How Information Asymmetry Gives Certain People an Asymmetric Advantage
Imagine you’re about to enter an incredibly complex maze. In the middle lies the grand prize of a million dollars.
Before beginning the maze, you look around to see your four competitors all trying to reach the million dollars first. You feel amazing; you’re in good shape, you drank three cups of coffee, and you’re ready to kill for that million dollars. The horn blows and the race begins.
You run as fast as you can towards what seems to be the middle, but after two quick minutes of running around the maze, someone with a megaphone yells, “And we have our winner. Thank you for playing!”. You see the winner after exiting the maze, and he reveals that he had a map detailing the exact layout and a step-by-step guide for how to reach the middle. You leave feeling miserable and scammed since the game was unequal from its inception.
What is Information Asymmetry?
Simply put, it’s the unequal availability of information to all parties (giving it the name information asymmetry). In the maze scenario, the map was given to one person and withheld from the rest of the group, creating an unequal premise to begin the maze in the first place. The difference in availability of information (e.g. the map) solely influenced the outcome of the maze. However, on a larger scale, information asymmetry remains an important phenomenon to understand simply because different availability of information influences individual decisions and economic well-being. To demonstrate information asymmetry’s influence on those two aspects, let’s first examine the more transactional example of the used car market to demonstrate these concepts.
The Market For Lemons
George Akerlof, Nobel laureate from Berkeley, cited the 1970’s used car market (a.k.a lemons) to demonstrate this concept because of how rampant information asymmetry was. To summarize his study, let’s take two different scenarios. In the first scenario, a used car seller with a 10 year old car in pristine shape would like to sell his car for a minimum of $5,000, and a buyer would like to buy that used car in pristine shape for a maximum of $6,000. In an ideal world, the buyer would know the car’s quality, negotiate the price, and meet in the middle at the price of $5,500, making each party better off in the transaction. However, the ideal situation is contingent on two ideas that don’t exist in real world transactions: not every used car is in great condition and not every buyer knows everything about that car.
Instead in the second scenario, the buyer enters the transaction with the knowledge that an average 10 year old used car needs at least $1,500 worth of work for it to run for five years since most used cars aren’t in pristine shape like we assumed in the first situation. With that in mind, the buyer’s willingness to purchase from the seller goes down to $4,500 instead of $6,000, making the transaction not rational for both the buyer and seller to enter in.
Contrasting both scenarios illuminates the importance of equally shared information, as the only thing changing in each scenario was the shared knowledge of the true value of the used car. While in scenario one the market functioned optimally with equal information, the market in situation two failed because of the buyer factoring in needless costs to fix the pristine car. Because the buyer and seller had different information and incentives in the second situation, their decisions and well-being changed as well, causing a market failure that made both parties worse off.
Information Asymmetry’s Relevance Today
Although it’s surely rational to assume that with the prevalence of the internet today, information asymmetry’s influence has become non-existent in markets. Markets for used cars today face nearly none of the same problems that were associated with information asymmetry; every buyer knows more than ever about the car (e.g. the mileage, engine life, etc.), making buyers more informed than ever before in most markets.
However, information asymmetry still plays a huge role in most of the world’s biggest and most important markets today.
Take for example job markets where employers know very little about the people they are hiring. While employers may have access to someone’s resume and past experience, employers can’t know the people’s personality traits, agreeability, work ethic, fit in the company’s culture, among many other important factors. That information asymmetry results in employees working for companies that aren’t a good fit or employers not getting what they expected with a certain person they hired. Since employers don’t know the “true worth” of an employee they’re hiring, they can’t negotiate a truly fair contract, affecting the well-being and decision making of both parties and potentially causing market failure. The phenomenon appears in healthcare, insurance, and so many other industries despite the internet’s prevalence.
Information Asymmetry in Financial Markets
Even with the availability of resources like we’ve never seen before, the average trader doesn’t have the resources available to compete with big investment banks and quant firms. Big companies which specialize in trading and timing financial markets use advanced trading algorithms, have access to advanced price movement data, and implement the most sophisticated indicators of future price movement while the average trader has access to basic programs like TradingView and a couple basic indicators.
However simultaneously, social media and online trading platforms make being a profitable trader seem manageable, even easy at times. They exclude the difficulty of the process, the disadvantages the average trader faces, and the near impossibility of being consistently in the green. Hence, information asymmetry attacks day traders on multiple fronts. On one side, the inequity in information about quality trading resources, and on the other, the inequity to information about the reality of day trading.
Facing these two issues is what causes many people, like myself, from seriously pursuing day trading as a productive use of time and source of income. Information asymmetry creates an unfair advantage for large quant firms and investment banks at the expense of the average trader. Because of these information inequalities, the market faces an inefficiency: one where certain buyers have more market power than others, leading to a suboptimal amount of traders and monetary exchanges per day.
Information asymmetry causes similar problems in making informed investment decisions as well. Investment banks (IB’s)and those with large piles of assets have access to even more advanced statistics about companies, including top analysts’ forward revenue projections and algorithms telling them when the best time to enter a position would be. These tools allow IB’s to create more accurate, financially sound models (like DCFs) that show the true value of a company more accurately than any regular investor.
Similarly, these discrepancies create an unfair advantage for more powerful entities and can perpetuate financial inequality for middle and low class individuals. These disadvantages along with a lack of quality financial education in schools makes it incredibly difficult to climb the financial ladder, negatively affecting the regular investor’s well-being mentally and financially.
Conclusion
Our maze example from before highlights the phenomenon of information asymmetry perfectly: life isn’t fair. Everywhere we go, there is some sort of inequality, one where one entity wins at the expense of another. However, when that inequality is caused by information asymmetry, problems and consequences intensify for everyone. Like we saw in the market for used cars, information asymmetry forces markets to perform at suboptimal quantities and prices, making the average person worse off.
Yet, it’s the same thing for financial markets. The advantage information asymmetry gives big entities like quant firms and investment banks discourages investors and traders, leading to a suboptimal amount of investors and traders participating in the market, simply because the odds are stacked against them. Hence, making efforts to reduce information asymmetry in financial institutions would reap huge benefits for the average investor and level the playing field for everyone, helping slightly reduce the inequities we see today.
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Thank you for reading my article! If you liked this writing, go ahead and check out some of my other work here. If you would like to become a writer for Financial Fluency, shoot me an email at kalan.karuppana@gmail.com.
