ASYMMETRIC INFORMATION EFFECTS ON LOAN SPREADS

Asymmetric Information Effects on Loan Spreads



Asymmetric Information Effects on Loan Spreads

Introduction

Asymmetric information exists when one participant in trade knows something that the other participant does not know about the quality of the particular good or service they are trading. This violates one assumption of perfect competition—“perfect information” (when market participants have all the information relevant to goods' and services' quality and price). The canonical example is the market for used cars (Akerlof 1970): The seller knows her attention to the car's maintenance, but the buyer's evaluation of the car's value is limited to the features he can observe and his knowledge of the average quality of this type of car. In this case, the seller has more information about the product's quality, but there are also markets in which the buyer has more information. When buying health insurance, for example, the buyer knows his own eating, drinking, and smoking habits, and the seller (the insurer) does not have as clear a picture of the buyer's quality of health.

Background Information

The concern of the economist or policy maker is that this asymmetry can lead to market failure: The asymmetric knowledge causes less trade between buyers and sellers than would be optimal for society; in the extreme case, only low-quality goods or services are traded. In this case of complete market failure, high quality goods are not sold: Used-car buyers assume (correctly) that only owners of “lemons” want to sell their cars, and insurance companies assume (correctly) that only less healthy individuals desire insurance. Like other market failures, asymmetric information corrupts the price mechanism: If the buyer lacks information (used cars), the market price will be too low for higher-quality exchange; if the seller lacks information (health insurance), the market price will be too high for higher-quality exchange.

Discussion

Consider a numerical example in the case of used cars to make these ideas concrete. There are two types: high quality cars valued at $15,000 and low quality cars valued at $10,000. These values, common to both buyer and seller, indicate the utility gained from owning a car. If 10 percent of the cars are low quality, then the prospective buyer could assume with 90 percent probability that he is buying a high-quality car and will offer to pay (0.90)($15,000) + (0.10)($10,000) = $14,500 or less. But at this price, only the owners of low-quality cars will be willing to sell. As a result, buyers and sellers expect only low-quality cars to be available on the market, and those cars sell for $10,000. Sellers of the low-quality cars know who they are, but the buyers do not. This phenomenon explains why a new car loses so much of its value as soon as it is driven off the dealer's lot.

A similar example illustrating the case of health insurance would show that there is less incentive for the high-quality (healthy) types to buy insurance, which drives up the price of insurance. Only the customers with poor health and higher willingness to pay ...