Asymmetric Information Explained

Quick Definition: Asymmetric information is when the buyer or the seller knows more than the other about the quality of the product. Asymmetric information is one cause of market failures.

What is asymmetric information?

Asymmetric information is one of the main causes of a market failure. Asymmetric information occurs when one party in a transaction (either the buyer or the seller) has more, or better information about the product than the other party. When this happens the market doesn’t function properly and usually stops working altogether.

What are the effects of asymmetric information?

The best way to explain how asymmetric information affects a market is to take an example. The second-hand car market is a good a place to start. Let’s say someone wants to buy a second-hand car – his name is Steve. Steve has a pretty good idea of what the average price is for a fully working second-hand car – in this case let’s say its £4000. Steve goes to a second-hand car dealer and asks to see his selection of second-hand cars. The dealer, Rob, shows him a car which looks to be in good condition and says he will sell it for £4000.

Now, this is when the problem of asymmetric information comes about. Steve would happily pay out £4000 for the car but he has no way of knowing the exact condition of the car – the engine may be on its last legs for all he knows. The only information he has is from Rob, the dealer. So, taking into account the possibility that the car might stop working after a couple of miles, Steve offers the dealer £2000. However, Rob knows everything about the car and knows for a fact that the car is in perfect condition and it will last for a long time, but he has no way of passing that information onto the buyer. Because he knows there is nothing wrong with the car, Rob rejects the offer so both the buyer and seller go home empty-handed. So here we can see how asymmetric information has completely broken down a simple market transaction.

Key terms

  • Adverse selection – This is when a market falls apart or stops working due to asymmetric information between the buyers and the sellers.
  • Market failure – This is a situation when the free market system leads to an inefficient allocation of resources. An example of a market failure is an externality.
  • Moral hazard – This is a situation when an individual in an economic transaction is willing to take more risks because the costs that could occur from their actions will not be felt by them. For example, if someone has insurance on their car they are more likely to drive dangerously because they if they crash they won’t have to pay for the damage.
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