Groucho Marx once said that he would not join a club that approached him who did not really know him1. He established that as the club had asked him to join; they had a poor selection process and were not worth joining1. From this example we can see that the selection process in the forms of institutions giving out credit is crucial in terms of the whether the consumer is feasible for borrowing.
A problem that occurs in asymmetric information is that of moral hazards. Unlike adverse selection, this problem occurs after the transaction between borrower and lender has taken place. Often an underestimated problem by lenders, that a borrower may use the loan as an alternative source of income, say in gambling. This is desirable by many as it boasts a higher return in income. However, it yields a higher return because of the amount of risk attached to it. This factor acknowledged, causes lenders to be less enthusiastic about giving out loans to consumers. The problem allows the market to fail once again as the producers in this market are not prepared to supply the demand.
Both of these problems have occurred due to the uncertainty of the future of money. No one can tell how the state of money will react past the present point in time.
What is also tied in with the hidden action of Moral Hazards is that of Monitoring Costs. This situation occurs when the borrower has more information that the lender in terms of the firms profits and cash flow. The lender does not immediately have access to the borrowers’ profit and loss accounts or any kind of cash flow forecast. Therefore the borrowing firm may try to fix its profits so as to refrain from paying back the entire debt. A situation like this would cause the firm to go into administration and be investigated by lawyers and accountants to examine this development. This naturally comes as an expense to the lender, but this form of debt aversion can also be disadvantageous to the firm itself as debt can increase through this unjust process.
All these points play a very vast and important role in finance as investment is a multi-billion pound a year industry, of which risk is the key factor in every financial contract. A lender would never doubt making a loan if the chance that it would be repaid was definite. As it happens though, there is a large lack of transparency in such markets to date.
An economist, David Brin, wrote works on the idea of “A Transparent Society”. Brin talks of how if there was direct information available to all parties then this problem would be resolved. It follows the economic route of perfect competition where all firms have direct knowledge of the actions of other firms, and under Brin would have to involve firms becoming price takers like perfect competition. If firms tried to undercut each other it would be a direct indication that information was not being declared. This is a valid theory from Brin; however one must question the feasibility of his point. An industry such as that of credit and insurance markets boasts much competitiveness in terms of interest rates and general pay back schemes; we experience this everyday as newspapers, magazines and television possess advertisements of the latest interest rate for a credit card. I believe it is unlikely that firms, whom rely so heavily on the interest they receive from repayments, are going to accept a set level of interest on payment schemes when lending.
I have discussed the general problems that occur through asymmetric information, now I would like to talk about the effects in regards to economic theory within the finance sector. Within financial systems there are many processes that take pace in order for markets to function effectively, or in some cases, ineffectively in dysfunctional markets.
An area that seems immediately affected is that of competition and its effect on the industry. The lack of information to firms means risk is high indefinitely. As some firms are bigger than others, these bigger firms can cope with bad credit borrowers as they have the resources to recover from such circumstances. Smaller firms though, who must keep costs low in order to function, are unable to react as efficiently than the more dominant firms in the market. As a result of this small firms tend to drop out of such a market as they cannot afford to regroup after a loss of earnings. This can lead to a monopoly forming within the industry which is fundamentally anti-competitive. To develop this point further, there is an issue therefore of aggressive market behaviour between firms. We can relate this to game theory and the prisoner’s dilemma where firms do their utmost to get the best out of their market position including sometimes making rival firms worse off. Notionally, this is known as a zero-sum game, where one firm would obtain a sum from its actions and leaving another firm to gain nothing. In the financial sector, it is currently impossible to reach the Nash Equilibrium as no one has complete information about each other, and there is always an incentive to cheat; this is done in order to gain higher returns from lending and is most noticeably done through interest rates in our example.
As well as having many disadvantages to the majority of the players in the market, it does have its benefits as well. This becomes apparent in an adaptation of Akerlof’s theory. As firms are holding valuable information about their product, they can use this wisely in terms of its sales. The lack of information allows consumers to inaccurately estimate the value of a particular good or service, as a result of this the demand of an industry can be overcharged for a particular good, and firms capitalise by increasing their revenue. The initiation of this by a firm can prove a valuable business tool in terms of manipulating demand. This in return has a social and economic (marginal) cost to the industry.
In researching this assignment many economic theorists have explained actions which would which would attempt to dampen the effects of asymmetric information. We have already seen a transparency theory from David Brin; however I found this was a more general theory and there are sub-topics within this overview of how the imbalance of information can be tackled.
A point that is particularly popular was that of market signalling, and through reputations of astute firms. This effectively involves a firm using its stature and brand name to provide information, and boast of its product. This means that the amount of information available about the product would increase. The firm signals to demand about the quality of its product or service and knowledge can be spread throughout the industry.
Another point of view was to a more regulated approach; that firms should be investigated by a form of panel that would allow a group of specialists to obtain the information and make it available to all. A “similar” approach to that of a Central Planning Bureau that was popular in West Germany many years ago at the time of the World Wars. In this case it would not be to try and govern what was produced, but to unleash invaluable information to the consumers. As it happen, there is no current authority by which companies are under obligation to release such information.
The responses that have been rallied by various interest groups on this topic all show the important consequence that asymmetric information has on finance. It is crucial to note here that the solutions to this problem are all difficult to put into action for their respective reasons; thus making it a complicated predicament to combat.
At the beginning of this essay I talked of risk, uncertainty, danger and possibility. Social factors of business that cannot be controlled, neither can they be predicted. The only tool that can be used is to obtain knowledge on the destination of money or credit. It is the inability to control risk that proves asymmetric information to have such an impact on the financial system.
Adverse selection, moral hazards and monitoring all show the power of perception of consumers and producers.
The definition of asymmetric information immediately makes us aware of the problems that can occur from it, and the possible effects it has within the financial sector. The notion is made entirely up of the risk and uncertainty of money and future actions in time. This is something that can never be entirely eradicated from the financial sector as a whole, but can be alleviated through attaining more information than is first available. This provision of information can allow consumers and producers to make more informed decisions and assuage the risk, but never fully remove this influential factor of economics.
