Information asymmetry

In contract theory and economics, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This asymmetry creates an imbalance of power in transactions, which can sometimes cause the transactions to go awry, a kind of market failure in the worst case. Examples of this problem are adverse selection,[1] moral hazard, and monopolies of knowledge.[2]

Information asymmetry extends to non-economic behavior. As private firms have better information than regulators about the actions that they would take in the absence of a regulation, the effectiveness of a regulation may be undermined.[3] International relations theory has recognized that wars may be caused by asymmetric information[4] and that "Most of the great wars of the modern era resulted from leaders miscalculating their prospects for victory".[5] There is asymmetric information between national leaders, wrote Jackson and Morelli, when there are differences "in what they know [i.e. believe] about each other's armaments, quality of military personnel and tactics, determination, geography, political climate, or even just about the relative probability of different outcomes" or where they have "incomplete information about the motivations of other agents".[6]

Information asymmetries are studied in the context of principal–agent problems where they are a major cause of misinforming and is essential in every communication process.[7] Information asymmetry is in contrast to perfect information, which is a key assumption in neo-classical economics.[8] In 2001 the Nobel Memorial Prize in Economics was awarded to George Akerlof, Michael Spence, and Joseph E. Stiglitz for their "analyses of markets with asymmetric information".[9]


Information asymmetry models assume that at least one party to a transaction has relevant information, whereas the other(s) do not. Some asymmetric information models can also be used in situations where at least one party can enforce, or effectively retaliate for breaches of, certain parts of an agreement, whereas the other(s) cannot.

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. An example of adverse selection is when people who are high-risk are more likely to buy insurance because the insurance company cannot effectively discriminate against them, usually due to lack of information about the particular individual's risk but also sometimes by force of law or other constraints. An example of moral hazard is when people are more likely to behave recklessly after becoming insured, either because the insurer cannot observe this behavior or cannot effectively retaliate against it, for example by failing to renew the insurance.

Adverse selectionEdit

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.[10]


Michael Spence originally proposed the idea of signaling.[11] 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 in learning", but only they know if they really are. This is an information asymmetry.

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. However, finishing college may merely function as a signal of their ability to pay for college, it may signal the willingness of individuals to adhere to orthodox views, or it may signal a willingness to comply with authority.


Joseph E. 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.

Examples of situations where the buyer usually has better information than the seller include estate sales as specified in a last will and testament, life insurance, or sales of old art pieces without prior professional assessment of their value. This situation was first described by Kenneth J. Arrow in an article on health care in 1963.[12]

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. Because of information asymmetry, unscrupulous sellers can "spoof" items (like replica goods such as watches) and defraud the buyer. As a result, many people not willing to risk getting ripped off will avoid certain types of purchases, or will not spend as much for a given item. Akerlof demonstrates that it is even possible for the market to decay to the point of nonexistence.

Akerlof also suggests different methods with which information asymmetry can be reduced. One of those instruments that can be used to reduce the information asymmetry between market participants is intermediary market institutions called counteracting institutions, for instance, a guarantees for goods. By providing a guarantee, the buyer in the transaction can use extra time to obtain the same amount of information about the good as the seller before the buyer takes on the complete risk of the good being a "lemon". Other market mechanisms that help reduce the imbalance in information include brand-names, chains and franchising that guarantee the buyer a threshold quality level. These mechanisms also let owners of high quality products get the full value of the good. These counteracting institutions then keep the market size from reducing to zero.

Information gatheringEdit

Most models in traditional contract theory assume that asymmetric information is exogenously given.[13][14] Yet, some authors have also studied contract-theoretic models in which asymmetric information arises endogenously, because agents decide whether or not to gather information. Specifically, Crémer and Khalil (1992) and Crémer, Khalil, and Rochet (1998a) study an agent’s incentives to acquire private information after a principal has offered a contract.[15][16] In a laboratory experiment, Hoppe and Schmitz (2013) have provided empirical support for the theory.[17] Several further models have been developed which study variants of this setup. For instance, when the agent has not gathered information at the outset, does it make a difference whether or not he learns the information later on, before production starts?[18] What happens if the information can be gathered already before a contract is offered?[19] What happens if the principal observes the agent’s decision to acquire information?[20] Finally, the theory has been applied in several contexts such as public-private partnerships and vertical integration.[21][22]

Sources of information asymmetryEdit

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 choose to engage in propaganda campaigns. Furthermore, an educational system relying on substantial tuition fees can generate information imbalances between the poor and the affluent. Imbalances can also be fortified by certain organizational and legal measures, such as document classification procedures or non-disclosure clauses. Exclusive information networks that are operational around the world further contribute to the asymmetry. Lastly, mass surveillance helps the political and industrial leaders to amass large volumes of information, which is typically not shared with the rest of the society.[23]

