A Report on the Idea of Market Failures Caused by Information Asymmetry

This report challenges the idea of market failures resulting from information asymmetry, and proposes the contrary; that it in fact can lead to opportunities, and even success. Information Asymmetry refers to when one side of a transaction, process, or situation, has more (or different) information, that is not available to the second party, and may therefore influence the outcome of the transaction. Although nowadays, thanks to legal requirements, there is more transparency and disclosure to prevent such inequality, although it still exists in many forms.

This report would argue that such legal actions are not necessarily required, as the uneven spread of information can present opportunities, and enable for innovations that otherwise would not be available. It can be presented as a source for either success or failure, depending on the entrepreneurial response from either party. According to this theory, there are some conditions, existing only in such scenarios, that can rather help innovation emerge, and forces entrepreneurs to examine new ways of obtaining further "mutual" information, and settling the matter.

There are two ways discussed in this article, in which information asymmetry can manifest and grow into opportunity. The first one being in R&D related activities, allocating control, or distribution, where these factors can be substituted with tangible means of negotiation, and therefore lead to creating better deals and cutting costs. The second way, refers more to the cognitive and individual knowledge aspect of the members involved in the transaction.

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Since their quality or amount of information defers, it can create a competitive advantage, allowing for "entrepreneurial discovery" among the parties involved, and can in turn be transformed into an opportunity that the second party might not be presented with. The ultimate goal of this report is to present a more wholesome perspective on the concept of asymmetrical information, and discuss its' advantages and drawbacks. Then, to apply the findings on innovation management processes in the fields of industrial economics, financial economics, and entrepreneurship, to help clearly understand how to capture the potential benefits of information asymmetry.

Theoretically, economic schools of thought generally assume that information in the market is evenly distributed, and everybody shares the same knowledge. According to findings, this is rarely the case, as every individual possesses information derived from their personal life experience. This on it own, transforms processes related to the transaction, such as selection, and providing incentives. This automatically creates unique conditions each time a transaction takes place, which makes room for opportunity. Opportunities are defined as a chance to meet market needs, and with regards to entrepreneurship, it adds the importance of using the tools at hand, (tools - referring to the existing knowledge) to make the best possible outcome.

Asymmetrical information is generally divided into two categories; moral hazard, and adverse selection, differing by the way they affect both individual sides of the deal, who may have "hidden knowledge", or "hidden actions". The two proposed ways of tackling the two categories of information asymmetry are:

1. Self-selection - which opposes adverse selection by disclosing, screening, or signalling information
2. Incentives & monitoring – aimed at reducing moral hazard problems.

Managing innovation under such cirucmstances, can help place value on knowledge in the supply chain, which allows agents to produce incentives for gaining private information. Limitations created by the knowledge gap, can allow agents to initiate legal environments where the innovator's investment is protected, and makes it easier for both parties to share knowledge and sign agreements to decide on the appropriate division of gains.

"Information economics" is a relatively new field of study, which shines light on never-discussed-before ideas regarding the impact of knowledge on the market structure and performance. The intangible nature of knowledge makes it hard to gather, interpret, and value, thus affecting the supply and demand equilibrium. The growing awareness of these theories can open doors to many new economic sciences that could perhaps use their findings to help understand some of the many market abnormalities that exist.

One research suggested that the information asymmetry helps determine the best fitting choice of organizational mode or design. Another research added that according to this decision, the organisation can then choose to "adopt" or "diffuse" innovations. In order to capture these otherwise "hidden" opportunities, an agent needs to act quickly in identifying and discovering them, so they can be exploited to their advantage. Once posessing differentiated information, a firm can use information-oriented strategies, or disclosure strategies, to control how the information is being exposed and shared to the public, which gives them a competitive advantage, and can help the firm's profitability.

If done correctly, and using entrepreneurial strategies, one can transform a market failure into an opportunity by eliminating the negative aspects of information asymmetry with regards to resource allocation. There are three proposed dimensions of prior knowledge that shape the process of entrepreneurial discovery; prior knowledge of markets, prior knowledge of servicing the market, and prior knowledge of customers. Upon developing capability through this dimensions, the firm can then do the following:

1. Discover the asymmetries.
2. Integrate the asymmetries into the organisational design which strategically transforms them into competitive advantage.
3. Turn this advantage into market opportunities.

The "dual" role of information asymmetry means that the parties in question may either fail, or use the uneven distriution to their advantage and succeed. Although it is a difficult task, market "agents" may use their skills as entrepreneurs and innovators, to turn the drawbacks of their misinformation, into a strategic tool for achieving their goals. Through means of negotiation, legal agreements, information disclosure, and other techniques, a firm can direct their operations to the desired outcome, regardless - or rather thanks to - the asymmetric information at hand.

Due to the nature of this topic, which is relatively new and unexplored, it completely lacks real life examples of the theories discussed, and does not clearly define practical ways of application. Some charts, or data comparisons, could have aided in carrying out and proving the arguments, rather than being only theoretical. More research about this topic and other fields of cognitive-economic sciences should be done to supplement this research.

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