How does information asymmetry affect your business?

 Information asymmetry is the uneven distribution of information between two parties in a transaction. For instance, when an insurance provider is verifying the claims made by his client, he is faced with gaps in information. How does he determine, with accuracy, that the claims are genuine or that they are motivated by intention? Buyer behavior is greatly driven by availability of information before and after the purchase. In order to make choices, buyers need information about the price and quality of the various alternatives that they are considering. However, when it comes to services, service quality is difficult to evaluate due to the intangibility and simultaneous production and consumption of services. Such gaps in information between buyers and sellers can open possibilities of exploitation while creating opportunities for competitive advantage.

There are two types of information asymmetry; moral hazard and adverse selection. Moral hazard refers to the buyer’s inability to observe actions taken by the seller after making a transaction. For instance, did my physician or attorney exercise due care? Or whether the salesman I hired on a fixed salary is not nailing sales targets due to slackness or low demand? Even if the services are observable after the transaction agreement has been made, without specialist know-how, the buyer cannot determine quality of the services. Adverse selection problems arise when private information about the transaction is only available to one of the contracting parties before making a transaction. For example, high risk health individuals can hide their risks and benefit from a cheaper insurance policy. In another scenario, a seller of a used car knows defects that a buyer does not.

While a possible remedy is increased observation, for example, making medical examinations mandatory before selling insurance, or a getting a trained expert to inspect used cars, this is often not the perfect solution. All the facts and contingencies prevailing at the time of service production cannot be fully known to the monitor, and cannot often be known to the service provider.

Then how do we increase the information available to transacting parties and lower the cost of information acquisition? How do we minimise the risk of making a faulty purchase because of lack of information about its quality attributes? One solution is to develop a reputation for credibility, quality, or whatever competitive advantage a business stands for. This is best done when the same business diversifies its range of services, develops a high reputation in one or many of the diversified streams, and automatically benefits from reputation transference. For example, if a clothing brand develops a high reputation for producing in-fashion high quality fabric, it is likely to transfer its credibility when it opens a cosmetics store. If people trust the name, they will be loyal to it no matter what it sells!