Asymmetric information

Asymmetric information occurs when one party to a transaction has more information about the deal than the other party. This situation most commonly arises when the seller of goods knows more about the goods than the buyer. Disparities of this type arise in situations where it is difficult to obtain information. Here are several examples:

  • The seller of a house may know about structural problems that the buyer may not realize for several years. Because of this information imbalance, the seller can demand a higher price than the buyer would agree to if the buyer had access to the same information.
  • A borrower knows more about his ability to pay back a loan than the lender. Since there is clearly asymmetric information in the relationship, the lender attempts to collect more information about the borrower, perhaps through an audit or other types of due diligence. If the lender still feels that it is operating at a disadvantage, it can charge an unusually high interest rate in order to compensate itself for the risk of not knowing a sufficient amount about the borrower.
  • An attorney hears that a prominent company is about to be subjected to a major government investigation. Since he learns about the investigation before the general public, there is asymmetry in the levels of information held by the attorney and the general public. He could take advantage of the situation by short selling shares of the company, on the expectation that the market value of its shares will decline in the near future.

From an economic perspective, asymmetric information is widespread, and forms the basis for many transactions. For example, a criminal attorney is a specialist in reducing the sentences of his clients, which is information that the clients do not have. Consequently, the attorney can take advantage of this imbalance by charging high fees to clients. The same concept applies to any knowledge worker, including doctors, accountants, tax specialists, and so forth.