What is Information Asymmetry?

2 years ago
Macroeconomics

Information gathering, just like any other activities, involves the use of scarce resources. Therefore, the cost-benefit principle states that a rational consumer will continue to gather information as long as its marginal benefit exceeds marginal cost.

In searching for further information, one must accept certain costs in return for unknown benefits, thus it carries an element of risk:

  • Expected value: the average amount one would win or lose if a gamble is played infinite number of times. It is the sum of all possible outcomes multiplied by their probability
  • Fair gamble: a gamble whose expected value is zero
  • Risk neutral person: someone who would accept any gamble that is fair or better

Asymmetric information describes a situation in which people on different sides of an economic exchange are not equally well informed about a particular aspect of the transaction that will affect the outcome for them. E.g. seller of a second hand car may not disclose faulty parts of the car to potential buyers to fetch a higher price.

Asymmetric information leads to market failure, because the true costs and benefits are not known to both sides. This prevents the market from reaching equilibrium, i.e. where marginal benefit equal to marginal cost, and thus is a cause of inefficiency.

As a result of specialisation, people hire experts who are better informed about certain tasks to carry out work. These arrangements are called principal-agent relationships:

  • Principal: someone who contracts another party to perform work on their behalf
  • Agent: someone who is contracted by another party to perform work on their behalf

The principal-agent problem is a situation where an agent’s objectives are not aligned with the principal and takes actions that do not result in the best outcome for the principal, yet it is too costly for the principal to monitor the agent’s actions

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Bijay Satyal
Dec 4, 2021
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