-control when making choices. Hence, although an individual may
be over-weight, self-control may not be exerted, and the individual eats an amount larger than is
optimal for their immediate health and life expectancy.

Information is not equally available to everyone. Asymmetric information results because efficient
information search inevitably stops short of complete information. Some people obtain more benefits
from information than others, are willing to incur higher search costs, and thus end up knowing more.
Or they incur lower information search costs and have easier access to the information. In a market,
sellers tend to have more information about the good than buyers. Asymmetric information gives rise to
adverse selection, moral hazard, and the principal-agent problem. These problems can be lessened
through signaling and screening.

Asymmetric information is an imbalance in the quality or quantity of information possessed by two or

more people. Some people simply have more information than others. This asymmetry is a direct
consequence of efficient information search. Because the acquisition of information, like the production
of any good, uses scarce resources and incurs an opportunity cost, no one knows everything and
everyone is ignorant about something (usually most things). In particular, those who stand to benefit
more are rationally motivated to incur greater cost and thus obtain more information.

The unequal distribution of information throughout the economy gives rise to three related problems --
adverse selection, moral hazard, and the principal-agent problem. Asymmetric information can result in
market inefficiency that limits the quality of goods exchanged in a market (adverse selection). It can also
lead to a discrepancy between who benefits from an action and who incurs the cost (moral hazard). And
it can cause a disconnection in the objectives of an agent authorized to represent a principal and the
principal who is unaware of the specific actions of the agent (principal-agent problem).

Edmunds: Building Trust Between Car Buyers and Sellers

The auto industry is one such market in which buyers are increasingly gaining access to equal
information and being put on a more level playing field.
In 1970, the term "information asymmetry" was used in a research paper to describe a situation in
which the seller knows more about a product than the buyer. This imbalance in information between
the two parties left consumers making highly considered purchase decisions without having full
knowledge about the products they were buying--and oftentimes the car they ended up buying was not
what was advertised. This caused massive distrust between buyers and sellers on the whole, regardless
of whether the seller was being honest or not.

"Buying a new or used car is the second biggest considered purchase that anyone has to make," said
Edmunds CEO Avi Steinlauf. "It's also a stressful and, sometimes, overwhelming process. At
Edmunds.com, we've dared to ask the question: 'Why does car buying have to be this way?' We strive to
make it easier for people to find the car that meets their every need. A big component of that is to make
sure car buyers have as much accurate information as possible. After all, a more informed shopper
makes for a better quality shopper at the dealership, which benefits both the buyer and the dealer,"
Steinlauf said, adding that Edmunds is focused on building trust between car buyers and sellers.

"But information is just one hurdle. We've also taken steps to listen to car buyers and address parts of
the process that bother them the most. For example, our research found that the biggest unmet need of
car buyers is simply getting an actual price on a specific car. We've tackled this issue head-on with our
new Price Promise product, which allows participating dealers to offer instant, real prices on cars listed
on Edmunds.com's inventory pages. It's remarkable how simply providing a fair, upfront price can get
deals off on the right foot. Our focus moving forward is to continue identifying these pain points and
figure out how Edmunds.com can play a role in building a bridge of trust between car shoppers and
dealers."

The auto industry, however, is only one such market in which companies have entered with the mission
of informing and empowering consumers. The real estate market is another market in which consumers
are gaining more access to information with which to make more informed decisions.

Redfin: Arming Homebuyers with Equal Access to Information

Investing in real estate or buying a home is one of the biggest purchase decisions a consumer will make
in their lifetime. Yet in the past, consumers in the market for a new home had very limited insight into
how much an average home in a particular area should actually cost, how long a property had been on
the market or access to important historic details about a property of interest.
Until recently, companies like Redfin had not entered the real estate market--providing homebuyers
with critical information like average home prices by neighborhood, a property's historic sale pricing, as
well as details on similar homes for comparison purposes.

"With complete access to the databases that realtors themselves use, Redfin is one of the only websites
to show consumers exactly what a realtor sees about what's for sale and what just sold, giving regular
folks the best possible shot at buying the right house for the best possible price," said Redfin CEO Glenn
Kelman. "We send instant alerts to mobile devices so consumers often know about homes for sale
before their traditional agent--and the other buyers competing to buy that house. The data we gather
firsthand from our own Redfin real estate agents also goes directly to consumers. Our website publishes
near-real-time data on whether thousands of home-buyers signed offers in greater or lesser numbers
the weekend after an interest-rate spike or a stock-market jolt, so our customers know first when the
market's slowing down. This is the juicy stuff that home-buyers need when sweating out the biggest
purchase of their lives."

