Within a firm's hierarchical structure, information is not distributed evenly, creating knowledge gaps between different levels. For instance, workers often possess specific knowledge that their managers lack, and managers have information that owners do not. A key consequence of this information gap is that directives from superiors may not be fully executed, as they lack complete information about what their subordinates know or are doing.

Information Asymmetry within a Firm's Hierarchy

Asymmetric information is a key source of principal-agent problems. It describes a situation where one party, typically the agent, has more or better information than the other, the principal. In an employment context, for example, an employee (the agent) knows their own level of effort, while the employer (the principal) does not.

Asymmetric Information in Principal-Agent Problems

The fundamental problem with incomplete contracts is their inability to ensure all parties' interests are met. This issue is rooted in asymmetric information, where information relevant to a transaction is not observable by all parties. When this unshared information is also not verifiable by a court, it cannot be included in an enforceable agreement. Consequently, crucial but unenforceable aspects, like employee effort, create difficulties in aligning actions with the firm's objectives.

The Problem of Incomplete Contracts

Adverse selection describes a market problem where one party has more information about a product's hidden attributes than the other, causing the terms of a transaction to drive certain potential participants from the exchange. It is so named because the prevailing price effectively 'selects' which goods or individuals remain in the market. [1] This can lead to a skewed outcome, such as when only the least healthy people buy health insurance at a given price, or in extreme cases, result in a missing market where no trades occur at all. [1]

Adverse Selection (Hidden Attributes Problem)

George Akerlof is a Nobel Prize-winning economist who, in 1970, first formally analyzed the market problems caused by asymmetric information. His foundational paper on the 'market for lemons,' which explores adverse selection, was initially rejected by academic journals as being either trivial or incorrect before its significance was recognized. Akerlof was awarded the Nobel Prize in 2001 for his contributions to this area of economics.

George Akerlof

The existence of asymmetric information in a market leads to outcomes that are not Pareto efficient. This inefficiency manifests because the imbalance of information prevents some mutually beneficial transactions from ever occurring. If information were symmetrical, these trades would proceed, resulting in a superior, Pareto-efficient allocation of resources.

Information Asymmetry as a Cause of Pareto Inefficiency

A primary cause of externalities is the absence of well-defined and enforceable property rights. When these rights are not established, for instance due to a government's failure to provide the necessary legal framework, there is no mechanism to compel producers to account for the external costs of their actions. This lack of property rights is frequently rooted in asymmetric information, where details about the externality, such as the exact amount of pollution, are unobservable or cannot be verified in court, making a right against it unenforceable. This institutional failure hinders private bargaining and allows market failures to persist.

Inadequate Property Rights as a Cause of Externalities

A significant obstacle for governments seeking to address externalities is the lack of necessary information. This information may be entirely unavailable or it may be unverifiable in a court of law, which prevents its use in enforcing contracts. This problem is particularly acute when external effects are complex or difficult to measure, which undermines the ability to guarantee property rights and results in incomplete contracts. The case of DuPont's PFOA pollution is an example where the government lacked critical information to address the harm.

Informational Barriers to Government Intervention on Externalities

Asymmetric information, also referred to as asymmetry of information, defines a situation within an economic interaction where some parties possess relevant information that other parties do not. This concept is closely associated with two major problems: adverse selection (due to hidden attributes) and moral hazard (due to hidden actions).

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Relationships that link elements together. They are often associated with flows, reactions, processes, and communication of information within a system.  

Interconnections ( systems )

To cite the ebook, use The CORE Econ Team 2023 The Economy 2.0: Microeconomics Open access e-text https://core-econ.org/the-economy/.

To cite a unit, use The CORE Econ Team 2023 The Economy 2.0: Microeconomics Open access e-text https://core-econ.org/the-economy/ Unit [unit number] (url).

CORE Econ - The Economy 2.0: Microeconomics

A flow is a quantity measured per unit of time—for example, tons of CO2 per year—that represents the rate of change in a stock. Flows are responsible for increasing a stock (inflows) or decreasing it (outflows). A key example is CO2 emissions, which act as an inflow to the atmospheric stock of greenhouse gases, while processes like natural CO2 decay and absorption by forests function as outflows.

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