Asymmetric Information

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Recommended: Problem of market failure and the need for government intervention in the market system

Asymmetric information is a problem which faces managers of firms everywhere. It occurs where one party to a transaction has more information than the other party to said transaction. This of course creates other problems for the managers as well. We can identify four main areas where asymmetric information causes problems. The problems caused are adverse selection, moral hazard, hiring practices and insider trading. This essay will follow the structure of firstly defining and further explaining each of these topics and what affect each has on the manager. We will then move onto possible solutions for these problems, which include screening, signalling and government intervention. Finally in this essay each of these solutions will be critically evaluated to show which of these is best suited for each problem created by asymmetric information.

Adverse selection is what occurs due to asymmetric information before the transaction actually takes place. It occurs due to a type of asymmetric information called hidden characteristics. Hidden Characteristics are things that one party to a transaction knows about itself but which are unknown by the other party (Baye, 2000). Adverse selection is a situation where a selection process ends with only those with undesirable characteristics left. Probably the best example of adverse selection is car insurance. Let us assume that there are two types of poor drivers, those that are just bad drivers and those that are just purely unlucky. This explains why there are some good drivers who have huge premiums or just can't get car insurance. The insurance company cannot determine which of the drivers have bad driving habits and which have only had a string of bad luck accidents. Therefore for the i...

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...al hazard, and uncertainty in hiring practises it is easy to see why this is a problem for managers. However as has been shown there are certain solutions to some of these problems, but many of these are solutions that have incomplete information in themselves. Therefore, it is obvious that in the foreseeable future there will always be asymmetric information for managers to deal with, and they are probably best informed to use the solutions presented here but also just use their best judgement.

REFERENCES

Baye, Michael. R, Managerial Economics & Business Strategy, 3rd Ed, 2000, McGraw-Hill, USA

Pass, Christopher, et al, Collins Dictionary Economics, 3rd Ed, 2000, HarperCollins Publishers, Glasgow

Katz, Michael L., Rosen, Harvey S., Microeconomics, 3rd Ed, 1998, Irwin/McGraw-Hill, USA

Hirshleifer, Jack , Time, Uncertainty, and Information, 1989, Oxford

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