In economics, information asymmetry occurs when one party to a transaction has more or better information than the other party. (It has also been called asymmetrical information). Typically it is the seller that knows more about the product than the buyer, however, it is possible for the reverse to be true: for the buyer to know more than the seller.

Information asymmetry models assume that at least one party to a transaction has relevant information whereas the other(s) do not. Some asymmetric information models can also be used in situations where at least one party can enforce, or effectively retaliate for breaches of, certain parts of an agreement whereas the other(s) cannot. In adverse selection models the ignorant party lacks information while negotiating an agreed understanding of or contract to the transaction, whereas in moral hazard the ignorant party lacks information about performance of the agreed-upon transaction or lacks the ability to retaliate for a breach of the agreement. An example of moral hazard is when people are more likely to behave recklessly if insured, either because the insurer cannot observe this behavior or cannot effectively retaliate against it, for example by failing to renew the insurance. An example of adverse selection is when people who are high risk are more likely to buy insurance, because the insurance company cannot effectively discriminate against them, usually due to lack of information about the particular individual's risk but also sometimes by force of law or other constraints.

Examples of situations where the seller usually has better information than the buyer are numerous but include used-car salespeople, mortgage brokers and loan originators, stockbrokers, real estate agents, and life insurance transactions.
Examples of situations where the buyer usually has better information than the seller include estate sales as specified in a last will and testament, sales of old art pieces without prior professional assessment of their value, or health insurance consumers of various risk levels.

Real World Examples
BANK
A bank that sets one price for all its checking account customers runs the risk of being adversely selected against by its high-balance, low-activity, thus most profitable, customers. In this case, the riskier or more reckless element would be for example, a customer who caries a low balance yet high activity account. This account is more likely to bounce, creating additional work and charges to the banking institution. Also, with more activity comes a higher operating cost for this account. So, the more risky customer is more work, less profitable, and more time consuming.

INSURANCE
Another example would be with two groups, smokers and non-smokers, being insured. The insurance company selling life policies is unable to differentiate between the two groups, so both pay the same premiums. Non-smokers are likely to die older than smokes, while smokers are likely to die younger than non smokers. So the life policy is a better buy for the smokers' beneficiaries, who will upon the smokers death, be compensated for that loss of life. The insurance company anticipates that the mortality rate of the combined policy holders exceeds that of the general population, and sets the premiums accordingly. The result is that non smokers tend to go uninsured though if they could buy a policy on terms that are actually fair given their characteristics, they would do so.
USED CARS
Yet another example would be people buying used cars and don't know whether they are "lemons" (bad cars) or "cherries" (good ones). They will be willing to pay a price that lies in between the price for lemons and cherries, a willingness based on the chance that a given car is a bad or good. For instance, if the probability of getting either a lemon or a cherry is 0.5, and the price for a lemon and a cherry is $4,000 and $12,000 respectively, the price consumers are willing to pay for a used car would be 0.5(4,000) + 0.5(12,000) = $8,000. The sellers will sell fewer good cars (since they think the price is too low) but will sell more bad cars (because they get a very good price for them). After a while, the buyers will realize this and no longer want to pay the old price for a used car. The price will lower and even fewer cherries, and even more lemons, will be put up for sale. In the extreme, the cherry sellers will have been driven out of business.
STOCK MARKET
A stock market example occurs when there is asymmetric information between the seller and the buyer. When a buyer has better information than a seller, or vice versa, the trade may occur at a lower price than otherwise. Ideally, trade prices should be set in a market where all traders have total knowledge of said market conditions. When there is adverse selection, people who know there is a higher probability of a certain positive price move, more than the average investor, they will trade. Conversely, when those who know there is a lower probability of a positive price move may decide it is too expensive to be worth trading, and hold off trading. In this way, the 'better informed' investors will obtain a trading advantage. A classic example of this would be insider trading.
This situation was first described by Kenneth J. Arrow in a seminal article on health care in 1963 entitled "Uncertainty and the Welfare Economics of Medical Care," in the American Economic Review.
George Akerlof later used the term asymmetric information in his 1970 work The Market for Lemons. He also noticed that, in such a market, the average value of the commodity tends to go down, even for those of perfectly good quality. Because of information asymmetry, unscrupulous sellers can "spoof" items (like software or computer games) and defraud the buyer. As a result, many people not willing to risk getting ripped off will avoid certain types of purchases, or will not spend as much for a given item. It is even possible for the market to decay to the point of nonexistence.
Although information asymmetry has recently been noted to be on the decline thanks to the Internet, which allows unknowledgeable users to acquire heretofore unavailable information such as the costs of competing insurance policies, used cars, etc. (See Freakonomics.) it is still heavily applied to human resource and personnel economics regarding incentive schemes when the employer cannot continually observe worker effort.

