Related links: http://www.richmondfed.org/publications/research/region_focus/2010/q4/jargon_alert_weblinks.cfmEconomics

Becky Johnsen

English

Research Papers in Economics

I
n economics, a standard assumption is that market
participants have — and base their decisions on —
“perfect information.” However, in real life, this is not
the case; consumers cannot possess all available knowledge
concerning all transactions. Even though the assumption
of perfect information is widely used, economists have
developed methods for studying the behavior of markets
with imperfect information. One important kind of imper-
fection is information asymmetry.
Information asymmetry exists when one party, typically
the buyer, has less perfect information than the other. If 
the price of a good or service does not accurately reflect its 
quality and the buyer does not possess as much information
regarding the product as the seller, this can place the buyer
at a disadvantage. The term “information asymmetry” was
popularized by George Akerlof in his 1970
paper “The Market for Lemons.” This
concept was applied further by Michael
Spence and Joseph Stiglitz, who, with
Akerlof, shared the 2001 Nobel Prize for
their work.
Information asymmetry is applicable
to many common transactions; a few
examples are fixing a car, selecting 
a college, and obtaining a home mort-
gage. In each of these instances, the
typical consumer weighs the opportunity
cost of gathering more information
against the potential costs associated with
accepting some level of ignorance about the product.
Consider the case of hiring a mechanic. As all car owners
know, it would require a substantial investment of time at a
trade school or working at a garage to understand a car as
well as the average mechanic, so most people do not attempt
to make their own repairs. In a worst-case scenario, a dishon-
est mechanic could overcharge the client and fail to repair
the car, resulting in an accident or further damage to the car.
However, most consumers seem to agree that this is an
unlikely situation, and instead accept the more likely sce-
nario that they may simply be overcharged. As a result,
information asymmetry often exists between the average
consumer and a mechanic. The consumer does not become
fully informed because it would be difficult to do so, and the
costs of possibly making a poor decision are acceptably low.
Another significant transaction many people enter into is
selecting a college. In this instance, information asymmetry
between the buyer, who pays the tuition, and the seller, the
college, is largely nonexistent. Here, information is readily
available to prospective students and parents. Institutions
send comprehensive brochures to students, and a wealth of
independent reviews and ranking systems are available 
on the Internet. Also, the cost of not investigating 
college choices is particularly high. If a student selects a 
college that is not a good fit, this may result in a costly and
time-consuming transfer to another institution, or years of
tuition that could have been better spent elsewhere. In a
worst-case scenario, the student may be forced to drop out
of college and be unable, for a variety of reasons, to return 
or attend another. As a result, information asymmetry is
largely nonexistent in this market. The consumer seeks to
become informed because information is easily accessible,
and not doing so creates a large risk that the transaction will
fail — a risk that entails significant costs. 
Granted, there are limitations to this example; there is
information accessible to the consumer only once the 
student has enrolled in college. It may
turn out a school is not a good fit for
even a well-informed applicant for 
reasons that could not have been reason-
ably predicted. Nonetheless, even in this
case, the consumer did everything 
possible to obtain information equal to
that of the college’s admissions officer,
reducing the possibility of information
asymmetry between the two parties.
The final example involves one of the
most important purchases most people
make: obtaining a home mortgage. As
recent issues in the mortgage market
demonstrate, there was widespread information asymmetry
between many borrowers and their lenders. Even though the
terms of a mortgage contract generally are quite explicit,
many home buyers find those contracts, especially their most
important features, difficult to understand. The costs of not
thoroughly understanding the mortgage agreement are large,
and may result in years of high-interest payments or even
foreclosure. So, the consumer has to make a choice: whether
to seek outside help in understanding the contract or simply
to trust the mortgage provider. That choice often determines
the level of information asymmetry in this market.
These examples illustrate the degree to which informa-
tion asymmetry is prevalent in many common transactions.
In some cases, there are high opportunity costs to spending
the time and money to gather information about a purchase,
so consumers do not bother with detailed investigations. 
In other cases, the risks of agreeing to less-than-optimal
terms could be highly consequential for a consumer,
prompting the consumer to conduct thorough research.
Rational consumers must balance these two factors when
making decisions in the marketplace.  RF
Information Asymmetry
10 Region Focus | Fourth Quarter | 2010 
JARGONALERT
BY BECKY JOHNSEN
I
L
L
U
S
T
R
A
T
I
O
N
:
 
T
I
M
O
T
H
Y
 
C
O
O
K

Jargon alert : Information asymmetry

http://www.richmondfed.org/publications/research/region_focus/2010/q4/pdf/jargon_alert.pdf

Jargon alert : Information asymmetry

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics