Asymmetric information is inherent in most, if not all, markets. To take a basic example, a patient admitted to a hospital probably has less information about illness and recovery options than the doctor does. Markets compensate for this by developing agency relationships where both parties are incentivized to produce an efficient outcome.
In the hospital case, the doctor has an incentive to diagnose accurately and prescribe treatments correctly, or else he might be sued for malpractice or otherwise have his reputation suffer. Since it is likely that doctors and patients have repeat relationships, the law of repeat dealings also shows that both actors are better off in the long run if they deal fairly with one another.
Asymmetric Information and Adverse Selection
According to economic theory, asymmetric information is most problematic when it leads to adverse selection in a market. Consider life insurance: A customer might have information about his risk that the insurance company cannot easily obtain.
To compensate for a lack of information, the insurance company might increase all premiums to offset the risk of uncertainty. This means that the riskiest individuals (who ostensibly value insurance most highly) effectively price out some of the less risky individuals (who aren’t willing to pay as much).
Adverse selection theoretically leads to a sub-optimal market even when both parties to an exchange are dealing rationally. This sub-optimality, once understood, provides an incentive for entrepreneurs to assume risk and promote a more efficient outcome.
Market Responses to Adverse Selection
There are a few broad methods of addressing the adverse selection problem. One very clear solution is for producers to provide warranties, guarantees and refunds. This is particularly notable in the used car market.
Another intuitive and natural response is for consumers and competitors to act as monitors for each other. Consumer Reports, Underwriters Laboratory, notaries public and online review services such as Yelp help bridge gaps in information.
The study of efficient market arrangements is known as mechanism design theory, which is a more flexible offshoot of game theory. Notable contributors include Leonid Hurwicz and David Friedman, son of Milton Friedman.