Imperfect information

Imperfect information is the condition that occurs in the market when one or more traders have more precise information than others. This concept is therefore studied in economics and is directly applicable to business scenarios, where the presence of information asymmetries is useful for explaining the different behaviors of the various economic subjects.

When information is not fully shared among the subjects who are part of the same economic process, we can therefore speak of imperfect information. And therefore a part of the interested parties has more information than the rest of the participants and can thus benefit from this situation.

There are many situations in which imperfect information occurs, but they can almost all be grouped into these 3 cases:

• Adverse selection
• Reporting and selection
• Moral hazard

Adverse selection

Adverse selection is a classic example of information asymmetry that mainly affects the insurance sector.

In fact, in quantifying the price of the policy, insurance companies start from a lack of knowledge of the actual possibility that the event that is then the subject of a reimbursement request will occur. The cost of the policy is therefore established on an estimate of the average cost of the damaging event. Therefore, insurance companies find themselves in a condition of information asymmetry with respect to their customers, who are instead more aware of their degree of risk of the insured object.

Reporting and selection

To explain this type of information asymmetry, let's start with the cases of sending the curriculum vitae. Those who send a CV to participate in a selection present themselves with a series of information related to their studies, aptitudes and interests. However, the truthfulness of this information is possessed only by the person sending the CV and not by the person receiving it. The recruiter could then make choices, simply based on this information. Hence the information asymmetry. So signaling consists of the process put in place by the potential candidate, while selection includes the mix of actions that the recruiter can carry out. The major difficulty is represented by the fact that the subject who finds himself in the situation of information asymmetry can only carry out a series of checks on the information and declarations issued by the counterparty.

Moral hazard

Moral hazard is a situation that occurs, for example, when you have a fault with an appliance and take it for repair. You are not experts in that field, and therefore entrust your object to the hands of an expert. If he is honest, he just replaces the damaged piece, in other cases he could take advantage of your "ignorance" to change other parts and thus increase his profit. This situation is referred to as moral hazard.

Why it is important for companies to use information asymmetry

Situations of information asymmetry consequently imply an information advantage. The subject or company that has an informational advantage can therefore make a series of choices in its favor. Being in informational advantage conditions the choice of the characteristics of the contract between the principal, the one who proposes the contract, and the agent, the one who can accept or refuse. From these two names comes the expression "problems of agency".

If the parties had common interests, all relevant information would be immediately exchanged and consequently, there would be no information asymmetry condition. If, on the other hand, one of the two parties has more or less information, this translates into greater contractual capacity. Information power is therefore synonymous with contractual and economic power.

Agency costs

Agency costs are those that arise due to the conflict of interest between principal and agent.

The principal is the person hiring and the agent is the one hired. The latter carries out its work on behalf of the former. Therefore, both the agent and the principal can be an individual or an organization of any kind.

The contract generates costs since the client does not have perfect information about his counterparty. An example of this situation is when a company's shareholders hire managers to run it. On the one hand, shareholders may be interested in maximizing the share price to increase their wealth. Likewise, they would be interested in paying out more dividends. On the other hand, managers would be more interested in the growth and consolidation of the company. This does not necessarily lead to stock price growth or higher dividends in the near term. As a result, a conflict arises over the priorities of the parties involved.

There are several methods used to minimize agency costs. Some of them are:

• Monitoring agent activity: This could be a solution when activities are easy to measure and monitor. However, the more complicated it is to control, the more cost it generates to monitor. For example, you can set income goals or production levels.
• Giving incentives: The goal here is to ensure that the agent and the principal have the same interests. For example, through the granting of shares and options, and the payment of commissions. Efficiency pay can also be considered.

In general, the risk of conflict is minimized by reducing information asymmetry. That is, the clearer the agent's interests are, the lower the costs involved in the relationship. Furthermore, incentives have the goal that each individual, pursuing his interests, achieves the goal of the group.

Author: Alice Nicoletti