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Asymmetric Information

Information asymmetry refers to a situation where agents have unequal access to information required to engage in a transaction. In effect the market transaction is subject to uncertainty about the characteristics of the product and/or the behavior of the other agent. Consequently, the decisions of the less informed agent will have to be based on some probabilities. This leads to imprecise pricing and hence inefficient market outcomes.

For example, a worker is usually better informed about his/her skills and motivation than the potential employer. The employer will have to partially guess the possible characteristics of the worker and might want to reflect this uncertainty on the wage to be paid to the worker. As a result, the worker might end up getting paid a lower wage than what he/she actually deserves on the basis of his/her productivity. This might discourage the worker and result in inefficiency of the labor market.

Information asymmetry can arise in a number of other markets. Insurance companies are often less informed about the characteristics of their clients than the clients themselves. Banks are less informed about the behavior of the borrowers than the borrowers themselves. Sellers of a commodity are usually better informed about the quality of the product than the buyers. Three major cases of market failure attributed to information asymmetry are widely investigated in Economics literature: adverse selection, moral hazard and principal-agent problem.

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