Asymmetric Information: When One Side Knows Too Much (And Uses It) HL Only

Asymmetric Information: When One Side Knows Too Much (And Uses It) HL Only

Imagine buying a second-hand car. It looks shiny, the seller’s smiling, the price seems fair, after all, it could be your lucky day. But two days later the engine starts making sounds like a blender full of gravel. Surprise! You’ve just been hit with asymmetric information.

This economic concept may sound fancy, but it’s basically what happens when one party in a deal knows more than the other - and uses that knowledge to their advantage. The result? Misguided decisions, unfair outcomes, and yep... market failure.

What Is Asymmetric Information?

Coined by economists trying to explain why markets sometimes work terribly, asymmetric information is when one side (buyer or seller) has more or better information than the other.

Think of it like playing poker with someone who’s already peeked at your hand. It creates an imbalance of power, and leads to some pretty irrational outcomes.

This isn’t just about dodgy car dealers - it happens everywhere: healthcare, insurance, finance, employment, even dating apps.

Why It Causes Market Failure

When one side knows more, they can act in opportunistic ways - making decisions that serve their self-interest but leave others worse off. Two major types of this behaviour are:

Type 1: Adverse Selection - The Lemon Problem

This happens before a transaction. One side hides dodgy details, the other side takes a leap of faith.

Example? Used car markets. Sellers know if the car’s a lemon. Buyers don’t. So buyers offer less money - just in case it’s rubbish. That discourages good sellers from even entering the market. Result: the whole market declines.

This is adverse selection - bad products (or risks) drive out the good.

Other real-life examples:

• Health insurance: People who know they’re likely to get ill are more motivated to get insurance - insurers can’t always tell in advance about their physical condition.

• Online dating: One side uploads a photo from 2014. The other assumes it’s recent. Classic pre-transaction information gap.

Type 2: Moral Hazard – What Happens After the Deal

Now imagine you’ve got full car insurance. Suddenly, parallel parking feels less stressful... maybe you are too relaxed. Why? You know someone else is covering the cost.

That’s moral hazard - when someone takes riskier behaviour because they don’t bear the full consequences.

Examples:

• People taking more sick days once they have job security.

• Bankers making risky investments because they expect government bailouts (2008 financial crisis, anyone?)

• Students studying less for a test because their mate promised to help them revise the night before.

Moral hazard kicks in after the transaction, once the safety net is already in place.

Why It All Leads to Market Failure

Both adverse selection and moral hazard result in bad decisions, wasted resources, and inefficient outcomes. That’s classic market failure - the market can’t allocate resources in a way that maximises social welfare.

And it's not just about too little information - sometimes it’s too much. Ever tried booking a hotel online and ended up trapped in a swamp of contradictory reviews? Yep, that’s the information overload effect - also part of the problem.

How Do We Fix It?

Governments and the private sector both try to reduce asymmetric information - and they can get quite creative.

Government Solutions

• Legislation – e.g. minimum age laws for gambling or smoking

• Regulation – watchdogs like the UK’s Advertising Standards Authority monitor adverts to ensure they’re “legal, decent, honest and truthful”

• Provision of information – food labels, energy ratings on appliances, health warnings on cigarette packs, vaccine info campaigns

All aimed at helping consumers make better-informed choices.

Private Sector Responses

Sometimes the private sector beats government to the punch with clever tricks like:

Signalling

When the informed party (e.g. a seller or job candidate) shows proof they can be trusted.

Examples:

• Offering warranties = “we believe in our product”

• Displaying certifications (like CPA or PMP) = “I’ve got the skills”

• Money-back guarantees = “we’re confident you won’t need this”

Screening

When the less informed party takes action to gather information before deciding.

Examples:

• Employers use interviews, CVs, and aptitude tests

• Insurance companies use health forms and driving histories

• Banks check credit scores

• Shoppers read online reviews (or text a mate: “Is this brand actually good?”)

Screening helps close the info gap before making a decision.

Final Thought: Knowledge = Power

Asymmetric information messes with markets - but it also explains why information is currency in economics.

Firms, consumers, and governments are all locked in a game of “who knows what.” The better informed we are, the better our chances of making rational, efficient decisions.

So next time someone tries to sell you a too-good-to-be-true phone on Facebook Marketplace or eBay… ask yourself: what am I missing here?

Stay well