The adverse effects of information asymmetry

The adverse effects of information asymmetry

Following the death of her first husband in a tragic accident, the newly widowed Joann Curley married 32-year-old electrician Robert “Bobby” Curley. Two months after the wedding, paperwork filed with Bobby’s insurance agency made Joann the sole beneficiary of his $300,000 life insurance policy. Unfortunately, Bobby began to experience unexplained hair loss, hallucinations and neurological damage before he finally died only 11 month later. Investigators would eventually determine that Bobby had been poisoned with Thallium, planted in his iced tea by Joann.[1] In the meantime, their insurance company who were unaware of the murderous plot, had paid out the $300,000 to Joann. While Bobby was falling victim to Joann’s thallium laced iced tea, his insurance company was falling victim to Information Asymmetry: a situation that arises when one side of a transaction has more information than the other. This article will examine the many ways information asymmetry can lead to adverse outcomes in markets that run the gamut from used cars to healthcare.

In an ideal market, both buyers and sellers have perfect information about all the products being bought and sold.[2] Armed with this knowledge, consumers can make rational decisions about what to buy that efficiently meet their wants and needs. However, perfect information about a market is very hard to obtain. In most markets there is at least some uncertainty about the quality of goods being sold, what prices competitors are selling for and so on, and this uncertainty gives rise to inefficiency.[2] More concerning is when one side of a transaction is operating on limited information while the other has much more knowledge at their disposal. This asymmetry of information can lead to market failure, with buyers and sellers making decisions that are inefficient and fail to increase overall welfare.[3]

When information asymmetry is high, market forces can influence the quality of goods sold to rapidly deteriorate. This occurs because in the context of low information, buyers are unable to distinguish between high- and low-quality products. Economists refer to this phenomenon as “adverse selection”.[3] Economist George Akerlof’s 1970 paper “Market for Lemons” explains the mechanisms behind this.[4] Using the used car market as an example, Akerlof suggests that there are two types of cars: ‘peaches’ which are high quality, valuable cars, and ‘lemons’ which are low quality, low worth cars. Sellers know whether their car is a lemon however buyers do not. Given that consumers cannot distinguish between peaches and lemons, they will pay the same price for a peach as they will for a lemon. If a market contains both peaches and lemons, Akerlof suggests this price will be equal to the average of the two. At such a price, sellers of peaches will be receiving a lower price than their car would ordinarily be worth, while sellers of lemons will be receiving a higher one. This creates a disincentive for the sellers of peaches, increasing the likelihood that they will leave the market. The sellers of lemons on the other hand, are incentivised to stay in the market and will command a greater slice of the pie. The work of Akerlof demonstrates one of the ways that information asymmetry in a market can result in worse outcomes for consumers.

In the context of healthcare, the information asymmetry between doctors and their patients creates a conflict of interest which can lead to poorer health outcomes.[5] Understanding the risks and benefits of various treatments can be a highly complex task. The efficacy of many treatments, particularly surgeries, is subject to great debate. Deciding if a treatment is necessary requires specialised knowledge that most patients do not have. Because of this, it is common for patients to trust doctors to make some decisions on their behalf.[5] However, because doctors are often the ‘sellers’ of the treatments they prescribe, trusting them to make decisions on a patient’s behalf risks creating a significant conflict of interest. There is a risk that doctors will recommend treatments for financial reasons that patients would not have chosen if fully aware of the costs and benefits. For example, surgeons could recommend an unnecessary surgery, and patients, who lack the information to evaluate it, would be likely to trust this recommendation. Economists refer to these extra treatments as “supplier induced demand” and in the market for surgeries, they can result in major medical complications.[5]

So how then can governments tackle the problems caused by information asymmetry? One solution is to implement professional licensing and quality regulations to prevent sellers from providing substandard products. Most nations have strict licensing requirements for healthcare workers for example. However, this risks creating more problems for consumers because the higher barriers to entry into the market may decrease the number of sellers. These sellers will then have greater market power which they can use to set high prices. Indeed, a 2004 survey of economists found many who believed that medical licensing constituted “a significant barrier to effective, cost efficient health care”.[6] Other proposed solutions include greater efforts towards consumer advocacy, professional ethics standards, and better information for consumers.[5] However, in many markets, perfect information for consumers is likely to remain elusive.

Much like the criminal intent to murder her husband hidden within the dark recesses of Joann Curley’s mind, solutions to the problems caused by information asymmetry are not readily apparent. However, given its impacts on consumer wellbeing, action to remedy this pressing issue is sorely needed.

[1] ‘Till death do us part’ [television broadcast]. Forensic Files. Medstar Television; 10 November 1999

[2] Dutta S. Introductory economics (micro and macro). New Delhi: New Age International (P) Ltd., Publishers; 2006.

[3] Black J, Hashimzade N, Myles G. A dictionary of economics. Oxford: Oxford University Press; 2012.

[4] Akerlof G. The Market for “Lemons”: Quality Uncertainty and the Market Mechanism. The Quarterly Journal of Economics. 1970;84(3):488.

[5] McPakeB. Health Economics an international perspective. 2nd ed.
Oxfordshire, England ; New York : Routledge; 2013.

[6] Svorny S. Licensing Doctors: Do Economists Agree?. Econ Journal Watch. 2004, Aug; 1(2)