Agents have symmetric information when all agents have the same information. Agents have asymmetric information when some agents have more information than others. Asymmetric information can cause market failure.
Examples of asymmetric information leading to market failure include:
1) Banks/Credit Markets.
Asymmetric information may exist in credit markets as borrowers are likely to know more about their own credit worthiness than a bank does. Consequently, low-risk borrowers will be limited to small loans with high rates of interest if banks cannot tell whether they are risky or not.
2) Mechanics.
A mechanic is likely to know more about cars than a customer at a garage. A mechanic could lie and claim a car needs more work done to it than is necessary.
Market Unravelling and Missing Markets Akerlof highlighted asymmetric information in the market for second hand cars. A second hand car could be a peach (good quality) or a lemon (bad quality). Assume sellers know if their car is a peach or lemon but buyers do not know. Buyers will only offer an average price for a car whether it is a peach or a lemon. All the peaches will leave the market because peach owners want more than the average price for their good quality car. The market begins to unravel. Asymmetric information causes adverse selection, that is, bad quality cars drive good quality cars out of the market. Only lemons are left, and buyers do not want lemons because they are bad quality cars, so buyers do not demand lemons. A missing market has developed, the market for second hand cars disappears, there is complete market failure.
To correct the market failure the government may implement a law stating that all second hand cars must meet some minimum quality criteria. Also, car sellers could signal that their cars are peaches by offering a warranty.
Merit Goods A merit good has benefits for the consumer who buys it but the consumer may be unaware of its full benefits. A merit good is under-consumed due to asymmetric information. Merit goods include healthcare and education.
Market failure occurs because the good is under-consumed. The government must intervene to correct the market failure. The government could subsidise merit goods to encourage their consumption, provide them for free or advertise the benefits of merit goods.
Demerit Goods A demerit good has costs for the consumer who buys it but the consumer may be unaware of its full costs. A demerit good is over-consumed due to asymmetric information. Demerit goods include drugs, smoking and gambling.
Market failure occurs because the good is over-consumed. The government must intervene to correct the market failure. The government could tax demerit goods to discourage their consumption, regulate the amount consumed, ban the good completely or advertise the costs of demerit goods.