This blog post examines how information asymmetry impacts markets, along with strategies to address it and the concept of equilibrium.
Information asymmetry refers to a situation where one party involved in a transaction possesses more information than the other. In such cases, the party with more information can set transaction terms favorably for themselves, potentially gaining a relatively larger profit, or excess profit. Conversely, the party lacking information is more likely to enter into unfavorable transactions, increasing the risk known as ‘adverse selection’. Adverse selection refers to the phenomenon where, due to information asymmetry, one cannot accurately assess the attributes of the counterparty, leading instead to selecting lower quality or undesirable options.
To mitigate or prevent such market failures arising from information asymmetry, economic agents devise various voluntary responses. These responses are broadly categorized into two types based on their mechanism for resolving information asymmetry: ‘screening’ and ‘signaling’.
‘Screening’ is a strategy where the information-deficient party—the entity lacking information—establishes mechanisms to indirectly verify or understand the other party’s information, thereby inducing the information-holding party to respond to these mechanisms. This is well illustrated, for example, in the job market where a company presents applicants with minimum qualification requirements or performance standards, thereby encouraging only those who meet those criteria to apply. In this way, screening enables more accurate judgments even in situations of information asymmetry and enhances transaction efficiency.
Conversely, ‘signaling’ refers to the proactive act by the information-holding party to convey or reveal their information to the other party in situations of information asymmetry. This strategy emphasizes the reliability of one’s information or highlights positive attributes to induce favorable transaction terms. A university diploma serving as a signal in the labor market is a case in point. While the diploma itself does not perfectly reflect the level of knowledge or skill, it signals that the job seeker possesses a certain level of ability and diligence, making the employer trust them more.
Depending on how these screening and signaling strategies operate in the market, different forms of market equilibrium are formed. Here, ‘equilibrium’ refers to a state where the market condition stabilizes and no longer shifts significantly in either direction. Generally, when screening or signaling functions effectively, the market reaches a ‘separating equilibrium’. A separating equilibrium is a market state where transaction conditions, particularly prices, are differentiated based on the attributes of the traded items. In this case, goods or services with higher quality information are traded at higher prices, while those with lower quality information are traded at lower prices. Consequently, all parties can achieve satisfaction through transactions matching their conditions, contributing to market efficiency and stability.
Conversely, if screening or signaling fails to function properly or has minimal effect, the market may remain in a ‘pooling equilibrium’ state. In a pooling equilibrium, information asymmetry persists, leading to goods or services with different attributes being traded at the same price. In such situations, high-quality products or services with favorable conditions are sold at the same price as low-quality or unfavorable alternatives. This makes superior suppliers vulnerable to losses in the market and, over the long term, erodes the market’s credibility. Ultimately, this loss of trust can lead to market contraction or even market collapse.
Let’s examine this with a more concrete example. Suppose Company A produces high-quality products, while Company B produces low-quality products. If their products are perceived and traded at the same price by consumers in a mixed equilibrium state, Company A receives less than fair compensation relative to its quality, suffering a relative disadvantage. Conversely, Company B, despite supplying low-quality products, can charge the same price, potentially gaining a short-term advantage. However, over time, consumers become aware of the disadvantages stemming from this information asymmetry and become reluctant to engage in transactions in a market where trust has been lost. Consequently, the entire market may be shunned, which could ultimately harm not only Company A, which produces high-quality products, but also Company B in the long run.
In this situation, the dynamics could change if Company A sends signals to consumers clearly revealing the quality of its products. For instance, certification marks, quality assurance systems, and long-term after-sales service provision can all serve as signals demonstrating high quality. If this signal is effectively communicated to consumers and builds trust, consumers will recognize Company A’s products as high quality and willingly pay the corresponding price. This ensures Company A receives fair profits while also creating differentiated demand for high-quality products in the market.
Meanwhile, Company B, considering its products are not high-quality in this situation, may choose a strategy of lowering prices instead of signaling. This approach allows it to secure a certain level of demand through low prices and maintain a stable market position. In this case, consumers gain the information and opportunity to choose high-quality products, while consumers selecting low-quality products also feel satisfied by trading at an appropriate price. When such a separation equilibrium is formed, the problem of adverse selection stemming from information asymmetry is mitigated, creating a structure favorable to all market participants.
However, this state of separation equilibrium can only be sustained when certain conditions are met. Factors such as the strategies of economic agents—specifically, the design and implementation of signaling or screening methods—the market size, the degree of information asymmetry, and the level of trust market participants place in signals and screening all interact complexly. For instance, if the market is too small or the degree of information asymmetry is excessively high, a separation equilibrium is difficult to establish. Furthermore, if the signals are not sufficiently clear or the costs are not appropriately balanced, consumers may still distrust the information. Thus, even if a separation equilibrium forms temporarily, it can revert to a mixed equilibrium due to changes in external conditions or circumstances. In some cases, it may lead to an unstable state where no equilibrium is established at all.
In conclusion, information asymmetry is a critical factor affecting market efficiency and sustainability. Signaling and screening strategies to resolve it are key determinants of the type of market equilibrium and its maintenance. When market participants can exchange information in more sophisticated and reliable ways, the market can progress toward a healthier and more sustainable direction.
