Asymmetric Information

Neoclassical economics is founded on the assumptions of complete and symmetric information. Information is complete when all parties to a transaction know, or have access to, all information that ought to be relevant to their activities. Information is symmetric when all parties know all relevant information possessed by others involved in an exchange. However, most economic activities involve some failure to meet these conditions. People often do not possess full information related to decisions they make, and more important, some people usually have better information than others. When two or more individuals interact, asymmetric information exists when at least one individual possesses relevant knowledge that others do not have. Asymmetric information pertains only to situations involving interactions of two or more people.

Asymmetric information is best understood in the context of an exchange between buyers and sellers. A classic example involves the selling of a used car. The owner of the car knows its quality, but the buyer does not. If it is difficult, costly, or even impossible for a buyer to determine the quality of the car, then we say the seller possesses private information. Asymmetric information is a problem because people who possess the superior information may have an incentive to intentionally misrepresent the product and defraud others, while people who do not possess the superior information may incur costs trying to obtain better information or to protect themselves from being harmed. For example, in the case of used cars, the seller might try to convince the buyer that the car is of better quality than it actually is to obtain a higher price for the car. Knowing this, the buyer might pay a mechanic to inspect the car; or the buyer might hire a lawyer to draft a bill of sale that stipulates that the seller is obligated to issue a refund to the buyer if serious mechanical problems arise with the car within a stated period of time.

There are several reasons why asymmetric information exists. First, acquiring information is costly. This is because it usually takes time to search for and identify relevant information. Thus, some people may find that the cost of acquiring information may not be worth the expected benefits from possessing it. Second, some information is difficult to transfer, such as scientific knowledge or firm-specific knowledge. Knowledge is difficult to transfer if it cannot be easily quantified or articulated explicitly. Related to this is the fact that people are boundedly rational, meaning they have a limited capacity of acquiring, processing, and storing information. People are also forgetful. Thus, even if information were freely available, cognitive limitations will prevent people from being able to integrate all relevant information into the decisions they make. The implication is that some people will inevitably have better or more complete information than others possess.