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2.3 Asymmetric Information: The Real Evil

Learning Objective

  1. What is asymmetric information, what problems does it cause, and what can mitigate it?

Finance also suffers from a peculiar problem that is not easily overcome by just anybody. Undoubtedly, you’ve already encountered the concept of opportunity costs, the nasty fact that to obtain X you must give up Y, that you can’t have your cake and eat it too. You may not have heard of asymmetric information, another nasty fact that makes life much more complicated. Like scarcityThe finite availability of resources coupled with the infinite demand for them; the fact that goods are not available in sufficient quantity to satisfy everyone’s wants., asymmetric information inheres in nature, the devil incarnate. That is but a slight exaggeration. When a seller (borrower, a seller of securities) knows more than a buyer (lender or investor, a buyer of securities), only trouble can result. Like the devil in Dante’s Inferno, this devil has two big ugly heads, adverse selectionThe fact that the least desirable borrowers and those who seek insurance most desire loans and insurance policies., which raises Cain before a contract is signed, and moral hazardAny postcontractual change in behavior that injures other parties to the contract., which entails sinning after contract consummation. (Later, we’ll learn about a third head, the principal-agency problem, a special type of moral hazard.)

Due to adverse selection, the fact that the riskiest borrowers are the ones who most strongly desire loans, lenders attract sundry rogues, knaves, thieves, and ne’er-do-wells, like pollen-laden flowers attract bees (Natty attracts frat boys?). If they are unaware of that selection bias, lenders will find themselves burned so often that they will prefer to keep their savings under their mattresses rather than risk lending it. Unless recognized and effectively countered, moral hazard will lead to the same suboptimal outcome. After a loan has been made, even good borrowers sometimes turn into thieves because they realize that they can gamble with other people’s money. So instead of setting up a nice little ice cream shop with the loan as they promised, a disturbing number decide instead to try to get rich quick by taking a quick trip to Vegas or Atlantic for some potentially lucrative fun at the blackjack table. If they lose, they think it is no biggie because it wasn’t their money.

One of the major functions of the financial system is to tangle with those devilish information asymmetries. It never kills asymmetry, but it reduces its influence, intermediaries by screening insurance and credit applicants and monitoring them thereafter, and markets by providing price information and analysis. With asymmetric information thus scotched, businesses and other borrowers can obtain funds and insurance cheaply enough to allow them to become more efficient, innovate, invent, and expand into new markets. By providing relatively inexpensive forms of external finance, financial systems make it possible for entrepreneurs and other firms to test their ideas in the marketplace. They do so by eliminating, or at least reducing, two major constraints on liquidityThe ease, speed, and cost of selling an asset. and capitalIn this context, long-term financing., or the need for short-term cash and long-term dedicated funds. They reduce those constraints in two major ways: directly (though often with the aid of facilitatorsIn this context, businesses that help markets to function more efficiently.) via marketsInstitutions where the quantity and price of goods are determined. and indirectly via intermediariesBusinesses that connect investors to entrepreneurs via various financial contracts, like checking accounts and insurance policies.. Another way to think about that is to realize that the financial system makes it easy to trade intertemporally, or across time. Instead of immediately paying for supplies with cash, companies can use the financial system to acquire what they need today and pay for it tomorrow, next week, next month, or next year, giving them time to produce and distribute their products.

Stop and Think Box

You might think that you would never stoop so low as to take advantage of a lender or insurer. That may be true, but financial institutions are not worried about you per se; they are worried about the typical reaction to asymmetric information. Besides, you may not be as pristine as you think. Have you ever done any of the following?

  • Stolen anything from work?
  • Taken a longer break than allowed?
  • Deliberately slowed down at work?
  • Cheated on a paper or exam?
  • Lied to a friend or parent?

If so, you have taken advantage (or merely tried to, if you were caught) of asymmetric information.

Key Takeaways

  • Asymmetric information occurs when one party knows more about an economic transaction or asset than the other party does.
  • Adverse selection occurs before a transaction takes place. If unmitigated, lenders and insurers will attract the worst risks.
  • Moral hazard occurs after a transaction takes place. If unmitigated, borrowers and the insured will take advantage of lenders and insurers.
  • Financial systems help to reduce the problems associated with both adverse selection and moral hazard by screening applicants and monitoring borrowers and insureds.