Information Asymmetry: Difference In Knowledge Means Difference In Power

Information asymmetry is a situation where one party has more or better information than the other. It creates an imbalance of power in the transaction. A way to visualize it is with a scale. One side is the seller, the other the buyer. When the seller has more or better information, the transaction is likely to occur in their favor. The power is in their hands. An instance is when a used car is sold: the seller has a much more nuanced understanding of the car’s condition than the buyer, who can only estimate the market value based on what the seller says and their assessment of the vehicle.

The power can be on either side. When buying health insurance, the buyer is not always required to detail their future health risks. As the insurance company does not have this information, the buyer pays the same premium as someone more or less likely to require a payout in the future. Thus the insurance company bets on this information asymmetry with probability: it hopes the buyer isn’t hiding their sudden demise from them. Information asymmetry is any point when there is a disbalance in this relationship of knowledge. It causes non-economic and sometimes even hazardous behavior.

Many wars can be attributed to information asymmetry. They come from leaders miscalculating their prospects for victory. Since there is a difference in what national leaders know about each other’s armies, quality and quantity of military personnel, tactics, geography, and political climate. They also have absolutely no way of accurately anticipating the motivations of other leaders. Catch them in a bad mood, and they’re clicking the big red button.

Information asymmetry feeds into many other models. Adverse selection is where the ignorant party lacks information when negotiating. Take people who are at risk of health problems who buy insurance since the insurance company cannot effectively discriminate against them. Another example are most complex medical treatments which the recipient has no hope of understanding: heart surgery, joint replacements. Yet another is moral hazard. An instance is when people behave recklessly after becoming insured, either because the insurer cannot observe this behavior or cannot retaliate against it.

Real-life examples of information asymmetry:

• Used Car Market: sellers know the true condition of their cars. Buyers have limited information. This results in the market being dominated by lower-quality cars. Buyers are unwilling to pay a premium for a car they cannot fully assess.

• Health Insurance: individuals know their health risks better than insurers do. High-risk individuals are more likely to seek out comprehensive coverage, potentially leading to higher premiums for everybody, a classic case of adverse selection.

• Financial Markets: corporate insiders have detailed information about a company’s performance. Much more than outside investors. This can result in market inefficiencies where stock prices do not reflect the underlying value or risk of a company, and sometimes to insider trading.

• Job Markets: employers often rely on resumes and interviews to assess a candidates’ true ability, but candidates can embellish their qualifications. This information gap leads to hiring decisions that don’t realistically reflect a candidate’s potential.

How you might use information asymmetry as a mental model: (1) find the knowledge gap — analyze your situation to see where information imbalances exist, asking which side has more information and why in most transactions; (2) implement signaling — develop ways to communicate reliability and reduce asymmetry, such as via third-party reviews or asking for detailed, private, insider disclosures to get into the nitty gritty; (3) mitigate risk — recognize that there is potential for moral hazards, and when lending for instance, use deductibles or collateral to ensure these risks are assessed appropriately; (4) be see-through — encourage and reinforce practices that reduce information gaps, especially in organizational settings where open communication and detailed reporting can be make or break.