Asymmetric information occurs when there is unequal information between parties during a transaction of a good or service. When an exchange takes place with asymmetric information it can lead to adverse selection: an undesirable transaction where the party with the information gets the favourable outcome (Merriam-webster.com, 2018). The existence of adverse selection in a market can lead to an inefficient allocation of resources towards the production or consumption of a particular good. In this essay I shall first be looking at adverse selection in product market, showing how it leads to market failure through the example of VW cheating emissions tests. In the second part of the essay I shall address how asymmetric information causes adverse selection in the labour market, using the example of prospective employees looking for jobs. Finally, I shall explore how entrepreneurs must borrow from credit markets effected by adverse selection. For all three examples I shall explore how different signalling and screening mechanisms can avoid the related problems. Sellers must be able to signal the quality of their good, whilst buyers must be able to screen out the useful and truthful information.
Adverse selection in the product market occurs where the seller has more information about a good than the buyer. A prevalent example in recent years has been the market for VW diesel cars. In late 2015 the Environmental Protection Agency (EPA) found that VW had been cheating emissions tests. This asymmetric information meant their cars were being marketed and sold as more emissions friendly than they actually were (Mansouri, 2016). As consumers believed the cars they were purchasing had these lower emissions, the demand was higher than it would have been if information was symmetrical. The higher demand caused more cars to be purchased, at a higher price, than the socially optimal level, resulting in market failure. As VW kept this information from its clients it affected their choice in car and resulted in adverse selection, causing a welfare loss equal to the shaded area on figure 1.
This welfare loss could be avoided by VW signalling the quality of their good. This can be accomplished via the building of a brands reputation. However, in the unique case of VW they tainted an already good reputation. The implementation of a warranty on future cars may be the best approach to avoid adverse selection. The case of eBay motors explores this idea, showing that a warranty can be a substitute to the reputation mechanism (Saeedi, 2012). VW placing a warranty on cars reduces risk to future buyers, as it’s only in a firm’s interest to place money on a good-quality good, due to the loss it will otherwise incur. If firms for example cheat future emissions test the buyer will be liable for a full refund. In M. Saeedi’s follow up paper he found that introducing a warrantee in eBay motors increased total welfare by 2.9%. (H et al, 2016). The VW example is unique as VW already had a very good reputation. There is a danger that when consumers purchase from ‘brand names’ they may not feel it necessary to signal out a warranty. Nonetheless, the inclusion of the warranty would serve as a way to adjust this market failure.
Adverse selection occurs from information asymmetry between the prospective employee and employer in the labour market. When comparing prospective workers, an employer does not have all the information available about job applicants, usually only a CV, references and an interview. It is a possibility that an applicant applying for the job is not going to provide truthful answers about their ability. This year the society of human resource management found in a background check study that 53% of all job applications contained inaccurate information (SHRM, 2018). Therefore, the employer may hire someone whose ability and motivation for the job were falsely advertised. Moreover, there may have been better applicants but due to the information asymmetry the employer had an unfavourable transaction, resulting in adverse selection.
Screening can act as a good method to avoid adverse selection, allowing the most suitable labourer to be employed. The existence of exam grades throughout an individual’s education can be used as a gauge of intelligence, this can be furthered by businesses having aptitude tests. Moreover, employers may enquire with previous employers to learn what the individual was like in the work place. This process of conducting background checks on prospective employees can highlight falsified information, alongside bringing to light important information left out by the applicant, such as a criminal record. Adverse selection is more likely to occur when firms that do not screen all information. In 2001 a research study found only 35% of business conducted background checks on prospective employees. It was found these firms ended up with a higher percentage of criminals and drug abusers (Conerly, Avery and Bernardy, 2001).
Once employed there are still transactions with information asymmetry that occur between the employer and employee, which can result in adverse selection. For example, I have created the hypothetical market for assembling tables. If a highly productive employee has better information about the labour force than the employer, they will know they assemble 8 tables per hour, whilst the average workers’ output is 5. Workers in manufacturing jobs are usually paid at a wage rate linked to the average productivity of the labour force (FT.com, 2018). The productive individual may leave this firm in search of a firm of higher average output, to attain a fairer wage. As a result, firms may lose their most productive employees, resulting in a weaker work force. The presence of asymmetric information has caused an unfavourable transaction to occur.
The implementation of performance related wages may serve to prevent the firm’s loss of its most productive labour. This pay is where employees’ wages are denoted by the output they produce between given points in time. In our example the individual producing 8 boxes per hour would receive a 60% higher wage than the average workforce who produce 5 boxes per hour. In this case, assuming a truthful workforce it is straight forward to implement performance related pay. However, in jobs where the output is less defined, such as roles in new drug development it is difficult to quantify someone’s productivity. Arguably, performance related pay only works to avoid the effects of adverse selection in labour markets where productivity is clear.
Asymmetric information is causing adverse selection in the US credit market, distorting the occupational choice between paid work and entering entrepreneurship (Scheuer, 2012). With symmetrical information a lender will knows the exact risk associated with a loan and can therefore charge an appropriate interest rate. However due to the information asymmetry financial institutions place borrowers in broad risk categories (Stuart, 2007). Fundamentally only individuals have full information about their ability and ventures. As a result of the broad risk categories and private information, cross subsidisation may occur. In credit markets one group subsidises the interest rate for another group. If cross subsidisation occurs between low risk- high quality borrowers, and high risk-low quality borrowers, then there may be insufficient incentives for the high quality borrows to loan and go into entrepreneurship. As a result, there are excessive amounts of low skilled workers entering entrepreneurship.
The implementation of a regressive tax on profits may avoid excessive low skilled workers entering entrepreneurship. Equivalently, this can be achieved by having less progressive business taxes compared to labour income taxes (Scheuer, 2012). The US exhibited this model in 2007 where federal corporate tax rates were less progressive than income taxes, with the range of rates being 34% -38% and 10%-39.6% respectively (Bankrate, 2007). This will act to tax the low profiting firms disproportionately largely, restoring occupational efficiency (Scheuer, 2012). Policy makers must be careful when trying to correct the effects of adverse selection. The relative regressive tax on profits to counter low skilled entrepreneurs may have negative effects on small high-quality firms, who can’t yet generate large profits.
In conclusion, asymmetric information can cause adverse selection in range of markets namely the product and labour market, when one party gets a more favourable transaction than the other. Screening and signalling provide a broad scope to dealing with the effects of adverse selection. Individuals seek to minimise risk. Undertaking background checks on prospective workers and providing warranties on products can act to reduce risk, in turn reducing the effects of adverse selection. A focus on increasing the sophistication of Big Data may serve to reduce the core of all the problems; information asymmetry. It’s important, however, when dealing with the problems related to adverse selection that we minimise trade-offs. Correcting the market failure caused by adverse selection may result in creating another market failure, as seen with the regressive corporate taxation potentially driving out small, high quality, but low profiting businesses.