Questions
What is the willingness to pay equal to if the probablilty of receiving a good lung is 40% costing $28,000and a faulty lung 60% costing $33,000?
A. 28,000
B. 34,000
C. 31,000
D. None of the above
(Answer C)

What is the main cause of adverse selection?
A. Lack of accurate information
B. Lying consumers
C. Reckless insurance companies
D. Wealth disparity in the US
(Answer A)

Adverse selection can actually work to companies advantage in the long run
True or false
(Answer false - leads to higher operating costs and reduced profitability per customer)

Adverse selection or anti-selection is a term used in economics and insurance. On the most abstract level, it refers to a market process in which bad results occur due to information asymmetries between buyers and sellers: the "bad" products or customers are more likely to be selected. A bank that sets one price for all its checking account customers runs the risk of being adversely selected against by its high-balance, low-activity (and hence most profitable) customers

In the usual case, a key condition for there to be adverse selection is an asymmetry of information - people buying insurance know whether they are smokers or not, whereas the insurance company doesn't. If the insurance company knew who smokes and who doesn't, it could set rates differently for each group and there would be no adverse selection. However, other conditions may produce adverse selection even when there is no asymmetry of information. For example, some U.S. states require health insurance providers to insure all who apply at the same cost. In this case, there may not be an actual asymmetry of information: the insurance company may know who is or isn't a smoker, but because the insurer is not allowed to act on that information, there is a "virtual" asymmetry of information.

Asymmetric information: Can be defined as information that is known to some people but not to other people.
Information asymmetries can precipitate a difference in the cost of internal and external finance, i.e. making internal net worth more valuable, holding constant investment opportunities (this is a ‘lemon market’ problem in valuation).
The classical argument is that some sellers with inside information about the quality of an asset will be unwilling to accept the terms offered by a less informed buyer. This may cause the market to break down, or at least force the sale of an asset at a price lower than it would command if all buyers and sellers had full information. This idea has been applied to both equity and debt finance.
For equity finance, shareholders demand a premium to purchase shares of relatively good firms to offset the losses arising from funding lemons. This premium raises the cost of new equity finance faced by managers of relatively high-quality firms above the opportunity cost of internal finance faced by existing shareholders.
In debt market, a borrower who takes out a loan usually has better information about the potential returns and risk associated with the investment projects for which the funds are earmarked. The lender on the other side does not have sufficient information concerning the borrower. Lack of enough information creates problems before and after the transaction is entered into. The presence of asymmetric information normally leads to adverse selection and moral hazards problems.
Information Asymmetry causes two issues worth to discuss.
Adverse Selection
This refers to a situation in which sellers have relevant information that buyers lack (or vice versa) about some aspect of product quality. This is the problem created by asymmetric information before the transaction occurs. It occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome, the bad credit risks, are the ones who most actively seek out a loan and are thus most likely to be selected.
In the simplest case, lenders cannot price discriminate (i.e. vary interest rates) between good and bad borrowers in loan contracts, because the riskiness of projects is unobservable. Thus, when interest rates increase, relatively good borrowers drop out of the market, increasing the probability of default and possibly decreasing lenders’ expected profits. In equilibrium, lenders may set an interest rate that leaves an excess demand for loans. Some borrowers receive loans, while other observationally equivalent borrowers are rationed.

QUESTIONS FOR STUDY


Sources:
http://en.wikipedia.org/wiki/Asymmetric_information

http://cbdd.wsu.edu/kewlcontent/cdoutput/TR505r/page5.htm