Efficient Operation of Markets

The Evidence on the Impact of Asymmetric Information on the Efficient Operation of Markets


Humans are the wisest animal on earth and we take all our decisions based on the information we gather from our surroundings. Market works on information. For each market activity, whether it is selling or buying, information is necessary. It is not necessary that the information possessed or gathered by a person are genuine. There are right and wrong information. The knowledge or information possessed or conceived by two individuals are always different because no two individuals are alike either physically or psychologically. Moreover, the nature of the environment in which different persons interact may also be different which again contributed for the difference in levels (asymmetry) of information possessed by two persons.

Asymmetric information is one of the major weapons in the hands of the marketers or sellers. Marketers often possess better knowledge about the product or service they offered to the customers. Customers on the other hand may not have technical knowledge about the product they are going to purchase. They forced to swallow whatever the information passed on to them by the sellers. Such information might be an incomplete one and might not be 100% correct as well. In short, the buyers forced to buy products or services without having adequate information about it. Consumers who purchase products without adequate information may face problems later and their confidence in the seller might be severely spoiled. This paper briefly explains the asymmetric information in the market and its impact on efficient operation of market taking examples from online market, insurance market and used car markets

Asymmetric information and online markets

Hou et al (2009) have pointed out that some researchers identify a higher online auction price than the offline/e-tailing market price for the same item, whereas others indicate the opposite. They also mentioned that the conventional bidders are uncertain about the true value of an auction item and have to estimate it. The buyers often pays a price that is more than what the item is worth (i.e., the winner‘s curse) (Hou et al, p.144). Online bidders are incapable of physically verifying the quality of the product they bidder for. They always depend on the information about the product features provided by the seller to decide whether to go for it or not. The concept of winner's curse occurs more frequently when there is high level of uncertainty occurs in the deal. If the buyers know more about the product, they will look for the possibilities of negotiation or bargaining before purchasing. On the other hand if the buyer possesses less information, he will normally refrain from bargaining which will immensely help the seller in selling the product or service at a higher rate.

Dewan and Hsu (2004) have pointed out that even though the digital attributes such as catalog number, description, size, seller rating, etc can be transmitted electronically, it is not possible to transmit the non-digital attributes such as product condition, product quality, seller reliability, etc using computer or internet (Dewan and Hsu, p.497). Recently, I read an internet blog article in which a person has mentioned his terrible experience with electronic purchasing. This person was an Indian and he was suffering from hair loss. An internet company offered him assistance and they convinced him that if he was not satisfied with the results of the product, they have the money back guarantee policy and he will get the money back except the postage charges. This Indian fellow purchased that product at a higher price and got no benefit out of it and lost his money even though the money back offer was there. The company was operating in Singapore as per the information provided in the website and his repeated messages for the retur of money have gone unanswered. Even though e-commerce is growing at a significant rate, from the above example it is evident that the asymmetry of information and the subsequent terrible experiences of the buyers are spoiling the electronic industry. Electronic sellers have the immense advantage that the buyers are not able to verify the product physically before the purchase.

Asymmetric information and insurance markets

Insurance market is another market in which the sellers exploit the buyers because of the asymmetry of information between them. Vehicle insurance and healthcare insurance sector are the worst affected areas as far as the exploitation of the buyers are concerned. Finkelstein & Pterba (2002) have found some correlation between features of insurance contract and risk types. They predict that high risk types will select any feature of an insurance contract for which the marginal value is higher for them - at all prices and for all possible contracts - than for low risk types (Finkelstein & Pterba, p.4). The nature of risk involved is the major criteria for the customers in deciding about whether to opt for high premium or low premium insurance product. People who opt for high premium insurance product may have high level of risks involved in their activities compared to those who opt for low premium products. For example, an entrepreneur may opt for high premium insurance products compared to other individuals. The insurance advisers on the other hand know this difference of attitudes of people and based on that, they advice the people hiding all the negative aspects of the products offered.