Glassdoor: Putting Career Information Into Context for Job Seekers

Career information--from average salaries to insight into company management--is another area in
which companies have long held an advantage over individual job seekers. Even today, salaries are
something most employees keep private. And even prospects who are offered interviews rarely gain real
insight into how a particular company is run, how the company manages, or other important indicators
that could help shape an informed decision. Candidates often make decisions based on biased and
limited insight offered up by the hiring party. Glassdoor, however, has made it its mission to solve this
problem.

"Glassdoor is on a mission to help people make more informed career and job decisions. Over the past
five years, we've disrupted how people make these important decisions by increasing workplace
transparency," said Glassdoor's SVP of People Allyson Willoughby. "People are more information hungry
than ever and today, Glassdoor is influencing them as they make decisions through researching what it's
really like to work at a company, from company culture to what management is like to salary potential
and more."
Related Issues

Information failure

Information failure is another, 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:

The job applicant, who fails to reveal at a job interview that they do not have a particular skill for the
job.

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.

The cigarette manufacturer, who does not inform smokers of the true health risk of smoking.

The buyer of a financial product, who is unaware of the true level of risk, as in the case of derivative
products.
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 focussed on and use to compare options and make
decisions. They may create a bias in favour of a particular decision, and perhaps against the best
interests of the individual. For example, research by Warwick University discovered that credit card
users focussed 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.

Framing

Individual choices also seem highly sensitive to the process of framing, which also provides a bias in
favour of a particular decision. How a choice, or how a new piece of information is ‘framed’ is likely to
affect the choice, even when two options have identical outcomes.

For example, numerous experiments have shown that when faced with either winning a given amount
of money or losing it, individuals are rather more averse to the loss. For example, individuals are likely to
fear a loss, of say £50, rather more than they feel they have gained from being offered £50.

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 analysed 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 business’s prospects to buy or sell shares and make a personal gain.

Extra costs
From a firm’s 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 people’s behaviour 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:

Consumers may under-estimate the net private and external benefit of merit goods.

Consumers may over-estimate the net private and external cost of demerit goods.

Fishermen may not know the size of fish stocks and, as a result, over-fishing current stocks.

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.

The Efficient Market Hypothesis (EMH)

The EMH tries to explain why stock market prices appear to follow a random walk i.e.; that their daily
variation is a random value following the Gaussian distribution. This random walk of stock market prices
had been originally noticed by Bachelier (1900) but had only become widely realized since Kendall
(1953), at which point it was considered something rather unusual. The reason that a random walk
appeared unusual was because from Neo‐Classical Economic theory (specifically Walrasian General
Equilibrium Theory), markets were supposed to approach equilibrium over the medium to long run and
they were supposed to do this by tâtonnement (the process of finding the market clearing prices to
precisely match supply and demand). Prior to Arrow (1951) and Debreu (1959), it had not yet been
realised just how restrictive the assumptions would have to be in order to enable Walrasian equilibrium
whilst keeping the system from degenerating into indeterminacy1. The EMH was originated by Fama
(1965) in his PhD thesis, and given its modern three‐type form in Fama (1970). The EMH explains the
random walk by assigning its occurrence to uncertainty i.e.; the existence of the future, whereby future
events are unknown to or mispredicted by the market. As we now know that determinate Walrasian
equilibrium requires perfect knowledge of the future, uncertainty causes substantial long‐term
deviations from expected behaviour.

There are three main forms of EMH, each becoming successively stronger in implication:

1. Weak form: That market price correctly represents all the information contained in the record of past
prices and trading volume

2. Semi‐strong form: The previous, and also that market prices rapidly adapt to new information and
correctly represent not only all past information, but also all present information currently widely
known.

3. Strong form: The previous two, and also that market prices not only correctly represent all past and
present information, but also accurately represent predicted future information and that the random
walk occurs due to mis‐predictions by the market about the future.

These forms all assume that the cost of credit is linear and uniform for all investors that transaction
costs do not exist and that information asymmetry does not exist. Of course, none of these are true in
reality but modern markets approximate these assumptions for the most part.

