Asymmetric information

Asymmetric information

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Information asymmetry extends to non-economic behavior. In adverse selection models, the ignorant party lacks information while negotiating an agreed understanding of or contract to the transaction, whereas in moral hazard the ignorant party lacks information about performance of the agreed-upon transaction or lacks the ability to retaliate for a breach of the agreement. The classic paper on adverse selection is George Akerlof’s “The Market for Lemons” from 1970, which brought informational issues to the forefront of economic theory. It discusses two primary solutions to this problem, signaling and screening. Michael Spence originally proposed the idea of signaling.

He proposed that in a situation with information asymmetry, it is possible for people to signal their type, thus believably transferring information to the other party and resolving the asymmetry. This idea was originally studied in the context of matching in the job market. An employer is interested in hiring a new employee who is “skilled in learning”. Of course, all prospective employees will claim to be “skilled at learning”, but only they know if they really are.

Spence proposes, for example, that going to college can function as a credible signal of an ability to learn. Assuming that people who are skilled in learning can finish college more easily than people who are unskilled, then by finishing college the skilled people signal their skill to prospective employers. No matter how much or how little they may have learned in college or what they studied, finishing functions as a signal of their capacity for learning. Stiglitz pioneered the theory of screening. In this way the underinformed party can induce the other party to reveal their information. They can provide a menu of choices in such a way that the choice depends on the private information of the other party. Examples of situations where the seller usually has better information than the buyer are numerous but include used-car salespeople, mortgage brokers and loan originators, stockbrokers and real estate agents.

George Akerlof in The Market for Lemons notices that, in such a market, the average value of the commodity tends to go down, even for those of perfectly good quality. Since the seminal contributions of Akerlof, Spence, and Stiglitz, the pervasive effects of information asymmetry in markets have been documented and studied in numerous contexts. Information asymmetry within societies can be created and maintained in several ways. Firstly, media outlets, due to their ownership structure or political influences, may fail to disseminate certain viewpoints or engage in propaganda campaigns. Blogging on financial websites provides bottom-up communication among investors, analysts, journalists, and academics, as financial blogs help prevent people in charge from withholding financial information from their company and the general public. Compared to traditional forms of media such as newspapers and magazines, blogging provides an easy-to-access venue for information.

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