Definition of asymmetric information

Asymmetric information is an imbalance of information that exists between buyers and sellers in a market that gives one side an unfair advantage in a transaction.

For example, when someone goes to buy a used car the seller of the car will normally know more about the car than the buyer.

Adverse selection

Adverse selection is where one party in a transaction has better information than another on which to make their buying or selling decision.

Because of adverse selection buyers and/or sellers make decisions that do not maximise welfare in a market and this leads to market failure.

Buyer advantage:

• This is where the buyer has an information advantage in a transaction.
• For example, when the buyer of car insurance has more information about their risk to the insurer than the insurance company selling them a policy.
• This means the buyer gets cheaper insurance and the insurance company receives a lower price than would be the case if the company had known about the buyer's risky driving. 
• The cost of insurance claims from risky drivers increases the costs of insurance companies and this is passed on as higher prices to other buyers of insurance. 
• Sellers can try to guard against this by screening where they ask buyers questions which can indicate their risk such as the questions on an insurance application form. 

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Seller advantage:

• Sellers often hold more information about the good or service they are selling than is available to the buyer.
• For example, a firm that sells second-hand cars knows more about the cars they sell than the buyer. 
• The seller is in a position to charge a higher price for the car than its true value (the seller knows about any faults in the car but the buyer does not).
• Sellers of higher-quality products can attract buyers by signalling where the seller offers their product such as a used car with a warranty.

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Moral Hazard

A moral hazard occurs when there is an incentive for people to change their behaviour because the negative consequences of their decisions are borne by others.

For example, if you own a car it is covered by comprehensive insurance.

Because of the insurance coverage, some people might drive their car much more recklessly than if it is not covered by insurance.

The costs of the repairs caused by reckless drivers will add to the costs of the insurance company and push up the price of insurance for everyone else.

Legislation and regulation

When goods are being bought and sold in an asymmetric situation both buyers and sellers face regulations and laws that try to correct the asymmetry.

For buyers

Governments set out rules that businesses legally need to follow such as: ‘goods of a satisfactory quality’ and ‘fit for the purpose they are used for’.

Laws will also state that buyers have a right to a refund or a replacement for goods.

For sellers

Rules and regulations are in place to protect them by requiring buyers to give complete information before they decide on a sale.

For example, when you buy car insurance you need to give the insurance company accurate information about yourself.

Advantages

The legal requirement forces buyers and sellers to give accurate information.

The cost of the policy to the government is low.  

Disadvantages

Administering, and enforcing any laws put in place.

The regulations can also increase bureaucracy, which increases business costs in markets. 

Education

Educating potential buyers it is possible for the government to reduce information asymmetry.

For example, schools and universities run courses in personal finance for students with allows them to make more informed decisions.

Advantage

Education can change long-term consumer behaviour by improving buyer decision-making.

Disadvantages

Education has an opportunity cost to the government.

There are problems assessing how effective education is in reducing information asymmetric information. 

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Public information and advertising

Governments can run public information and advertising campaigns to help potential buyers become more informed about the goods and services they are buying.

For example, governments in many countries run adverts that inform people about the health consequences of alcohol consumption. 

Advantage

Education can change long-term consumer behaviour by improving buyer decision-making.

Disadvantages

Advertising has an opportunity cost to the government.

There are problems assessing how effective advertising is in reducing information asymmetric information. 

a. Define the term asymmetric information. [2]

Asymmetric information is an imbalance of information that exists between buyers and sellers in a market that gives one side an unfair advantage in a transaction.

b. Explain how mortgage applications can be an example of asymmetric information. [4]

When a person applies for a mortgage the lender makes their lending decision based on the information given to them by the borrower.

If the person borrowing money from the lender chooses to exaggerate their income and hide previously missed payments then the lender will be making their decision based on false information in this asymmetric situation.

The borrower may be given a loan when they should not be or the interest rate they are charged should be higher than the lender offers. 

c. Explain how asymmetric information in the mortgage market might lead to adverse selection. [4]

Because insurance companies are aware of potential customers making mortgage applications with misleading information they increase the interest rate they charge to all of their borrowers.

This reduces the supply of mortgages to the mortgage market.

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