In contract theory, mechanism design, and economics, an information asymmetry is a situation where one party has more or better information than the other. Information asymmetry creates an imbalance of power in transactions, which can sometimes cause the transactions to be inefficient, causing market failure in the worst case. Examples of this problem are adverse selection, moral hazard, and monopolies of knowledge. A common analogy used to visualise information asymmetry is the typical weighing scale, wherein one side represents the seller and the other the buyer. When the seller has more or better information, the transaction will more likely occur in the seller's favour (the balance leans to the seller's side). An example of this could be when a used car is sold, in which case the seller is likely to have a much better understanding of the car's condition—and hence its market value—than the buyer, who can only estimate the market value based on the information provided by the seller and their own assessment of the vehicle. Conversely, in a scenario where the buyer has more information, the scale leaning towards the buyer's side represents a shift in the power to manipulate the transaction. When buying health insurance, the buyer is not always required to provide full details of future health risks. By not providing this information to the insurance company, the buyer will pay the same premium as someone less likely to require a payout in the future. Alternatively, a state of equilibrium can be achieved whereby both agents are equally knowledgeable. If it's the case that all information relevant to a given transaction is known to both (or all) parties, the situation is said to be a perfect information scenario. Information asymmetry extends to non-economic behaviour. Private firms have better information than regulators about the actions that they would take in the absence of regulation, and the effectiveness of a regulation may be undermined. International relations theory has recognized that wars may be caused by asymmetric information and that "Most of the great wars of the modern era resulted from leaders miscalculating their prospects for victory". Jackson and Morelli wrote that there is asymmetric information between national leaders, when there are differences "in what they know [i.e. believe] about each other's armaments, quality of military personnel and tactics, determination, geography, political climate, or even just about the relative probability of different outcomes" or where they have "incomplete information about the motivations of other agents". Information asymmetries are studied in the context of principal–agent problems where they are a major cause of misinforming and is essential in every communication process. Information asymmetry is in contrast to perfect information, which is a key assumption in neo-classical economics. In 1996, a Nobel Memorial Prize in Economics was awarded to James A. Mirrlees and William Vickrey for their "fundamental contributions to the economic theory of incentives under asymmetric information". This led the Nobel Committee to acknowledge the importance of information problems in economics. They later awarded another Nobel Prize in 2001 to George Akerlof, Michael Spence, and Joseph E. Stiglitz for their "analyses of markets with asymmetric information". The 2007 Nobel Memorial Prize in Economic Sciences was awarded to Leonid Hurwicz, Eric Maskin, and Roger Myerson "for having laid the foundations of mechanism design theory", a field dealing with designing markets that encourage participants to honestly reveal their information.
History The puzzle of information asymmetry has existed for as long as the market itself but remained largely unstudied until the post-WWII period. It is an umbrella term that can contain a vast diversity of topics. Greek Stoics (2nd century BCE) treated the advantage that sellers derive from privileged information in the story of the Merchant of Rhodes. Accordingly, a famine had broken out on the island of Rhodes and several grain merchants in Alexandria set sail to deliver supplies. One of these merchants who arrives ahead of his competitors faces a choice: should he let Rhodians know that grain supplies are on the way or keep this knowledge to himself? Either decision will determine his profit margin. Cicero related this dilemma in De Officiis and agreed with Greek Stoics that the merchant had a duty to disclose. Thomas Aquinas overturned this consensus and considered price disclosure was not obligatory. The three topics mentioned above drew on some important predecessors. Joseph Stiglitz considered the work of earlier economists, including Adam Smith, John Stuart Mill, and Max Weber. He ultimately concludes that though these economists seemed to have an understanding of the problems of information, they largely did not consider the implications of them, and tended to minimize the impact they could have or consider them merely secondary issues. One exception to this is the work of economist Friedrich Hayek. His work with prices as information conveying relative scarcity of goods can be noted as an early form of acknowledging information asymmetry, but with a different name.
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