Outline:

Asymmetric Information Definition

Economic Advantages
Information Asymmetry in Finance
Contract Theory
Moral Hazard
The Lemons Problem
The Principal Agent Problem
Remedies for Information Failure
Sources
Asmmetric Information Definition
Asymmetric information, sometimes referred to as information failure, is present
whenever one party to an economic transaction possesses greater material knowledge
than the other party. This normally manifests itself when the seller of a good or service
has greater knowledge than the buyer, although the opposite is possible. Almost all
economic transactions involve information asymmetries.
Asymmetric information is the specialization and division of knowledge in society
as applied to economic trade. For example, medical doctors tend to know more about
medical treatment than their patients; after all, those doctors specialize in medicine,
while their patients do not. The same principle applies to manufacturers, teachers,
police officers, attorneys, restaurant operators and yoga instructors, or any other
specialized profession.

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.

Information Asymmetry in Finance

Information asymmetries tend to be greatest in those areas where information is
complex, difficult to obtain or both. For instance, it is relatively difficult to obtain large
information asymmetries when trading baseball cards, but it is relatively easier in fields
such as law, medicine, technology or finance.
To prevent abuse of customers or clients by specialists, financial markets often
rely on reputation mechanisms. Financial advisors and fund companies that prove to be
the most honest and effective stewards of their clients' assets tend to gain clients, while
dishonest or ineffective agents tend to lose clients or face legal damages.
Financial markets exhibit asymmetric information in that in a financial transaction, one of
the two parties involved will have more information than the other and will have the
ability to make a more informed decision.
When it comes to the purchase or sale of a financial security, asymmetric
information occurs when either the buyer or seller has more information on the past,
present or future performance of that financial security. If the buyer has more
information, he knows that the security is underpriced relative to its aggregate
performance. If the seller has more information, he knows that the security is overpriced
relative to its aggregate performance. Asymmetric information gives either the buyer or
seller a better opportunity to make a profit over the purchase or sale of a financial
security.
When it comes to borrowing or lending money, asymmetric information occurs
when the borrower has more information about his financial state than the lender does.
The lender is more unsure whether the borrower will default on the loan. The lender can
look at a borrower's credit history and salary levels, but this provides limited information
compared to what the borrower knows about his own financial situation. To account for
this asymmetric information, a lender will charge a risk premium to compensate for the
disparity in information.
Asymmetric information can lead to either moral hazard or adverse selection.
Moral hazard occurs when a party will take a risk because the cost of the risk won't be
felt by that party. Adverse selection is a process that occurs when undesired results
happen because of buyers and sellers have access to different information. Both moral
hazard and adverse selection result in market failures.

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."

Contract theory analyzes a decision makers behavior under specific structures.

Under these structures, contract theory aims to input an algorithm that will optimize the
individuals decisions. Such practice divided contract theory into three types of
frameworks: moral hazard, adverse selection, and signaling. These models find ways
for parties to take appropriate actions under certain circumstances stated in the
contract.

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.

The Principal Agent Problem

Asymmetric information is also associated with the principal-agent problem. In an
increasingly complex world, individual decision making often relies on the advice given
by experts, and a potential principal-agent problem can occur whenever decision
makers rely on advice from others with more knowledge than they have. For example,
the shareholders of firms, the principals, usually delegate responsibility for day-to-day
decision making to appointed managers, the agents. This creates a situation of
asymmetric knowledge, with managers knowing much more than the shareholders, and
raises the possibility of inefficiencies, especially when shareholders and managers have
different objectives.
Examples of these inefficiencies include situations when managers decide to
take the easy life, knowing that shareholders will not find out, and managers deciding
to cheat and not reveal information to shareholders. This may occur in situations
involving insider dealing, where managers can exploit their knowledge of a businesss
prospects to buy or sell shares and make a personal gain.

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.

Remedies for Information Failure

Clearly, government has a considerable role in trying to ensure that some of these
information failures are reduced or eliminated. The two basic strategies are to increase
both the supply of, and demand for, information.

Increasing the supply of information:

Options to increase the supply of knowledge include:
1. Government may force producers to provide accurate information about products
through accurate labelling. For example, requiring that the alcoholic content of
drinks is printed on alcoholic drinks, and stating the E numbers found in a
product E numbers are the European system for indicating chemical additives
in food and drink.
2. Public broadcasts to improve knowledge may also be made, such as informing
smokers and drinkers of the true cost of their habit. To help inform the public, a
government can subsidise public service TV and radio broadcasting, as in the
case of BBC TV and radio.
3. Laws may be passed to force public limited companies to be more transparent,
and publish their financial accounts, as well as have them audited to ensure
accuracy.
4. Government may also regulate advertising standards to make advertising more
informative, and less persuasive.
5. Employers may be forced to request that job applicants disclose information
about themselves, such as whether they have a criminal record.
6. Government may force car owners to have their vehicles regularly checked by a
Ministry of Transport (MOT) test, which provides some basic information to
potential buyers. All cars over 3 years old must be tested each year, and this
gives some assurance to potential buyers that the car is road worthy.
7. In addition to direct intervention, government may establish organisations to act
as regulators and watchdogs, such as the Office of Fair Trading, which tries to
ensure that firms compete fairly, and the Competition Commission, which
investigates abuse of market dominance by firms with monopoly power. The
 Advertising Standards Authority (ASA) also promotes ethical advertising and
regulates the advertising industry in an attempt to improve the accuracy of
information available to consumers. The ASA is a self-regulatory body
established in 1962, and insists that adverts should be ..honest, decent and
truthful.. .. and in line with the principles of fair competition generally accepted in
business...

Increasing the Demand for Information

1. Market theory suggests that demand for knowledge will increase if it is provided
freely, or at low cost, hence consumers should not have to pay for information.
However, consumers may become overwhelmed with information and fail to take
it into account.

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.

Nudging towards more effective decisions.

Behavioural economists argue that small nudges can be used to counteract the effect of
misleading or overly complex information.
One problem is that in certain situations individuals may not be able to exert self-control,
and select less than healthy choices. For example, food packaging will clearly portray
food in its most appealing light, but this may reduce an individuals self-control when
making choices. Hence, although an individual may be over-weight, self-control may not
be exerted, and the individual eats an amount larger than is optimal for their immediate
health and life expectancy.
Sources:

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/