3.1.2.2 - Imperfect and asymmetric information

Information and informed choice

A consumer can compare benefits and costs more accurately when relevant information is available, understandable and credible.

The rational-choice model does not work well if a person misjudges the alternatives. Imperfect information means that decision makers lack full or accurate relevant information. A consumer may know a product's price but not its durability; an employer may observe qualifications but not future effort. Both parties can be poorly informed. Imperfect information is broader than unequal information.

Consider these invented one-year phone contracts. Both provide identical service, and the consumer knows they will keep the contract for exactly twelve months.

For A, $12\times£20+£30=£270$. For B, $12\times£22=£264$. Choosing solely by the advertised monthly charge makes A appear £2 cheaper, yet B saves £6 over the relevant period. If the setup charge is hidden, a consumer who tries to minimise total spending may make a worse choice according to their own preferences. That is a mistake about the alternatives, not proof that they prefer the more expensive service.

Information is also costly to obtain. Reading every review of a £2 purchase may cost more time than a small improvement in the choice is worth. A rational consumer can stop searching when the expected benefit of extra information falls below its cost. Uncertainty does not disappear simply because a person gathers more information: future reliability cannot always be known beforehand.

Asymmetric information and selection

Asymmetric information occurs when one side of an economic transaction has relevant information that the other side lacks.

A seller of a used bicycle may know whether its frame has been damaged, while a buyer cannot tell from appearance. The information is asymmetric because it is unevenly held; this is not merely a situation where nobody knows future repair costs. Information asymmetry can favour either side. A job applicant may know more about their abilities than the employer, and an insurance applicant may know more about their own risk than the insurer.

One possible result is adverse selection: hidden characteristics before an agreement affect which people or products participate. Suppose buyers cannot distinguish durable bicycles from unreliable ones. They offer a price reflecting the risk of poor quality. That offer may be too low for owners of durable bicycles, who withdraw them from sale. The remaining mix becomes less reliable, reducing buyers' willingness to pay further. Some mutually beneficial trades in good bicycles may never occur.

This is a possible chain, not a claim that every second-hand market collapses. Reliable inspection, enforceable warranties and sellers' reputations can make quality more observable or give the seller an incentive to supply good quality. Repeat business matters because a seller expecting future customers has more to lose from misleading today's buyer. A high price by itself is not proof of high quality: an unreliable seller can also ask a high price.

The market may therefore allocate too little to good-quality transactions or too much to products whose benefits are overstated. Market failure means an inefficient allocation of resources by the market. The lost trades illustrate how information problems can cause it, even when both sides respond sensibly to the information they possess.

Hidden action and incentives

Information asymmetry can also matter after an agreement when one party cannot fully observe the other's actions.

Moral hazard occurs when protection from consequences changes behaviour and the other party cannot fully observe or control the relevant action. The term does not mean that all insured people act dishonestly. It describes an incentive problem.

For example, before insurance a bicycle owner bears the full financial loss from theft. After obtaining full insurance, the owner bears less of that loss. If locking the bicycle carefully takes effort, some owners may become less careful. The insurer cannot observe each locking decision, and theft risk and claims can rise. The cost is partly shifted to the insurer and ultimately to the pool of policyholders through premiums. A deductible, where the owner bears part of each loss, preserves some incentive to take care. Monitoring or security conditions can also help, although they are costly and may be hard to enforce.

Distinguish this from adverse selection. If an applicant already knows they habitually park in high-risk places and the insurer cannot identify that risk before offering a policy, the problem is hidden characteristics at selection. If insurance itself encourages less careful parking afterwards, the problem is changed action after protection. The two can occur in the same market, but they are different mechanisms and suggest different responses.

The consequences are conditional. An owner may continue taking care because theft causes inconvenience, because the bicycle has sentimental value, or because future premiums may rise. Those remaining costs weaken the incentive change. Information asymmetry creates a potential problem; its size depends on the contract and the behaviour it actually changes.

Improving information and its limits

Better disclosure, trustworthy verification and incentives to provide accurate information can reduce inefficient choices and lost trades.

Different problems require different responses. A clear total-price label addresses hidden fees. An independent safety inspection helps a buyer assess otherwise hidden quality. A seller-funded warranty transfers some consequences of breakdown back to the seller, giving the seller a reason to avoid unreliable products. These mechanisms can help governments, consumers and firms; an instruction to “provide more information” is incomplete unless it explains which information matters and why it is credible.

Suppose a college commissions an independent inspection service for second-hand bicycles. A certificate reports frame condition and the inspection date. Buyers can distinguish inspected durable bicycles from doubtful ones, so they may offer a price that keeps good sellers in the market. Beneficial trade can expand. However, the certificate covers the inspected condition, not every possible future fault. If inspectors are paid to ignore damage or certificates are forged, the expected information improvement may be small. Inspection fees also use scarce resources and can outweigh the benefit for low-value bicycles.

Evidence should separate the mechanism from the outcome. Higher sales after introducing a certificate are consistent with restored trust, but sales could also rise because of a seasonal increase in demand. A useful comparison would track otherwise similar bicycles with and without credible inspection, along with faults, prices and buyer understanding. More sales alone do not prove greater efficiency if poor products are still sold or certification costs exceed the gains.

Imperfect information can therefore make a rational decision difficult without making the consumer irrational. Information policies can improve decisions, yet their effectiveness depends on relevance, comprehension, credibility and the costs of obtaining and using the information.

Quick recap

Imperfect information is missing or inaccurate knowledge; asymmetric information is unevenly held relevant knowledge. Hidden characteristics can cause adverse selection, while hidden actions after protection can cause moral hazard. Credible information and suitable contracts can reduce these problems, but they have costs and limits.