Chapter 19: Asymmetric Information

Asymmetric Information:

Sometimes one party to a transaction has better information that’s relevant to its outcome than the other. This is called asymmetric information. As you might imagine there’s several problems that can arise and rightly be anticipated by prospective buyers and sellers when there’s asymmetric information. As a result, some otherwise beneficial economic transactions don’t take place. Precisely those missed transactions where the (marginal) benefit to buyers exceeds the (marginal) cost to sellers create deadweight loss when they don’t happen.

There’s basically two main problems arising from asymmetric information: adverse selection and moral hazard. We further separate out adverse selection of buyers versus adverse selection of sellers.

An example scenario where there’s adverse selection of sellers is in the used item market. A seller of a used car typically has better information about the quality of the car than the prospective buyer does. There’s a problem when the buyer is worried about getting ripped off: They have no way to verify the quality of the car and might be afraid they’ll buy a bad car. As a result buyers aren’t willing to pay as much for a specific car as they would have otherwise. This is bad because with lower than necessary prices those sellers who have good cars available might decide against selling because they don’t get enough in return. As a result the pool of available used cars are disproprotionately populated with bad cars.

Adverse selection of buyers is exemplified by the insurance market—the person taking out the insurance policy probably has better information about their own underlying riskiness than does the insurance company. This is bad because insurance companies might be worried that those asking for insurance coverage disproportionately have greater need for insurance and therefore higher costs. As a result the insurance company must raise its rates. But then any buyer who doesn’t think they’ll get their money’s worth for their insurance will decide not to take out a policy. That’s bad for the insurance company because they make profits when they sell policies to people who don’t use them and they lose money when they have to cover their clients’ claims. As a result of higher prices that discourage less risky clients from buying insurance in the first place, the pool of those actually covered and paying for insurance involves the highest risk clients who then have to pay high insurance rates.

Moral hazard arises when there’s an incentive mismatch. Basically the person performing the market relevant actions has different incentives than those benefiting from it. An example is in the labor market where an hourly worker incurs the costs of additional effort from working hard without receiving the benefits. If the employer is unable to monitor how hard the worker is working, the worker might slack off. Labor economists call this ‘shirking’. Another example goes back to the insurance example. Once a person is covered by an insurance policy they may fail to take adequate precautions. One reason for this is that they’ll bear the entire costs of the additional effort (to avoid a bad outcome) but won’t bear any of the costs of rectifying the bad outcome. An example would be device insurance for smart phone. If you have device insurance (or even just a protective case) you might be less caution with your device than if you don’t. Probably you’ll treat the uncased smartphone like it’s made out of glass (because it is).

In all of these cases the possibility of the potential issue introduces inefficiency in the form of deadweight loss due to the economic transactions that don’t occur. There’s an array of solutions that can possibly shift the information balance or correct incentives to fix the situation.

In the case of adverse selection of sellers a good solution is to have some sort of third party verification (this restores information credibly) such as through Vehicle Identification Number lookups (sites like TrueCar or CarFax). Sellers of good cars can offer warranties on the assumption that a warranty would be too costly for sellers of bad cars to offer but not too costly for the seller of good cars.

In the case of adverse selection of buyers, there’s health exams in the case of medical and life insurance (this solves the information imbalance), there’s regulations on when people can sign up for insurance (if you can only purchase health insurance during ‘open enrollment’ the seller doesn’t have to be as worried that the patient suspects a major/costly medical problem as the main motivation for why they’re purchasing a policy).

Deductibles solve the moral hazard problem: The insured person has to pay some portion of the costs up to some threshold when insurance coverage picks up the rest. This creates a disincentive to overuse of insurance and an incentive to take whatever precautions are possible.

Monitoring solves the moral hazard problem by restoring the information problem. Sometimes that’s not possible, in such cases it might be possible to condition payment on productivity such as paying a piece-rate wage. This won’t work everywhere because not everything is easily quantifiable. In places where there’s not a key output to condition payment on it makes sense to instead give workers an ownership stake in the organization which aligns their incentives with the performance of the firm.