Asymmetric information refers to a situation in a contractual agreement or economic transaction where the two parties involved have disproportionate information. When one party has greater information and material knowledge than the other party in a contract, asymmetric information occurs.
Asymmetric information is otherwise called “information failure” or “imbalance information”. It is often common in transactions between buyers and sellers where the seller has higher information or knowledge about the product than the buyer. It is also possible for the buyer to have greater material knowledge than the seller.
A Little More on What is Asymmetric Information
Asymmetric information can be applied to any form of trade or transaction, in fact, it is said that all economic transactions feature asymmetric information. Inequality in the information possesses by parties in a contract or the presence of lopsided information causes asymmetric information.
Asymmetric information occurs in diverse types of trade relationships, even in medicine. For instance, a doctor, nurse or pharmacist often has greater information about medical practices and products than patients. Also, in a construction contract, an architect or an estate planner possesses greater knowledge than the owner of a piece of land.
Economic Advantages of Asymmetric
Despite that asymmetric information is attributed to information imbalance and unequal knowledge between parties in an economic transaction or contract, it has some benefits. Most healthy markets and economy desire asymmetric information was given the following benefits;
- It results in increasing knowledge between experts in specialized fields. For instance, medical doctors, pharmacists, architects, teachers and other professionals always strive to be at the top of their game by having greater knowledge.
- Asymmetric information enhances the productivity of professionals and experts in certain fields because they see their clients as being reliant on them.
Disadvantages of Asymmetric Information
Asymmetric information is not without some disadvantages, the major ones include the following;
- Asymmetric information can lead to inefficiencies in certain markets, especially if the inequality or gap between the information that both parties possess is too much.
- Imbalance information can also cause fraudulent tendencies in the market, given that some professionals use the extra information they possess about the transaction to milk extra penny from the other party.
- Asymmetric information leads to the abuse of the party with less information by the one who has greater information.
- In insurance, asymmetric information can lead to adverse selection, especially, if the policyholder hides certain information from the insurer.
Information Asymmetry in Finance
Asymmetric information abounds in the finance world, this is when finance experts possess greater material knowledge than clients. Given the unequal information possessed by the financial advisor and the customers, customers tend to seek advice from the experts. In order to limit the abuse of customers by financial advisors and experts, it is essential that information about the financial world is made available. Also, financial advisors are expected to act in utmost good faith when transacting, they must also act in the best interest of their clients. One major solution to information asymmetry in finance is the abundance of financial information that individuals can access via the internet and other publications and data sources.
Reference for “Asymmetric Information”
Academics research on “Asymmetric Information”
Dividend policy under asymmetric information, Miller, M. H., & Rock, K. (1985). Dividend policy under asymmetric information. The Journal of finance, 40(4), 1031-1051. We extend the standard finance model of the firm’s dividend/investment/financing decisions by allowing the firm’s managers to know more than outside investors about the true state of the firm’s current earnings. The extension endogenizes the dividend (and financing) announcement effects amply documented in recent research. But once trading of shares is admitted to the model along with asymmetric information, the familiar Fisherian criterion for optimal investment becomes time inconsistent: the market’s belief that the firm is following the Fisher rule creates incentives to violate the rule. We show that an informationally consistent signalling equilibrium exists under asymmetric information and the trading of shares that restores the time consistency of investment policy, but leads in general to lower levels of investment than the optimum achievable under full information and/or no trading. Contractual provisions that change the information asymmetry or the possibility of profiting from it could eliminate both the time inconsistency and the inefficiency in investment policies, but these contractual provisions too are likely to involve dead‐weight costs. Establishing which route or combination of routes serves in practice to maintain consistency remains for future research.
Asymmetric information, bank lending, and implicit contracts: A stylized model of customer relationships, Sharpe, S. A. (1990). Asymmetric information, bank lending, and implicit contracts: A stylized model of customer relationships. The journal of finance, 45(4), 1069-1087. Customer relationships arise between banks and firms because, in the process of lending, a bank learns more than others about its own customers. This information asymmetry allows lenders to capture some of the rents generated by their older customers; competition thus drives banks to lend to new firms at interest rates which initially generate expected losses. As a result, the allocation of capital is shifted toward lower quality and inexperienced firms. This inefficiency is eliminated if complete contingent contracts are written or, when this is costly, if banks can make nonbinding commitments that, in equilibrium, are backed by reputation.
Asymmetric information and risky debt maturity choice, Flannery, M. J. (1986). Asymmetric information and risky debt maturity choice. The Journal of Finance, 41(1), 19-37. When capital market investors and firm insiders possess the same information about a company’s prospects, its liabilities will be priced in a way that makes the firm indifferent to the composition of its financial liabilities (at least under certain, well‐known circumstances). However, if firm insiders are systematically better informed than outside investors, they will choose to issue those types of securities that the market appears to overvalue most. Knowing this, rational investors will try to infer the insiders’ information from the firm’s financial structure. This paper evaluates the extent to which a firm’s choice of risky debt maturity can signal insiders’ information about firm quality. If financial market transactions are costless, a firm’s financial structure cannot provide a valid signal. With positive transaction costs, however, high‐quality firms can sometimes effectively signal their true quality to the market. The existence of a signalling equilibrium is shown to depend on the (exogenous) distribution of firms’ quality and the magnitude of underwriting costs for corporate debt.
Testing for asymmetric information in insurance markets, Chiappori, P. A., & Salanié, B. (2000). Testing for asymmetric information in insurance markets. Journal of political Economy, 108(1), 56-78. The first goal of this paper is to provide a simple and general test of the presence of asymmetric information in contractual relationships within a competitive context. We also argue that insurance data are particularly well suited to such empirical investigations. To illustrate this claim, we use data on contracts and accidents to investigate the extent of asymmetric information in the French market for automobile insurance. Using various parametric and nonparametric methods, we find no evidence for the presence of asymmetric information in this market.
Too much investment: a problem of asymmetric information, De Meza, D., & Webb, D. C. (1987). Too much investment: a problem of asymmetric information. The quarterly journal of economics, 102(2), 281-292. This paper shows that under plausible assumptions, the inability of lenders to discover all of the relevant characteristics of borrowers results in investment in excess of the socially efficient level. Raising the rate of interest above the free market level will restore optimality. This conflicts with generally held views and is contrasted with the Stiglitz-Weiss model. It is shown that the assumptions which yield overinvestment support debt as the equilibrium method of finance. However, under the Stiglitz-Weiss assumptions, used to derive an underinvestment result, equity is shown to be the equilibrium method of finance.