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Asymmetric Information 1
Asymmetric Information 1
Economic Advantages
Growing asymmetrical information is a desirable outcome of a market economy.
As workers specialize and become more productive in their fields of expertise, they can
provide greater levels of value to workers in other fields. For example, a stockbrokers
services are less valuable to customers who already know enough to buy and sell their
own stocks with confidence.
One alternative to ever-expanding asymmetric information is for workers to study
in all fields, rather than specializing in those fields where they can provide the most
value. This comes with large opportunity costs and would likely result in a lower level of
aggregate output, lowering standards of living.
Another alternative is to make information abundantly and cheaply available,
such as through the internet. This does not replace asymmetric information, however. It
only has the effect of moving information asymmetries away from simpler areas and into
more complex areas.
Contract Theory
Contract theory is the study of the way individuals and businesses construct and
develop legal agreements. It analyzes how different parties make decisions to create a
contract with particular terms in case uncertain conditions happen, and it also covers
how individuals and businesses make contracts with asymmetric information. Contract
theory draws upon principles of financial and economic behavior as different parties
have different incentives to perform or not perform particular actions.
The first formal research on this topic in the field of economics was done in the
1960s by Kenneth Arrow. Since contract theory covers both behavioral incentives of a
principal and an agent, it falls under a field known as law and economics, also known as
the economic analysis of law. One of the most prominent applications of contract theory
is being able to find the optimum design for employee benefits.
In 2016, economists Oliver Hart and Bengt Holmstrm won the Nobel Memorial Prize in
Economic Sciences for their contributions to this field. According to the press release,
"Through their initial contributions, Hart and Holmstrm launched contract theory as a
fertile field of basic research. Over the last few decades, they have also explored many
of its applications."
According to contract theory, contracts exist to put a line between what the
principal expects to happen and what will happen. It provides a clear and specific
understanding and agreement of how both parties stand and how they should perform.
It also covers the implied trust between both parties that all of the constructed
representations are valid and will be followed.
Moral Hazard
Moral hazard occurs when peoples behaviour is less careful than it could be, either
because they believe that their carelessness will not be found out, or because they are
encouraged to behave carelessly. This occurs because there is insurance protecting
them from the adverse effects of their careless decision. For example, a pupil at school
can idle along because they believe, either that their parents will provide insurance
against their idling, or that the State will provide them with an income if they fail to get a
job.
There are many other examples of information failure, including the following situations:
1. Consumers may under-estimate the net private and external benefit of merit
goods.
2. Consumers may over-estimate the net private and external cost of demerit
goods.
3. Fishermen may not know the size of fish stocks and, as a result, over-fishing
current stocks.
4. Firms may provide misleading information about products, such as producers of
cosmetics claiming to make people beautiful, holiday brochures making resorts
appear more attractive, and car drivers not knowing how much pollution they are
creating.
The Lemons Problem
When parties to a transaction are ignorant of certain aspects of the transaction,
such as the quality of the product they are buying, they are forced to make
assumptions, often based on price. For example, a buyer may assume that goods are of
poor quality if their price is low and that goods are of high quality if their price is high.
In some markets, only low quality products will be sold - the so-called lemons
problem. The lemons problem was first analysed by American economist George
Akerlof in 1970. Akerlof explored the problem associated with pricing second hand cars
in the USA, which he called a lemons market a lemon is a derogatory term for a poor
quality second-hand car. However, the lemon's problem has many wider implications in
terms of understanding information failure in general.
For example, in terms of second hand cars, buyers may be suspicious of the
motives of seller, and wonder whether the car is a lemon. If an individual buys a new
car for 30,000 and tries to sell on the second-hand market shortly after, they may be
forced to accept a much lower price, given that buyers will be suspicious of the seller's
motive. Not having all the facts, potential buyers are likely to assume the worst and
expect the car to have a problem - in other words, it is a lemon. Therefore, given that
second hand cars will generally attract a low price, only those sellers who actually have
poor quality cars will use this market. After a short period, it can be predicted that all
cars sold on the second hand car market will be lemons.
When applying this concept to other markets it can be suggested that, whenever
there is information failure, there is the possibility that markets will become lemons
markets. If so, the supply of good quality products will fall and the supply of poor quality
will products rise.
From a firms perspective, the principal-agent problem can increase costs, and
make the firm less efficient than it could be. These inefficiencies include the costs
associated with monitoring the performance of the managers and having to pay a
premium to attract the best managers.
2. Government may also promote the formation of pressure groups such as anti-
smoking groups, which campaign for more knowledge to be made available by
producers.
3. In addition, promoting literacy, numeracy, and IT skills may help increase the
demand for information. Having the skills to acquire knowledge can create an
increase in demand for knowledge, and a greater appreciation of the value of
information in making rational choices.
http://www.investopedia.com/terms/a/asymmetricinformation.asp
http://www.economicsonline.co.uk/Market_failures/Information_failure.html
http://www.economicshelp.org/blog/glossary/asymmetric-information/