An economy is said to be characterized by information asymmetry when some parties to business transactions may have an information advantage over others.
Types of information asymmetry
The first is adverse selection. Adverse selection occurs because some persons, such as managers and other insiders know more about the current condition and future prospects of the firm than outside investors. There are various ways that managers and other insiders can exploit their information advantage at the expense of others, for example, by biasing or otherwise managing the information released to investors. This may affect the ability of investors to make good investment decisions. Financial reporting is one of the mechanisms that are used to control the problem of adverse selection by credibly converting inside information into outside information.
The second one is moral hazard. This problem occurs because of the separation of ownership and control that characterizes most medium and large businesses. It is almost impossible for shareholders to observe directly the extent and quality of top managerial effort on their behalf. A manager may take advantage of this by shirking on effort and blaming any deterioration of firm performance on factors beyond his or her control. If this happens there are serious implications for investors.
Accounting net income can be one of the effective antidotes to the problem of moral hazard. Net income can be incorporated into executive compensation contracts to motivate manager performance. Net income can also inform the securities and managerial labor markets, so that a manager who shirks will suffer a decline in income, reputation, and market value over time.
Importance of Information asymmetry
Information asymmetry is a very important concept because securities markets are subject to information asymmetry problems. This is because of the presence of inside information and insider trading. Insiders know more than outsiders about the true quality of the firm. They may take advantage of their privileged position of information to earn excess profits. They may take actions that are beneficial to them but are detrimental to the interests of investors.