Information asymmetry is a predominant issue in economics. In most sales transactions, the seller has more information than the buyer, in other words the seller has the opportunity to sell low quality faulty products for higher prices. This leads buyer to distrust seller and therefore develop a feeling of questioning products on the market.
A good way to explain this particular issue is analyzing Adverse selection, which is a market process where information asymmetry causes negative results. For example health insurance companies. Insurance companies depend on various clients, that is they need a certain number of healthy individuals to pay premiums (an amount to be paid for an insurance policy) and not use a lot of the company’s services. The premium prices of the ones who pay more than what the company spends on them, has to exceed the ones who pay less than what they insurance company to balance out. However, people who most likely buy health insurance are people who need it due to their health problems. These people are more costly to the insurance companies because they need more services than a healthy person. The insurance companies do not know every new policy applicants health status but can certainly do everything in their power to find out as much as they can, and this lack of information leads these kind of companies to raise premiums in order to reduce the risk of covering their clients’ health bills than they can afford. This increase in premiums will cause the healthiest people to cancel their insurance which will result into a further increase in premium price to balance out this new gap. Since insurance companies now have a riskier and more costly group, the companies will need more money to sustain its clients, which will lead them into another increase in premiums, and this will result into the averagely healthy people canceling their insurance as well. This vicious cycle goes on, until the only people insured by the companies are the least healthy. At this point, the premiums paid will not even begin to cover the costs of the sick. In theory, this could potentially lead to the fall of the health insurance industry, however, this is an unlikely scenario as this kind of risk is diminished by things like employer offered insurance, which makes the largest source of money for insurance companies and the people’s need to feel safe or people’s need to take precautions.
Another information asymmetry example is the “Market for Lemons”, a term originally by the economist George Akerlof. The ‘used car’ market is the classic example of quality uncertainty (lack of enough information on quality). A damaged used car is generally the result of unnoticeable actions,such as the owner’s driving style, how the car was being maintained and accidents. Because the buyer does not have this information, his/her best assumption is that the vehicle is of average quality, and therefore will pay only an average fair price. As a result, the owner of a car in great condition, will suffer from this because he/she will not be able to get a price high enough to make selling his/her car in great condition worthwhile. Therefore, the owner of good cars will not sell his/her vehicles in the used-car market because it reduces the quality of cars in the used-car market, which reduces the price buyers will pay, and also reduces the quality of cars sold and so on.
” George Akerlof.” The Market For Lemons. 1970. <http://wikisum.com/w/Akerlof:_The_market_for_lemons>