Application in researchEdit

Accounting and FinanceEdit

A substantial portion of research in the field of accounting can be framed in terms of information asymmetry, since accounting involves the transmission of an enterprise's information from those who have it to those who need it for decision-making. Likewise, in finance literature, the acknowledgment of information asymmetry between organizations challenged the Modigliani–Miller theorem, which states that the valuation of a firm is unaffected by its financial structure. Information asymmetry shed light on the importance of aligning interests of managers with those of stakeholders. Furthermore, financial economists apply information asymmetry in studies of differentially informed financial market participants (insiders, stock analysts, investors, etc.) or in the cost of finance for MFIs.[24]

Effect of bloggingEdit

The effect of blogging as a source of information asymmetry as well as a tool reduce asymmetric information has also been well studied. 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.[25] Compared to traditional forms of media such as newspapers and magazines, blogging provides an easy-to-access venue for information. A 2013 study by Saxton and Anker concluded that more participation on blogging sites from credible individuals reduces information asymmetry between corporate insiders, additionally reducing the risk of insider trading.[26]

A Game of imperfect information with sub-games. Here each player will have no information of each other's move while making decisions. This representation is of one person's decisions in a game, however, it does not correspond to the actual timing of the player's decisions. The dashed line between nodes represent information asymmetry and show that, during the game, a party cannot distinguish between the nodes. Picture Author: Elosaurus. File:A Game of imperfect information with subgames shown..svg

Game TheoryEdit

A large amount of the foundational ideas in game theory builds on the framework of information asymmetry. In simultaneous games, each player has no prior knowledge of an opponent's move and with sequential games, players have little prior knowledge of the opponent's move but often don't have perfect information. Therefore, the existence and level of information asymmetry in a game determines the dynamics of the game. James Fearon in his study of the explanations for war in a game theoretic context notices that war could be a consequence of information asymmetry - two countries will not reach a non-violent settlement because they have incentives to distort the amount of military resources they possess. [27]

Artificial IntelligenceEdit

Tshilidzi Marwala and Evan Hurwitz in their study of the relationship between information asymmetry and artificial intelligence observed that there is a reduced level of information asymmetry between two artificial intelligent agents than between two human agents. As a consequence, when these artificial intelligent agents engage in financial markets it reduces arbitrage opportunities making markets more efficient. The study also revealed that as the number of artificial intelligent agents in the market increase, the volume of trades in the market will decrease.[28][29] This is primarily because information asymmetry of the perceptions of value of goods and services is the basis of trade.


Information asymmetry has been applied in a variety of ways in management research ranging from conceptualizations of information asymmetry to building resolutions to reduce it.[30] A 2013 study by Schmidt and Keil has revealed that the presence of private information asymmetry within firms influences normal business acitivites. Firms that have a more concrete understanding of their resources can use this information to gauge their advantage over competitors.[31] In Ozeml, Reur and Gulati's 2013 study, they found that 'different information' was an additional source of information asymmetry in venture capitalist and alliance networks; when different team members bring diverse, specialized knowledge, values and outlooks towards a common strategic decision making event, the lack of homogenous information distribution among the members leads to inefficient decision making. [32]

