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Leeds University
Business School

Assessed Coursework Coversheet
For use with individual assessed work

200975766 Student Identification Number:

Module Code: LUBS _____5002M_____________

Module Title: __Information and Organisation Design __

Module Leader: Andrew Robinson

Declared Word Count: ____1492________

Asymmetric Information and Its impact upon the Market Function

Introduction
Financial market functioning is based on certain fundamentals and technical principles. Information about the market scenarios and the background activities are stated as the fundamental aspects of the financial market movements. If a deal is being carried out between two entities and one entity possesses additive information over another then this scenario reflects the actualization of an unfair financial transaction. The possession of additive information by one entity over another in the financial market is stated as information asymmetry or asymmetric information (Hughes, Liu and Liu, 2007). The current discussion includes the overall assessment of various theories that had been presented over the period of time and their practical application into the financial market in context of asymmetric information. In addition, the discussions carried out in the current essay also elaborate the impact of asymmetric information over the financial activities that are carried out in the financial markets.

Asymmetric Information and Its impact upon the Market Function
In reference to economics as well as to that of contract theory, the concept of asymmetric information reflects the view of an unfair advantage of one entity over another entity in context of information regarding any financial transaction. The core reason for the actualization of unfair advantage is due to power imbalance. In certain scenarios, the imbalance of power demonstrates the aspect of awry transaction which is a worst case of market failure. Some of the prominent examples of this concept include adverse selection, moral hazards and monopoly of information. Generally, the discussion of the concept of information asymmetry is studied in reference to the agency theory or principal-agent problem. One of the prime impacts of information asymmetry is related to the absence of essential components in the process of communication.

Some of the prominent theories that help in understanding the concept of information asymmetry include George Akerlof, Michael Spence and Joseph Stiglitz. In addition to this, the agency theory and contract theory also elaborate the assistance in terms of developing the understanding of the concept of information asymmetry. In the year 1970, a research paper had been presented by George Akerlof titled “The Market for Lemons: Quality Uncertainty and the Market Mechanism”. The paper examined how the transactions that were being carried out in the market on the qualitative perspective, were affected due to the instability or imbalance of information. Both the entities possess similar information but if the seller or the buyer possesses excessive information over another entity, then this scenario is stated to be information asymmetry.

An example of the practical application of this theory is when an individual prefers to purchase the stocks of an organization but the seller possesses the information that what particular organization’s stock is underperforming. Though the seller motivates the buyer to make that particular purchase, after the purchase the buyer has nothing in his possession but “lemons”. The term lemon which expresses the meaning of making the purchase of an automobile and after the purchase has been made, the buyer realizes that the purchased automobile is defective. Similarly, according to Sufi (2007), the buyer makes the purchase of stocks of an ineffective performing organization because the seller possessed excessive information, which was not accessible to the buyer. After the stocks are purchased, the buyer of the stocks can be stated as the person holding lemons in the hand.

The above presented example elaborates the scenario of information asymmetry. The concept presented by George Akerlof can be supported by various models and theories. The model of adverse selection and moral hazards model are the two prominent models that elaborate the understanding of concept of information asymmetry. The model of adverse selection describes a situation where a party possesses less useful information than another. And the moral hazard model elaborates the understanding of skills absence with regard to retaliate for breaching of the agreement or contract.

For example, if an individual possesses high risk of his life or of its business institution but that information is not known to the insurance institution. In addition to this, the buyer of the insurance does not provide the appropriate information to the insurance company. This example expresses the concept of adverse selection because the seller of the transaction does not possess sufficient information about the buyer’s risk extent but still makes negotiations over the agreed contract (Chae, 2005). Moreover, after the insurance is bought by the buyer, the buyer behaves recklessly because the seller either possesses no capability for observing the reckless behaviour of the buyer, or is unable to observe the reckless behaviour of the buyer due to lack of information. The above presented example expresses the understanding of information asymmetry in which the buyer has the advantage over the seller (Lambert, Leuz and Verrecchia, 2012). With regard to moral hazard, if a buyer acquires an insurance from an insurance company, and the insurance company bears all or part of behavior cost and risk, then the company faces the moral hazard as the buyer might break a contract and does not need take all responsibility.

Similarly, in the financial institutions such as banks and other mortgage houses when provides the funds to an individual in against of keeping the security of an immovable property of the buyer. In this scenario, the seller does not possess skills for assessing the pattern of repayment of the buyer regardless the credit history of the buyer is effective. On the other hand, the buyer does not have sufficient skills with regard to the assessment of the seller behaviour after the funds are provided. The above presented example expresses the application of the adverse selection on the buyer perspective and moral hazards on the seller perspective (Lambert, Leuz and Verrecchia, 2012).

The two prominent ideas or theories that can be preferred in order to avoid the concept of information asymmetry are signalling and screening. The core idea of signalling was generated by Michael Spence and the generation of the idea was carried out in reference to the searching of the job. Michael Spence expressed the view that when an employer searches for the appropriate personnel for the job, the employer discusses the questions if the employee is an efficient learner or not. Every respondent will agree to the presented statements that employee possesses the skills of learning. However, not every individual possesses the skills of learning. But if a party who has more useful information and is willing to share it with another party, then the transaction will improve. For example, in the stock market, if two individuals make a transaction, then one entity expresses the signal of investing the funds into the appropriate alternative and the seller expresses the interest of making good money over the transaction (Leary and Roberts, 2010). This is one of the alternatives that reduce the extent of information asymmetry. Similarly, the concept of screening is based on the situation in which the buyer knows more information about themselves than the seller knows about buyers, but the seller can be provided some purchase options for buyers in order to know their information. For example, some buyers are more likely to purchase a larger memory Ipad on higher price than a smaller memory with lower price. Then the seller possesses the buyers’ purchasing psychology and their purchasing power accordingly.

These are some of the alternatives that assist the buyer as well as the seller to avoid the scenario of information asymmetry. There are numerous examples that can be observed in the financial services in context of information asymmetry. The most prominent example of information asymmetry is from the stock markets where the buyers of the stock do not possess sufficient information about the particular organization. In addition to this, the seller does not provide the private information due to the presence of personal interest. This scenario is related to the agency theory. Similarly, money markets and commodity markets also express a similar scenario where the individual does not possess the second end of the transaction and is unable to assess the private information. The middle man keeps its personal interest and does not provide the information to the buyer or to the seller about the transaction. This particular scenario elaborates the view of moral hazards concept.

Conclusion
In an overall perspective, it can be stated that in the financial market activities either in buying or selling the product, the concept of information asymmetry overall influences the environment in negative perspective. The core reason is the false treatment of the transaction in concurrence to the lack of information and the lack is not overcome by the other party. This concept also elaborates the view that if appropriate information is not provided to the buyer or to the seller then the gap overall reduces the extent of market transaction and the powers or authorities are transferred to the handful individuals. This scenario overall implies the effect on the pattern by which the individual thinks about the market activities on the financial perspective.

References
Chae, J. (2005). Trading volume, information asymmetry, and timing information. The journal of finance, 60(1), 413-442.
Lambert, R. A., Leuz, C., and Verrecchia, R. E. (2012). Information asymmetry, information precision, and the cost of capital. Review of Finance, 16(1), 1-29.
Leary, M. T., and Roberts, M. R. (2010). The pecking order, debt capacity, and information asymmetry. Journal of Financial Economics, 95(3), 332-355.
Sufi, A. (2007). Information asymmetry and financing arrangements: Evidence from syndicated loans. The Journal of Finance, 62(2), 629-668.
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