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Asymmetric Information

Unequal, disproportionate, or lopsided information between two parties

What is Asymmetric Information?

Asymmetric information is, just as the term suggests, unequal, disproportionate, or lopsided information. It is typically used in reference to some type of business deal or financial arrangement where one party possesses more, or more detailed, information than the other.

 

Asymmetric Information

 

The issue with asymmetric information starts before any transaction takes place. Typically, one party possesses more information than the other before entering into the transaction in the first place, often with the intent to get a better deal than is due. Consider, for example, the sale of a used car. The individual or dealership selling the car typically knows more about the vehicle than they pass along to the buyer.

 

The Issue of Moral Hazard

One example of asymmetric information, in the broader economic sense, relates to moral hazard. By definition, moral hazard is fundamentally based on asymmetric information. In a moral hazard situation, a party that is entering into an arrangement of some type (often involving insurance) knows that their actions will be covered by the other party,. Thus, they don’t necessarily concern themselves with how risky the situation is, or are encouraged to take risks, knowing they won’t suffer the consequences.

 

Asymmetric Information in the Financial World

Asymmetric information examples are everywhere. In the financial world, consider a situation where a lending institution enters into an agreement with a borrower. The lender establishes the terms and agreements that the borrower must stipulate to, and usually, background checks are done.

However, the borrower may not accurately explain what they are borrowing the money for and may use it in a way that involves a level of risk that – had the lender been aware of it – would likely have led the lender to decline making the loan. The lender may end up with a loan that isn’t repaid on time or isn’t paid back at all. Such a situation can result in far-reaching consequences if the loss is so great that the lender is forced to charge higher interest rates to other borrowers to make up for the loss.

The ideal situation for any agreement or deal is one of perfectly symmetrical information, where each party has the same information, and both parties have all the information relevant to the transaction. That way, both parties can enter into the deal with confidence and reap from it what they expect.

Asymmetric information exists virtually everywhere, making flawless business agreements and transactions almost impossible to come by. In the best cases, asymmetric information causes some hurdles but leaves both parties relatively unscathed. At its worst, asymmetric information can cause severe financial hardship to one party and lead to broken agreements and failed deals.

 

Information Asymmetry Outside of Economics

Asymmetric information exists outside of economics as well. Disproportional information can exist in all facets of life, but one common place where it can be found is within international relations and politics.

The leaders of countries consistently meet to make trade agreements and to establish allegiances,. Asymmetric information in such situations can lead to an unfair benefit for one nation over another. In extreme cases, war can ultimately break out because of asymmetric knowledge by one party or another. And in such cases, the winning side or the side that gains the right to dictate the terms of surrender is the side that holds more information or better information about their own troops and the strategies of the opposing side.

 

Related Readings

Thanks for reading CFI’s explanation of asymmetric information. CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Due Diligence
  • Mosaic Theory
  • Public Company Filings
  • Qualitative Characteristics of Accounting Information

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