Asymmetric information: – situation that arises when one party’s insufficient knowledge about the other party involved in a transaction makes it impossible to make accurate decision when conducting a transaction.
Adverse selection: – is an asymmetric information problem that occurs before the transaction has taken place.
Suppose there are 2 persons ‘A ‘and ‘B’ who want to take a loan from a relatively new bank in the market ‘XYZ’. The loan takers A and B know their financial condition, capacity to repay and the future earning prospects, which the bank doesn’t. The bank has to gather information about their clients’ credit-worthiness. So that they can differentiate between the ‘good’ and the ‘bad’ borrowers, who are unknown to them. In this context, the new banks may face adverse selection problem in the sense that they do not know whether borrowers A and B are new entrants seeking loan for investing in a new venture or are “bad” borrowers rejected by other incumbent bank. The result is that the bank “XYZ” faces worse distribution of borrowers than the incumbent bank. This puts entrants into a worse position than incumbents and may lead to deterred entry.
Considering the same example above, suppose ‘A’ is a good firm with good credit history and ‘B’ a new firm with no credit history or may be poor credit history seek loan. Because of asymmetric information problem discussed above our bank ‘XYZ’ has a hard time in distinguishing between both of them and hence will charge an interest rate on loan that is an average of interest rate to be charged on loan given to firm A (lower than firm B because there is less risk associated in giving a loan to firm A). Since firm A knows that it is a good firm, they know that the interest rate charged on their loan requirement is overcharged, firm A will not borrow from the bank XYZ but since interest rate charged from firm B will be lower than their valuation firm B would be eager borrow from the bank. As a result, bank XYZ end up having a portfolio comprising of bad credit risks.
This reply was modified 2 years, 5 months ago by Ayush Nair.