Information asymmetry

In contract theory, mechanism design, and economics, an information asymmetry is a situation where one party has more or better information than the other.

Information asymmetry creates an imbalance of power in transactions, which can sometimes cause the transactions to be inefficient, causing market failure in the worst case. Examples of this problem are adverse selection,^[1] moral hazard,^[2] and monopolies of knowledge.^[3]

A common way to visualise information asymmetry is with a scale, with one side being the seller and the other the buyer. When the seller has more or better information, the transaction will more likely occur in the seller's favour ("the balance of power has shifted to the seller"). An example of this could be when a used car is sold, the seller is likely to have a much better understanding of the car's condition and hence its market value than the buyer, who can only estimate the market value based on the information provided by the seller and their own assessment of the vehicle.^[4] The balance of power can, however, also be in the hands of the buyer. When buying health insurance, the buyer is not always required to provide full details of future health risks. By not providing this information to the insurance company, the buyer will pay the same premium as someone much less likely to require a payout in the future.^[5] The adjacent image illustrates the balance of power between two agents when there is perfect information. Perfect information means that all parties have complete knowledge. If the buyer has more information, the power to manipulate the transaction will be represented by the scale leaning towards the buyer's side.

Information asymmetry extends to non-economic behaviour. Private firms have better information than regulators about the actions that they would take in the absence of regulation, and the effectiveness of a regulation may be undermined.^[6] International relations theory has recognized that wars may be caused by asymmetric information^[7] and that "Most of the great wars of the modern era resulted from leaders miscalculating their prospects for victory".^[8] Jackson and Morelli wrote that there is asymmetric information between national leaders, when there are differences "in what they know [i.e. believe] about each other's armaments, quality of military personnel and tactics, determination, geography, political climate, or even just about the relative probability of different outcomes" or where they have "incomplete information about the motivations of other agents".^[9]

Information asymmetries are studied in the context of principal–agent problems where they are a major cause of misinforming and is essential in every communication process.^[10] Information asymmetry is in contrast to perfect information, which is a key assumption in neo-classical economics.^[11]

In 1996, a Nobel Memorial Prize in Economics was awarded to James A. Mirrlees and William Vickrey for their "fundamental contributions to the economic theory of incentives under asymmetric information".^[12] This led the Nobel Committee to acknowledge the importance of information problems in economics.^[13] They later awarded another Nobel Prize in 2001 to George Akerlof, Michael Spence, and Joseph E. Stiglitz for their "analyses of markets with asymmetric information".^[14] The 2007 Nobel Memorial Prize in Economic Sciences was awarded to Leonid Hurwicz, Eric Maskin, and Roger Myerson "for having laid the foundations of mechanism design theory", a field dealing with designing markets that encourage participants to honestly reveal their information.^[15]

^ Charles Wilson (2008). "adverse selection," The New Palgrave Dictionary of Economics 2nd Edition. Abstract.
^ Dembe, Allard E. and Boden, Leslie I. (2000). "Moral Hazard: A Question of Morality?" New Solutions 2000 10(3). 257–79
^ John O. Ledyard (2008). "market failure," The New Palgrave Dictionary of Economics, 2nd Ed. Abstract.
^ Cite error: The named reference :4 was invoked but never defined (see the help page).
^ Cite error: The named reference :5 was invoked but never defined (see the help page).
^ Fullerton, Don; Wolfram, Catherine (13 May 2010). The Design and Implementation of U.S. Climate Policy (PDF). Chicago Illinois: University of Chicago Press. p. 11. ISBN 9780226269146. Retrieved 9 March 2019.
^ Jackson & Morelli 2011, pp. 35, 40–43.
^ Ikenberry 1999, p. 128.
^ Jackson & Morelli 2011, pp. 40, 42.
^ Christozov D., Chukova S., Mateev P., Chapter 11. Informing Processes, Risks, Evaluation of the Risk of Misinforming, in Foundations of Informing Science, ISI, 2009, pp. 323–356
^ "The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2001". NobelPrize.org. Retrieved 2020-03-07.
^ "The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1996". NobelPrize.org. Retrieved 2020-11-19.
^ Rosser, J. Barkley Jr. (2003-01-01). "A Nobel Prize for Asymmetric Information: The economic contributions of George Akerlof, Michael Spence and Joseph Stiglitz". Review of Political Economy. 15 (1): 3–21. doi:10.1080/09538250308445. ISSN 0953-8259. S2CID 154549764.
^ "The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2001: Information for the Public", press release from the Royal Swedish Academy of Sciences, Nobel Foundation, nobelprize.org, October 2001, accessed November 12, 2007.
^ "The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2007" (Press release). Nobel Foundation. October 15, 2007. Retrieved 2008-08-15.

[1] Charles Wilson (2008). "adverse selection," The New Palgrave Dictionary of Economics 2nd Edition. Abstract.

[Dembe,_Allard_E_2000-2] Dembe, Allard E. and Boden, Leslie I. (2000). "Moral Hazard: A Question of Morality?" New Solutions 2000 10(3). 257–79

[3] John O. Ledyard (2008). "market failure," The New Palgrave Dictionary of Economics, 2nd Ed. Abstract.

[:4-4] Cite error: The named reference :4 was invoked but never defined (see the help page).

[:5-5] Cite error: The named reference :5 was invoked but never defined (see the help page).

[6] Fullerton, Don; Wolfram, Catherine (13 May 2010). The Design and Implementation of U.S. Climate Policy (PDF). Chicago Illinois: University of Chicago Press. p. 11. ISBN 9780226269146. Retrieved 9 March 2019.

[FOOTNOTEJacksonMorelli201135,_40–43-7] Jackson & Morelli 2011, pp. 35, 40–43.

[FOOTNOTEIkenberry1999128-8] Ikenberry 1999, p. 128.

[FOOTNOTEJacksonMorelli201140,_42-9] Jackson & Morelli 2011, pp. 40, 42.

[10] Christozov D., Chukova S., Mateev P., Chapter 11. Informing Processes, Risks, Evaluation of the Risk of Misinforming, in Foundations of Informing Science, ISI, 2009, pp. 323–356

[11] "The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2001". NobelPrize.org. Retrieved 2020-03-07.

[12] "The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1996". NobelPrize.org. Retrieved 2020-11-19.

[:0-13] Rosser, J. Barkley Jr. (2003-01-01). "A Nobel Prize for Asymmetric Information: The economic contributions of George Akerlof, Michael Spence and Joseph Stiglitz". Review of Political Economy. 15 (1): 3–21. doi:10.1080/09538250308445. ISSN 0953-8259. S2CID 154549764.

[officialpressrelease-14] "The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2001: Information for the Public", press release from the Royal Swedish Academy of Sciences, Nobel Foundation, nobelprize.org, October 2001, accessed November 12, 2007.

[15] "The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2007" (Press release). Nobel Foundation. October 15, 2007. Retrieved 2008-08-15.

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