why does " asymmetric information" cause market failure?

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gsenviro eNotes educator| Certified Educator

Asymmetric information is a condition where one of the parties has access to more or better information as compared to another party (or parties). This unequal distribution of information causes a power imbalance in a business relationship and may result in the information-rich party taking advantage of the information-poor party, leading to a downward spiral in the business and potential market failure. Examples of asymmetric information are adverse selection, moral hazard and information monopoly. 

In adverse selection, buyers and sellers have access to different information and this may cause market failure. For example, if a manufacturer is not getting consumer feedback, he or she will keep on producing an item for which there may no longer be a demand. Another example is an interviewee hiding details that may affect his prospects, while the interviewer may withhold information about the company, resulting in a scenario where at least one of the parties stands to lose.

Moral hazard is a situation where one party is unable to retaliate against the other. An example is reckless driving by an insured driver since he/she does not have to pay for damages of any accident. 

Asymmetric information results in such scenarios where imperfect power distribution causes inevitable market failure (a condition where a firm's self-interests are adversely affected). An example is an insurance firm failing to discriminate against high-risk individuals who may take undue risks, causing the firm to pay heavy damages and lose out to competition. Another could be a farmer growing too much of a crop that may have low market value (due to buyers withholding information).