The hidden costs and risks in insurance products may not be revealed to the public by the insurance advisers. For example, mutual fund products are subjected to market risks since most of the mutual funds are associated with the share markets. The mutual fund advisers will never say anything about the risks involved in depositing in mutual funds. Even the offer document may not highlight any of the risk involved or the service charges involved. Only after joining the schemes, people will realize the dangers involved in it.

Healthcare insurance sector is one of the worst affected areas in which the asymmetric information create problems for the patients or the insurance seekers. Olivella and Hernández (2008) has mentioned importance of adverse selection in healthcare insurance sector because it is one of the main justifications for public intervention in insurance markets (Olivella and Hernández, p.2) Adverse selection refers to a market process in which unhealthy results occur when buyers and sellers have asymmetric information. Adverse selection can affect sellers or the service providers also. For example, banks have unified rules for all the public irrespective of the rich or the poor. It is difficult for them to make different rules for different persons. Such standardized rules utilized by the greedy customers in taking loans from banks for each and everything without assessing their financial abilities. Banks were forced to provide loans for all the lean seekers without assessing their financial capabilities. The loan takers failed to repay the loans and many big banks collapsed in America recently because of that. In other words asymmetric information can affect the service provider also.

Asymmetric information and used car markets

Asymmetric information is a serious threat for the buyers of used cars. The used car seller may have all the information about the condition of the vehicles he is going to sell. But if he reveals the problems of the vehicle, nobody will buy vehicles from him. On the other hand, if he was able to convince the customer about the quality of the vehicles on sale, he will get more sales. So, naturally he will be forced to hide the negatives of the vehicle in front of the customer. The buyer may not get any support from the original manufacturer for the used cars he purchased. The vehicle manufacturers always give service and warranty to the new vehicles only. If the used car buyer needs service or warranty, the seller normally will charge more.

Schneider (2005), has pointed out that adverse selection prevents used cars from reaching owners who value them most highly. He has also mentioned that the absence of regulatory structures have contributed to the inefficiencies resulted from asymmetric information (Schneider, p.1&4). The used car sellers have the benefit that they are free from the barriers of legal frameworks as far as the quality of the vehicles they sold. It is difficult for a customer to sue against used car seller because of the poor quality of the vehicle, if the seller has not provided any warranty for it. In short, used car market is another area in which the theory of adverse selection and asymmetric information negatively impact the market.


Asymmetric information or the theory of adverse selection negatively affects the market. Both buyers and sellers can be the victims of asymmetric information. In most of the cases, the buyers will be affected by the asymmetric information. The asymmetric information leads to unhealthy trends in the market which may spoil the relationships between the customers and the sellers or service providers. The absence of legal frameworks helps both the customers and the sellers in utilizing the asymmetric nature of information for their own advantages. For the healthy growth of the market the cooperation between the buyers and the sellers are essential and for that purpose information needed to be symmetric between the buyers and the sellers.

Works Cited

1. Dewan Sanjeevand Hsu Vernon. 2004. “Adverse Selection In Electronic Markets: Evidence From Online Stamp Auctions”. Journal of Industrial Economics, Vol. 52, No. 4, P. 497-516. 04 February 2010.

2. Finkelstein and Poterba. 2004. “Adverse Selection in Insurance Markets: Policyholder Evidence from the UK Annuity Market”. Journal of Political Economy, Vol. 112, p. 183-208. 04 February 2010. <http://www.econ.yale.edu/seminars/labor/lap03/poterba-030306.pdf>

3. Hou Jianwei, Kuzma Ann and Kuzma John.2009. “Winner‘s Curse or Adverse Selection in Online Auctions”. 04 February 2010. <http://www.csulb.edu/journals/jecr/issues/20093/Paper3.pdf>

4. Olivella and Vera-Hernandez. 2008. “Testing for Adverse Selection into Private Medical Insurance”. IFS Working paper, WP06/02. 04 February 2010. <http://www.ifs.org.uk/wps/wp0602.pdf>

5. Schneider “Estimating the Effects of Adverse Selection in Used Car Markets”. 04 February 2010. <http://www.econ.yale.edu/seminars/apmicro/am05/schneider-051208.pdf>

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