Asymmetric Information
It’s Impact on the
Financial Markets
Econ 102
What is the Problem?
• In economics and contract theory,
information asymmetry deals with the
study of decisions in transactions where
one party has more or better information
than the other. This creates an imbalance
of power in transactions which can
sometimes cause the transactions to go
awry.
Examples of asymmetric
information
• Seller usually has better information: used-car
salespeople, mortgage brokers and loan
originators, stockbrokers, Realtors, real estate
agents, and life insurance transactions.
• Buyer usually has better information: estate
sales as specified in a last will and testament, 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.[2]
Classifying the problems
• Examples of this problem are adverse
selection and moral hazard. Most
commonly, information asymmetries are
studied in the context of principal-agent
problems.
Adverse Selection
• the ignorant party lacks information while
negotiating an agreed understanding of or
contract to the transaction
• 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
Moral Hazard
• moral hazard the ignorant party lacks
information about performance of the agreedupon transaction or lacks the ability to retaliate
for a breach of the agreement
• 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.
Principal-Agent
• principal hires an agent, such as the
problem that the two may not have the
same interests, while the principal is,
presumably, hiring the agent to pursue the
interests of the former
Empirical Studies
• Lazear (1996) saw productivity rising by 44%
(and wages by 10%) in a change from salary to
piece rates, with a half of the productivity gain
due to worker selection effects.
• Fernie and Metcalf (1996) find that top British
jockeys perform significantly better when offered
percentage of prize money for winning races
compared to being on fixed retainers.
Empirical Studies
• Kahn and Sherer (1990) find that better
evaluations of white-collar office workers
were achieved by those employees who
had a steeper relation between
evaluations and pay.
• Nikkinen and Sahlström (2004) find
empirical evidence that agency theory can
be used, at least to some extent, to
explain financial audit fees internationally.
Readings
• Moral hazard: (MBN) Ch. 20 Mortgage
Meltdown
• Principal/Agent: MBN Ch. 22 Is your
Banker Heading to Vegas?
• Barron: Ch. 21 Asymmetric Information