Question

In which of the following situations is an information asymmetry likely to cause problems? [LO 10.1] a. Parents know more than their children about how to write a good college application. b. People who book hotel rooms online know less about the quality of the room they are reserving than the hotel's management.

Short answer

Situation B is more likely to cause problems due to information asymmetry.

Step-by-step solution

Understanding Information Asymmetry

Information asymmetry occurs when one party in a transaction has more or better information than the other. This can lead to unfairness or inefficiencies.

Analyzing Situation A

In situation A, parents know more than their children about how to write a good college application. However, this difference in knowledge is generally not problematic because parents typically assist their children with the application process. Their goal is to help, rather than exploit the information gap.

Analyzing Situation B

In situation B, the people booking hotel rooms online know less about the quality of the room than the hotel's management. This discrepancy can lead to problems because the hotel might present the rooms in an overly positive light, exploiting the information gap to attract bookings, potentially causing disappointment upon arrival.

Evaluating Both Situations

Situation B is more likely to cause problems due to the potential for hotels to misrepresent room quality for economic gain. This fits the criteria of an information asymmetry causing issues, as opposed to situation A, where the information discrepancy is typically benign and aimed at assistance.

Key concepts

Asymmetric Information

Asymmetric information happens when one party in a transaction holds more or better information than the other. This imbalance can result in various issues.

• It may lead to unfair advantage.
• The more informed party might exploit this gap.

In our examples, one such instance is when hotel management knows more about room quality than customers booking online. Here, customers potentially face the risk of being misled, as they cannot fully assess the room's quality before arriving. Thus, hotels might exaggerate to attract customers, demonstrating a clear case of asymmetric information.
Sometimes, efficiency is compromised when there is a significant discrepancy in available information. People may make suboptimal choices due to lack of knowledge, impacting economic outcomes and satisfaction levels.

Economic Inefficiency

When there's asymmetric information, it often results in economic inefficiency. This means resources aren't allocated to their best possible use. Such inefficiencies are common in markets where buyers and sellers possess unequal information.
The hotel booking example is a prime case. Guests might end up paying for a room that doesn't meet their expectations, leading to wasted money and dissatisfaction. On the flip side, hotels might lose potential customers if people are aware of such risks in the future. Consequently, even though the hotel initially benefits from the booking, it might suffer reputational damage and loss of trust.
In the long term, these inefficiencies can lead to market failures where the true quality or value is obscured, preventing optimal decisions.

Knowledge Gap

The knowledge gap refers to the difference in information possessed by different parties. This gap can play a crucial role in creating asymmetric information situations. It can emerge in various forms, like expertise difference, access to resources, or simple communication barriers.

• In the college application scenario, parents may have in-depth insights, from their experiences, highlighting this gap.
• However, unlike the hotel scenario, their goal is typically to aid and not hinder their children, showcasing that not all knowledge gaps lead to problematic asymmetry.

Understanding these gaps is essential for addressing information issues. Bridging the gap can involve better communication or using intermediary means to ensure both parties have similar access to information, reducing the chances of exploitation or dissatisfaction.