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Handbook > Decision-Making Under Uncertainty > Asymmetric Information > Coping with the Effects Printer Friendly

Coping with Effects of Asymmetric Information

There are different strategies for mitigating inefficiencies that arise due to information asymmetry. Some strategies focus on investing in signals that convey as much information as possible to the less informed side. This is called signaling. It is a mechanism through which providers of superior quality try to distinguish themselves from the suppliers of inferior quality. For example sellers of a good quality car may want to offer warrantee for technical failures to convince the buyers that the car is dependable. This will help to differentiate between bad and good qualities since it will be too costly for the sellers of the poor quality to provide warranty. In the labor market, individuals may want to invest in better education to convince the potential employers that they possess superior skills. Reputations established through brand names, franchises and standardized quality can also serve as strong signals.

Other strategies try to exploit the power of incentives to minimize the impact of asymmetric information on efficiency. For example the owner-manger problem could be minimized by allowing the mangers get some percentage of profits. The manger-worker problem could be reduced through performance based compensations and rewards. Higher wages could also make it expensive for the worker to misbehave and hence may improve efficiency. This falls under what is called efficiency wage theory. A highly paid worker will have an incentive to improve efficiency so as not to lose the job. But the effectiveness of incentive designs in mitigating inefficiency depends on the extent to which agents respond to incentives.

Moral hazard problems in insurance markets can be minimized by refusing to provide full coverage so that the insured feels part of the pain when negligent damages occur. Collateral requirements may reduce the inefficiencies that arise due to moral hazard problems in credit utilization.

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