Asymmetric Information in the Stock Market
Source: https://www.bloomberg.com/view/articles/2016-08-11/the-dirty-little-secret-of-finance-asymmetric-information
In many market situations, there lies the problem of asymmetric information between the buyer and seller. Asymmetric information is the idea that one of the parties knows more information about the good than the other party in the market. Asymmetric information creates a market failure that inhibits efficiency in the market. In this case, the article discusses asymmetric information as it pertains to the stock market. When stocks are bought and sold, there is a fundamental lack of information on the part of both the buyer and the seller about the company in question. In an ideal stock market, there should be very little trading since buyers and sellers would be wary of the other party knowing more information about the stock and thus feel concerned that they are getting a bad deal. However, in financial markets, people do not act rationally and large volumes of trading occurs every day. The traders profit from the asymmetry of information in the market since they make money off the difference in price that they charge buyers and sellers for a stock. As the large volume of trades is executed throughout the day, the information that the traders have is incorporated into the price of the asset, but that information can still lead to bubbles and crashes.
In class, we discussed the used car market in which the seller often knows more about the condition of the car than the buyer, and therefore, might seek to sell the car at a price that is not the fair price given the quality of the car. We discussed the idea of an asymmetric information equilibrium in the used car market in which buyers and sellers can reach an equilibrium despite the asymmetries in information about the quality of the car in the market. In financial markets, it is much harder to reach this kind of equilibrium because certain types of private information that would influence the value of an asset is not available to traders and the public market, and so there can never be an ideal sharing of information. However, the traders who profit from the price differences in assets that they buy and sell each day tend to know more information about the stock than other people in the market. So, as they execute their large volume of trades, this information seeps into the market and is reflected in the price of the stock. This creates a somewhat functional asymmetric information equilibrium, but market failures still occur and traders do sometimes fail to realize or account for certain pieces of information that end up drastically affecting the price of the asset. Subsequently the stock market remains susceptible to enormous market failures such as the recession and other market crashes.