Why does "asymmetric information" cause market failure?

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Asymmetric information is a term used when one party is more informed about a product or service than another. For instance, when one is bargaining for a product, he or she does not know how low the seller is willing to go. Similarly, the seller does not know how much a buyer is willing to spend. The lack of balance in information can result in market failure.

Asymmetric information can lead to market failure because it can result in an inconsistent or insufficient allocation of resources towards the manufacture or consumption of a given good or service. For example, if a company provides false information about its product so that it seems better than that of its rivals, there will be high demand for the good resulting in an increase in price, which would not be the case if there was transparency.

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Asymmetric information is a dysfunction in the core operating premise of a free market. It violates the presumption that all actors in a market economy are making well-informed, best-available-option decisions about buying and selling goods and services, which can lead to several different kinds of market failure.

Consider the financial crisis of 2008, in which a limited number of people with information about the impending housing market crash were able to "short" mortgage stocks. This was a success for the individuals who predicted the crash, but since many more people lacked or did not use the information about the housing bubble, the overall market failed and caused widespread financial loss.

In economics-class terms, the specific market failures that information asymmetry can lead to are moral hazard (when a buyer or a seller has some incentive to be misleading about the risks of a transaction, like in the 2008 crash, when some mortgage lenders got bonuses for initiating mortgages that were more risky than buyers thought) and adverse selection (when a buyer or a seller has information that the other party in the transaction lacks—insider trading is a classic example).

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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).

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