There is substantial empirical evidence2 proving that generally speaking, in most cases over the long
run, no one company or group can consistently outperform the market. This implies that market prices
are always as true & fair as possible over the long term, and that therefore the strongest form of EMH
mostly applies, falling back to at worst semi‐strong in liberal capital Economies such as the UK. Note that
the EMH requires investors to be rational which is also a requirement of Neo‐Classical Economic theory.
It also implies that there is no point in studying the past price behaviour of a stock when making an
investment decision, and for semi‐strong and strong forms there is no point in studying any past
information at all! This would mean that market analysts and fund managers work entirely by luck (and
therefore do not deserve the fortunes they are paid).
Problems with the Efficient Market Hypothesis

There are many arguments which have been used to discredit the EMH over the decades. Many focus on
market anomalies such as the January effect where the price of small‐cap stocks will rise abnormally
during the first few days of trading in a new year (Pietranico & Riepe [2004]), or the existence of long‐
term successful investors such as Warren Buffet or George Soros, but there are far more problematic
prima‐facie problems at a theoretical level. The three most important of these problems are as follows;

Problem 1: Information Asymmetry

One obvious requirement of EMH is that new information must circulate around all investors very
quickly indeed if even semi‐strong EMH is to be possible. Good information is costly to generate and
rapidly loses value as more people learn it (Chen [2005]), so there is an obvious vested interest against
the widespread sharing of information. Empirical studies show that good information tends to be
hoarded by investors – indeed, often there are even deliberate attempts at disseminating mis‐
information by one investor to other investors! (Akerlof [1970]) Yet the empirical record (Patell &
Wolfson [1984]) would suggest that news is incorporated into price within ten minutes despite that
substantial disparities in investor access to information exist. This problem of how the market is really so
able to adjust its prices so accurately and so quickly when such information asymmetry exists has
occupied a lot of recent research which we shall come to shortly.

Problem 2: Investors are not rational

Investors are people, and they don’t always behave rationally. Just like the fashion for skirt lengths,
markets also undergo fashionable trends – certain industries or stocks will become fads, leading to
investor over‐confidence or under and market bubbles and crashes. In 1996 in response to an ever‐
rising bull market in the US stock market, Federal Reserve chairman Alan Greenspan warned against
“irrational exuberance” – yet those who heeded his words lost millions as the market sped up even
faster as the crash everyone knew was coming came closer. As Keynes once said, "Markets can remain
irrational longer than you can remain solvent".

Problem 3: Stock market crashes happen far too often

According to EMH, substantial stock market movements should be rare and not severe due to the
properties of normally distributed randomness. Unfortunately, as we have learned to our cost, severe
market crashes are a fundamental feature of competitive markets in general – as Ormerod (2005)
correctly points out, failure & extinction is the statistical norm rather than the exception.

References

Akerlof, G.A.(1970), ‘The Market for "Lemons": Quality Uncertainty and the Market Mechanism’,
Quarterly Journal of Economics, Vol.84, August, pp.488-500.

Estrin, S. and Laidler, D(1995), Introduction to Microeconomics, 4th ed., Prentice Hall/Harvester
Wheatsheaf, Hertfordshire, UK.

Gibson, H.R.(1987), Asymmetric Information in Insurance Markets: A Situation of Moral Hazard,.

Hillier, B.(1997), The Economics of Asymmetric Information, Macmillian Press, Hampshire, UK.

Jackson, J. and McConnell,C.R.(1985), Economics, 2nd Australian ed., McGraw-Hill, Sydney, Australia.

Nicholson, W.(1998), Microeconomic Theory: Basic Principles and Extensions, 7th ed., The Dryden Press,
Orlando, Florida, USA.

Pindyck, R.S. and Rubinfeld, D.I.(1989), Microeconomics, 2nd ed., Macmillian Press, USA.

Rees, R.(1989), ‘Uncertainty, Information and Insurance’, in Hey, J.D.(eds), Current Issues in
Microeconomics, Macmillian, Hampshire, UK.

Stigler, G.J.(1961), ‘The Economics of Information’, Journal of Political Economy, Vol.69, June, pp.213-
225.

Stiglitz, J.E.(1993), Economics, W.W. Norton & Company, New York, USA.

Varian, H.R.(1990), Intermediate Microeconomics: A Modern Approach, 2nd ed., W.W. Norton &
Company, New York, USA.

http://www.businessdictionary.com/definition/information-asymmetry.