See alsoEdit


  1. ^ Charles Wilson (2008). "adverse selection," The New Palgrave Dictionary of Economics 2nd Edition. Abstract.
  2. ^ John O. Ledyard (2008). "market failure,"  The New Palgrave Dictionary of Economics, 2nd Ed.  Abstract.
  3. ^ Fullerton, Don; Wolfram, Catherine (13 May 2010). The Design and Implementation of U.S. Climate Policy (PDF). Chicago Illinois: University of Chicago Press. p. 11. ISBN 9780226269146. Retrieved 9 March 2019.
  4. ^ Jackson and Morelli, pp. 35, 40-43.
  5. ^ Ikenberry, p. 128.
  6. ^ Jackson and Morelli, pp. 40, 42.
  7. ^ Christozov D., Chukova S., Mateev P., Chapter 11. Informing Processes, Risks, Evaluation of the Risk of Misinforming, in Foundations of Informing Science, ISI, 2009, pp. 323-356
  8. ^ "The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2001". Retrieved 2020-03-07.
  9. ^ "The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2001: Information for the Public", press release from the Royal Swedish Academy of Sciences, Nobel Foundation,, October 2001, accessed November 12, 2007.
  10. ^ Johannes Hörne (2008). "signalling and screening" The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
  11. ^ Spence, Michael (August 1973). "Job Market Signaling". The Quarterly Journal of Economics. 87 (3): 355–374. doi:10.2307/1882010. ISSN 0033-5533. JSTOR 1882010.
  12. ^ Arrow, Kenneth J. (1963). "Uncertainty and the Welfare Economics of Medical Care". American Economic Review. American Economic Association. 53 (5): 941–973. JSTOR 1812044.
  13. ^ Baron, David P.; Myerson, Roger B. (1982). "Regulating a Monopolist with Unknown Costs". Econometrica. 50 (4): 911–930. CiteSeerX doi:10.2307/1912769. JSTOR 1912769.
  14. ^ Maskin, Eric; Riley, John (1984). "Monopoly with Incomplete Information". The RAND Journal of Economics. 15 (2): 171. doi:10.2307/2555674. ISSN 0741-6261. JSTOR 2555674.
  15. ^ Cremer, Jacques; Khalil, Fahad (1992). "Gathering Information before Signing a Contract". American Economic Review. 82 (3): 566–578.
  16. ^ Crémer, Jacques; Khalil, Fahad; Rochet, Jean-Charles (1998a). "Contracts and Productive Information Gathering". Games and Economic Behavior. 25 (2): 174–193. doi:10.1006/game.1998.0651. ISSN 0899-8256.
  17. ^ Hoppe, Eva I.; Schmitz, Patrick W. (2013). "Contracting under Incomplete Information and Social Preferences: An Experimental Study". Review of Economic Studies. 80 (4): 1516–1544. doi:10.1093/restud/rdt010.
  18. ^ Hoppe, Eva I.; Schmitz, Patrick W. (2010). "The costs and benefits of additional information in agency models with endogenous information structures". Economics Letters. 107 (1): 58–62. doi:10.1016/j.econlet.2009.12.026. ISSN 0165-1765.
  19. ^ Crémer, Jacques; Khalil, Fahad; Rochet, Jean-Charles (1998b). "Strategic Information Gathering before a Contract Is Offered". Journal of Economic Theory. 81 (1): 163–200. doi:10.1006/jeth.1998.2415. ISSN 0022-0531.
  20. ^ Hoppe, Eva I. (2013). "Observability of information acquisition in agency models". Economics Letters. 119 (1): 104–107. doi:10.1016/j.econlet.2013.01.015. ISSN 0165-1765.
  21. ^ Hoppe, Eva I.; Schmitz, Patrick W. (2013). "Public-private partnerships versus traditional procurement: Innovation incentives and information gathering" (PDF). The RAND Journal of Economics. 44 (1): 56–74. doi:10.1111/1756-2171.12010. ISSN 0741-6261.
  22. ^ Khalil, Fahad; Kim, Doyoung; Shin, Dongsoo (2006). "Optimal Task Design: To Integrate or Separate Planning and Implementation?". Journal of Economics & Management Strategy. 15 (2): 457–478. CiteSeerX doi:10.1111/j.1530-9134.2006.00107.x. ISSN 1058-6407.
  23. ^ The tools used to create information asymmetries are described in the following article
  24. ^ Garmaise, M. & G. Natividad (2010). "Information, the Cost of Credit, and Operational Efficiency: An Empirical Study of Microfinance". Review of Financial Studies. 23 (6): 2560–2590. doi:10.1093/rfs/hhq021.
  25. ^ Saxton, Gregory D. "Financial blogs and information asymmetry between firm insiders and outsiders". Annual Meeting of the American Accounting Association.
  26. ^ Saxton, G. D. and A. E. Anker (2013). "The Aggregate Effects of Decentralized Knowledge Production: Financial Bloggers and Information Asymmetries in the Stock Market." Journal of Communication 63(6): 1054-1069.
  27. ^ Fearon, James D. (1995). "Rationalist Explanations for War". International Organization. 49 (3): 379–414. doi:10.1017/S0020818300033324. ISSN 0020-8183. JSTOR 2706903.
  28. ^ Marwala, Tshilidzi; Hurwitz, Evan (2017). Artificial Intelligence and Economic Theory: Skynet in the Market. London: Springer. ISBN 978-3-319-66104-9.
  29. ^ "Artificial Intelligence can Reduce Information Asymmetry : Networks Course blog for INFO 2040/CS 2850/Econ 2040/SOC 2090". Retrieved 2020-03-01.
  30. ^ Bergh, Donald D.; Ketchen, David J.; Orlandi, Ilaria; Heugens, Pursey P. M. A. R.; Boyd, Brian K. (2018-09-21). "Information Asymmetry in Management Research: Past Accomplishments and Future Opportunities". Journal of Management. 45 (1): 122–158. doi:10.1177/0149206318798026. ISSN 0149-2063.
  31. ^ Schmidt, Jens; Keil, Thomas (2013-04-01). "What Makes a Resource Valuable? Identifying the Drivers of Firm-Idiosyncratic Resource Value". Academy of Management Review. 38 (2): 206–228. doi:10.5465/amr.2010.0404. ISSN 0363-7425.
  32. ^ Ozmel, Umit; Reuer, Jeffrey J.; Gulati, Ranjay (2012-07-24). "Signals across Multiple Networks: How Venture Capital and Alliance Networks Affect Interorganizational Collaboration". Academy of Management Journal. 56 (3): 852–866. doi:10.5465/amj.2009.0549. ISSN 0001-4273.


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External linksEdit