A lower price
The definition of asymmetric information can be as simple as to say the disequilibrium of knowledge between one party and another. The definition allows us to assume that one party becomes better off, due to the opposing party being worse off. In terms of finance, the relationship we talk about is that of the lenders versus the borrowers. The lenders have more information than the borrowers as they are experts in the respective field, and have the equipment and power to be able to obtain such information.
For example, in financial intermediaries they acquire such knowledge to assess the risk of lending, in reverence to receiving the money back. Asymmetric information provides a theoretical and practical basis to economic and financial issues, and due to its huge implications to the financial system, it is seen as a very important subject that is reviewed by economists. There are three main implications to finance that asymmetric information has. The first of which is adverse selection. This is a process that occurs before a transaction with a borrower and a lender in the financial system.
This problem arises when people attempt to take out loans that are high credit risks to the lending firm. Those who are the potential bad creditors are more dynamic in the way they apply and approach for a loan. As a consequence of this they are more likely to acquire this loan. Due to the venture being high risk, many firms may be unsuccessful at recovering the lent money. The market can then fail from this position, as lenders refuse to give loans to customers as the threat of them regaining their money increases.
The reason for market failure is that there is a demand for money, and there are potentially good creditors out there; but due to this lack of information, nothing is supplied. An example I have looked at closely is that of George Akerlof. Akerlof came up with the theory of lemons idea. This theory is based on the used cars industry. The example becomes relevant as there is naturally asymmetric information here as many consumers within the industry are unsure of the quality of the owner’s car.
As a result of this, estimating the worthy price of the car becomes difficult and so an inevitable dilemma. The owner of the car is the party with the information; they know the state and quality of the car. The buyer however knows little about the history of the car and so cannot comprehend the value of the car. Naturally, a good car is worth more than a bad car, and so if the buyer’s willingness to pay for the car is at a lower price, then the owner may not want to sell the car, as it does not reflect the true value of the vehicle.
The overall quality of cars in the second hand market would immediately drop through this lack of knowledge, and fewer sales would be made as no one wants to buy a below average car. This leads to failure in the market, as only poor cars are for sale, and the demand is particularly low or non-existent. Groucho Marx once said that he would not join a club that approached him who did not really know him1. He established that as the club had asked him to join; they had a poor selection process and were not worth joining.
From this example we can see that the selection process in the forms of institutions giving out credit is crucial in terms of the whether the consumer is feasible for borrowing. 1 A problem that occurs in asymmetric information is that of moral hazards. Unlike adverse selection, this problem occurs after the transaction between borrower and lender has taken place. Often an underestimated problem by lenders, that a borrower may use the loan as an alternative source of income, say in gambling.
This is desirable by many as it boasts a higher return in income. However, it yields a higher return because of the amount of risk attached to it. This factor acknowledged, causes lenders to be less enthusiastic about giving out loans to consumers. The problem allows the market to fail once again as the producers in this market are not prepared to supply the demand. Both of these problems have occurred due to the uncertainty of the future of money. No one can tell how the state of money will react past the present point in time.
