Information asymmetry – where one party has superior information, putting the other party at a disadvantage – is often seen as the underlying cause of business transactions failing to meet expectations. Quoted examples of information asymmetry include “moral hazard” and “adverse selection”, with the former being the change in behavior of one of the parties in relation to the level of risk, and the latter referring to a situation where a bad choice is made because of a lack of information available to the person making the choice.
When party A has information which is not available to party B, or when party A can hold party B to clauses in a contract, even if the contract turns out to be detrimental to party B , but party B does not have the same safeguard, this is information asymmetry. While information asymmetry can occur in virtually any business transaction, the insurance business lends itself to an effective illustration of the principle. In adverse selection, insurance companies are often bound by law not to discriminate when selling insurance. For high risk individuals, the insurance company may be able to load the premium, or even negotiate certain conditions under which the insurance won’t pay out, but they are still providing insurance to the applicant based on the knowledge made available to them. Moral hazard can also be illustrated in insurance terms in that the insured person, knowing that they are covered by insurance, may engage in risky behavior – such as leaving an insured car in an unsafe area, or setting fire to their insured building for the insurance money – thereby increasing the chances of having to claim from the insurance company.
An analysis of how markets are affected by asymmetric information earned American economists Joseph Eugene Stiglitz, Michael Spence and George Akerlof the 2001 Nobel Prize in Economic Sciences. Their work has provided economists, stock analysts, investors and researchers with a clearer picture of the impact of asymmetric information in various contexts, and can also be applied to fields outside the scope of economics. It has been noted that the increased availability of information on the internet has somewhat leveled the playing field and to an extent reduced the impact of information asymmetry on financial transactions.