Information Asymmetry Explained (With Examples)

Information asymmetry is a condition under which one business party possesses more information than the other party they are dealing with. One party’s access to more relevant and up-to-date information can result in business imbalances and even exploitation.

In 2001, Joseph Stiglitz, George Akerlof, and Michael Spence shared the Nobel Prize in Economics for their study of asymmetric information in capital markets. Notably, Akerlof showed how the financial sector in developing countries could be skewed when financial service providers—armed with college degrees, deep networking, and privileged information—exploited retail market participants who were not nearly as informed or connected.

The Nobel committee highlighted Akerlof’s 1970 essay, "The Market for Lemons," as an invaluable study on the economics of information. Akerlof's "lemons problem" used the secondhand car market to describe how information asymmetry (with the seller keeping information from the buyer) could greatly impact a specific capital market and even lead to market failures.

Information asymmetry affects business transactions in three primary ways.

• Adverse selection: Adverse selection refers to a business relationship where the buyer and seller have access to different information (although one information set is not necessarily superior to the other). Each party may make moves based on knowledge they presume they have but the other does not. Such information asymmetry can affect retail markets and labor markets alike. It can even affect personal relationships.
• Moral hazard: In the language of economics, a moral hazard occurs when a company or individual takes on increased risk because it does not personally bear the full consequences of that high risk. For instance, the fund manager for a pension fund may invest in riskier stocks than they would in their own personal portfolio because, if the funds collapse, they will not personally lose money (although they may lose their job as a consequence). In this case, the fund manager has inside information about their investments that participants in the pension fund do not, and perhaps the pensioners would not approve of such financial risk if given the option.
• Monopoly of knowledge: In a monopoly of knowledge, only a select few individuals are presented with the necessary information to understand a situation and make decisions. Monopolies of knowledge can occur in government, where only officials with security clearances can be informed of privileged intelligence. In some businesses, only senior management receives full access to company information provided by a third party, yet lower-level employees may be called upon to make key decisions with only limited information at their disposal.

You can find examples of asymmetric information in all sorts of business relationships.

1. 1. Health insurance: An actuary in the insurance industry has more information about statistical risks than the people they are insuring. This helps explain why seemingly healthy people may be charged surprisingly high premiums by an insurance company. It also explains why insurance markets traditionally have very little room for negotiation.
2. 2. Financial markets: Financial professionals tend to have far more access to market information than retail investors. Some unscrupulous brokers may steer their clients toward high-risk investments or those that charge a higher rate for service fees, or they may withhold inside information about a business's profitability. Information asymmetry between the financial professionals and their clients may prompt this behavior.
3. 3. Car sales: A used car salesman often has more information about the reliability of secondhand cars than their potential buyers. What may seem like a good car to a lightly informed client may actually be inadequate based on the salesman's private information.

Get the MasterClass Annual Membership for exclusive access to video lessons taught by masters, including Bob Iger, Sara Blakely, Paul Krugman, Robin Roberts, Chris Voss, and more.