Asymmetric Information

Essay #2 – Certain markets have an information problem where one party to a transaction has more information than the other. Explain, using the correct economics language, the following two issues and potential solutions to each: a) corporate executives are supposed to run companies for the benefit of the stockholders. What kinds of problems exist and how can they be solved? b) online schools know more about the true quality of their programs than ether potential students or the government financial aid programs do. There is currently a lot of fraud I these programs. What can be done to overcome this problem?

In economics, a situation of asymmetric information can arise when one party to a transaction has more information than the other. While there are numerous examples where this condition arises, many can be classified as either hidden actions or hidden characteristics. In either case, the knowledge lacking party would like to know the pertinent information, but the informed party has some incentive to keep the information hidden.

The relationship between stockholders and corporate executives is an excellent example of hidden actions. Often in these types of principal-agent relationships, where one party is performing a task on behalf of another, a moral hazard arises due to the principal’s inability to closely monitor the performance of the agent. In the case of the stockholder and corporate executive relationship, the stockholder (the principal) has an ownership interest in the corporation while the executives (the agents) control the day to day operations. Although the stockholders essentially pay the executives to realize maximum profits, it is difficult to monitor any hazardous, immoral behavior the executives may pursue.

Solving the principal-agent moral hazard issue can be difficult due the inability of the principal to perfectly monitor the agent. Also, in the case of the shareholder-executive relationship, lack of business knowledge can...