JARG ONALERT Information Asymmetry BY BECKY JOHNSEN

n economics, a standard assumption is that market independent reviews and ranking systems are available participants have — and base their decisions on — on the Internet. Also, the cost of not investigating I“perfect information.” However, in real life, this is not college choices is particularly high. If a student selects a the case; consumers cannot possess all available knowledge college that is not a good fit, this may result in a costly and concerning all transactions. Even though the assumption time-consuming transfer to another institution, or years of of perfect information is widely used, economists have tuition that could have been better spent elsewhere. In a developed methods for studying the behavior of markets worst-case scenario, the student may be forced to drop out with imperfect information. One important kind of imper- of college and be unable, for a variety of reasons, to return fection is information asymmetry. or attend another. As a result, information asymmetry is Information asymmetry exists when one party, typically largely nonexistent in this market. The consumer seeks to the buyer, has less perfect information than the other. If become informed because information is easily accessible, the price of a good or service does not accurately reflect its and not doing so creates a large risk that the transaction will quality and the buyer does not possess as much information fail — a risk that entails significant costs. regarding the product as the seller, this can place the buyer Granted, there are limitations to this example; there is at a disadvantage. The term “information asymmetry” was information accessible to the consumer only once the popularized by George Akerlof in his 1970 student has enrolled in college. It may paper “The Market for Lemons.” This turn out a school is not a good fit for concept was applied further by Michael even a well-informed applicant for Spence and Joseph Stiglitz, who, with reasons that could not have been reason- Akerlof, shared the 2001 Nobel Prize for ably predicted. Nonetheless, even in this their work. case, the consumer did everything Information asymmetry is applicable possible to obtain information equal to to many common transactions; a few that of the college’s admissions officer, examples are fixing a car, selecting reducing the possibility of information a college, and obtaining a home mort- asymmetry between the two parties. gage. In each of these instances, the The final example involves one of the typical consumer weighs the opportunity most important purchases most people cost of gathering more information make: obtaining a home mortgage. As against the potential costs associated with recent issues in the mortgage market accepting some level of ignorance about the product. demonstrate, there was widespread information asymmetry Consider the case of hiring a mechanic. As all car owners between many borrowers and their lenders. Even though the know, it would require a substantial investment of time at a terms of a mortgage contract generally are quite explicit, trade school or working at a garage to understand a car as many home buyers find those contracts, especially their most well as the average mechanic, so most people do not attempt important features, difficult to understand. The costs of not to make their own repairs. In a worst-case scenario, a dishon- thoroughly understanding the mortgage agreement are large, est mechanic could overcharge the client and fail to repair and may result in years of high-interest payments or even the car, resulting in an accident or further damage to the car. foreclosure. So, the consumer has to make a choice: whether However, most consumers seem to agree that this is an to seek outside help in understanding the contract or simply unlikely situation, and instead accept the more likely sce- to trust the mortgage provider. That choice often determines nario that they may simply be overcharged. As a result, the level of information asymmetry in this market. information asymmetry often exists between the average These examples illustrate the degree to which informa- consumer and a mechanic. The consumer does not become tion asymmetry is prevalent in many common transactions. fully informed because it would be difficult to do so, and the In some cases, there are high opportunity costs to spending costs of possibly making a poor decision are acceptably low. the time and money to gather information about a purchase, Another significant transaction many people enter into is so consumers do not bother with detailed investigations. selecting a college. In this instance, information asymmetry In other cases, the risks of agreeing to less-than-optimal

between the buyer, who pays the tuition, and the seller, the terms could be highly consequential for a consumer, OOK

college, is largely nonexistent. Here, information is readily prompting the consumer to conduct thorough research. THY C available to prospective students and parents. Institutions Rational consumers must balance these two factors when TION: TIMO

send comprehensive brochures to students, and a wealth of making decisions in the marketplace. RF TRA ILLUS

10 Region Focus | Fourth Quarter | 2010