Asymmetric Information

Asymmetric information, as the adjective indicates, refers to situations, in which some agent in a trade possesses information while other agents involved in the same trade do not. This rather self-evident premise has nevertheless revolutionized modern economic thought since the 1970s. Take, for example, two major results in the economics and finance literature, the first fundamental theorem of welfare economics and the Modigliani-Miller theorem. The first welfare theorem states that in a competitive economy with no externalities, prices would adjust so that the allocation of resources would be optimal in the Pareto sense. A key assumption for the theorem to hold is that the characteristics of all products traded on the market should be equally observed by all agents. When such assumption fails to hold, i.e. when information is asymmetric, prices are distorted and do not achieve optimality in the allocation of resources. Standard government interventions such as regulation of monopolies to replicate a competitive environment, or fiscal policy to alleviate the effects of externalities, are no more sufficient to restore optimality. Similarly, in the finance literature, the Modigliani-Miller theorem concluded that the value of a firm is independent of its financial structure. The acknowledgment of asymmetric information within organizations shifted the debate on optimal financial structure from fiscal considerations, to the provision of incentives to align the interests of managers and workers with the interests of stakeholders.