This blog post examines the impact of information asymmetry on markets and the screening and signaling strategies used to resolve it.

Information Asymmetry, Adverse Selection, and Market Equilibrium

In modern market economies, most transactions are based on diverse information. However, not all parties involved possess the same information. In fact, it is far more common for one side to hold significantly more information. Economists refer to this situation as ‘information asymmetry’.
Information asymmetry means that one party involved in a transaction possesses information unavailable to the other. While this may appear to be a simple phenomenon, it actually causes a significant problem that greatly impairs market efficiency. The party possessing the information can use it to set transaction terms favorable to themselves, thereby gaining extra profit. Conversely, the party lacking the information faces the risk of entering into unfavorable transactions and consequently becomes more vulnerable to the effects of adverse selection.

Two Approaches to Reduce Information Asymmetry: ‘Screening’ and ‘Signaling’

Persistent information asymmetry can paralyze market functioning. Consequently, various mechanisms operate to improve it. Economic agents voluntarily strive to reduce information gaps, and these efforts manifest in two ways: ‘screening’ and ‘signaling’.
Screening is a method where the party lacking information—the weaker party—presents appropriate mechanisms or conditions to induce the better-informed counterpart to voluntarily reveal information. This can be illustrated by an insurance company setting high deductibles for customers, thereby ensuring only those confident in their health actually purchase the insurance. Screening can be described as a strategy where the information-deficient party ‘gains information indirectly through the other party’s actions’.
Conversely, signaling is the act of the information-advantaged party, the stronger position, voluntarily disclosing information to achieve favorable outcomes. This can be seen as an attempt to eliminate the disadvantage of information asymmetry or, conversely, to actively leverage one’s superior position to maximize benefits. For example, a graduate of a prestigious university emphasizing their academic background on a resume is a classic case of signaling in the job market. This serves to indirectly convey their capabilities and reliability to employers.

Forms of Equilibrium Emerging in Markets: Separation Equilibrium and Mixed Equilibrium

When mechanisms like screening and signaling operate, various forms of equilibrium can emerge in markets. Here, equilibrium refers to a stable state that remains unchanged once reached, absent external shocks.
When screening and signaling operate effectively, a ‘separating equilibrium’ is formed. A separating equilibrium means that trading partners with different attributes transact under different conditions (e.g., price, quality, etc.). In other words, it is a market state where differentiated pricing structures and transaction methods reflecting information differences are maintained. In this separating equilibrium state, all transacting parties can engage in satisfactory transactions aligned with their respective information levels.
Conversely, a ‘pooling equilibrium’ occurs when signaling or screening fails to function properly, leading to transactions of differing attributes occurring under identical conditions. In this case, information asymmetry remains unresolved, and the risk of adverse selection intensifying is high. This leads to a decline in overall market trust, ultimately carrying the risk of market contraction or, in severe cases, market collapse.

Specific Example of Signal Sending: The Case of Companies A and B

Suppose Company A produces high-quality products, while Company B manufactures low-quality products. If consumers perceive the products of these two firms identically and they trade at the same price in a mixed equilibrium, Company A receives a price lower than the quality it provides, suffering a relative loss. If this adverse selection persists, Company A is likely to exit the market, ultimately shrinking both the overall market’s credibility and scale. This creates a structure where even Company B, which provides low-quality products, suffers losses in the long run.
However, the situation changes if Company A can send clear signals to consumers that its products are high quality. Examples include offering significantly longer warranty periods, utilizing premium certification marks, or actively leveraging consumer reviews and reputation. If these signals function effectively, consumers will trust Company A’s products and be willing to pay a premium price. This creates differentiated demand for high-quality products.
Conversely, Company B, finding it difficult or undesirable to send the same signals, responds with a low-price strategy. In this case, a segregated equilibrium forms within the market, where high-quality products trade at high prices and low-quality products at low prices. Thus, signaling mitigates the adverse selection problem, ultimately creating a structure beneficial to all market participants. Consumers seeking high-quality products make satisfying choices, while those seeking low-quality products can purchase them at appropriate prices. Furthermore, both Company A and Company B secure market positions suited to them, enhancing the market’s sustainability.

Maintaining and Shifting Equilibrium: Market Dynamics

However, once a separation equilibrium is established, there is no guarantee it will persist indefinitely. This equilibrium can collapse or shift due to changes in economic agents’ strategies, intensification or reduction of information asymmetry, market growth or contraction, shifts in consumer perceptions, or changes in the level of trust in signals or screening mechanisms.
For instance, if market participants lose trust in a specific signal, the utility of signaling diminishes, potentially reverting the market to a mixed equilibrium. Conversely, the introduction of new technologies or institutions that reduce information asymmetry may naturally lead to the establishment of a segregated equilibrium. It is crucial to understand that market equilibrium is not static but a dynamic state that is constantly readjusted.

In Conclusion: Wisdom to Overcome Information Asymmetry

Information asymmetry is one of the fundamental characteristics of markets. While it cannot be completely eliminated, it can be mitigated to some extent through the mechanisms of screening and signaling. As market participants develop more sophisticated strategies and consumers enhance their sensitivity to and analytical skills regarding information, markets can escape the risk of adverse selection and maintain a healthy structure.
Ultimately, the future of the market hinges on how information is exchanged and interpreted within it. Viewing the problem of information asymmetry not merely as a risk, but as a strategically exploitable opportunity, is becoming increasingly important. From this perspective, screening and signaling are not just economic theories, but essential insights for understanding and designing the real markets we live in.