Asymmetric Information

Asymmetric information is a situation in which one side of a transaction has relevant knowledge that the other side lacks. A borrower knows more about their own ability to repay than the bank, a seller knows more about a product's defects than the buyer, and a company's managers know more about its prospects than outside investors. When the better-informed party can use that advantage, prices may not reflect true value and some mutually beneficial deals never take place.

The study of asymmetric information transformed microeconomics from the 1970s onwards. George Akerlof, Michael Spence and Joseph Stiglitz shared the 2001 Nobel Prize in economics for analysing markets with this feature. It is an umbrella concept: its main consequences are adverse selection, illustrated by Akerlof's market for lemons, and moral hazard, which underlies the principal-agent problem. Together they are a major source of market failure.

Picture buying a second-hand bicycle from a stranger online. The seller knows whether the gears slip or the frame was once cracked; you only see the photos. Because you cannot tell a well-kept bike from a neglected one, you offer a cautious price, and the owner of a genuinely good bike may decide it is not worth selling to you.

The same thing happens whenever one side of a deal cannot see what the other sees. People respond by asking for guarantees, checking reviews, hiring inspectors or simply walking away, and each of those responses has a cost. In extreme cases a market for a perfectly good product never forms at all.

Economists distinguish two forms of the problem.

• Hidden information before the deal. One party knows a characteristic the other cannot observe, such as health, driving skill or product quality. This leads to adverse selection, in which the people most eager to trade at a given price are disproportionately the ones the other side would rather avoid.
• Hidden action after the deal. One party's behaviour cannot be fully observed once the contract is signed, such as how carefully an insured driver drives or how hard a manager works. This leads to moral hazard and to the agency costs that arise when owners delegate decisions.

Markets have developed two main responses. In signalling, the informed party takes a costly action that is easier for a high-quality type to afford. Michael Spence's 1973 model showed that education can work as a job-market signal even if it did not raise productivity, because it is less costly for more able workers to obtain. Warranties, brand investment and a company's decision to pay a dividend are often analysed as signals.

In screening, the uninformed party designs choices that make the informed party reveal itself. Michael Rothschild and Joseph Stiglitz showed in 1976 that insurers can offer a menu of policies, for example a low-premium plan with a high deductible and a high-premium plan with full cover, so that low-risk and high-risk customers sort themselves. Lenders screen through collateral requirements and loan terms.

• Credit markets. Joseph Stiglitz and Andrew Weiss argued in 1981 that raising interest rates can attract riskier borrowers, so banks may ration credit instead of simply charging more. A credit score and formal underwriting reduce the information gap.
• Securities markets. Rules requiring a prospectus and audited financial statements, and enforcement by bodies such as the SEC, exist largely to narrow the gap between issuers and investors. Bans on insider trading address the misuse of private information.
• Rating and verification. A credit rating summarises information about a borrower so that investors do not each have to investigate it, although rating agencies are paid by issuers, a conflict highlighted in the 2008 financial crisis.
• Payments and onboarding. Know your customer checks and merchant risk reviews help banks and payment firms learn who they are dealing with before taking on risk.

Information economics is widely accepted, but its policy lessons are debated. Some economists argue that private mechanisms such as reputation, online reviews, independent inspection and guarantees solve most information problems without regulation, and that mandatory disclosure can produce long documents few people read. Others argue that information gaps are pervasive in finance, healthcare and insurance and justify strong disclosure rules, consumer protection and, in some cases, compulsory participation. Research in behavioural economics adds that even when information is disclosed, people with bounded rationality may not process it, so having the facts available is not the same as acting on them.

• The Nobel Prize: Economic Sciences 2001