Asymmetric information and the firm

It has been pointed out in that asymmetric information can create rather than destroy markets. But we can push the argument further and consider asymmetric information and the firm.

Asymmetric information is not a problem for the firm but an essential way for it to operate. Harold Demsetz ('The Theory of the Firm Revisited', "Journal of Law, Economics, and Organization", 4(1) Spring: 141-61) recognised this when he noted that given the limitations on what a single worker can know, the total competence that a firm has to possess, must be divided up into bits which are manageable. Each bit is allocated to groups of workers and their actions co-ordinated by management. Thus workers who produce on the basis of knowledge they themselves do not possess, have their activities directed by someone who does possess (at least more) of the necessary knowledge. In this way direction is a substitute for education, that is for the transfer of the knowledge itself. Specialisation in knowledge not only exacerbates asymmetric information, it actually demands it.

Everyone can not and should not know everything. The organisational issue this creates for the firm is to ensure that the worker with information reveals it fully to those who need to know it. In their book "Saving Capitalism From the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity" Rajan and Zingales point out that we are in fact seeing a new "kinder, gentler firm". This is in response to the increase in the importance of knowledge in the form of human capital, increased competition and access to finance, all of which have increased the worker's importance and improved the outside options for workers, thereby changing the balance of power within firms. In Rajan and Zingales's view "[t]he single biggest challenge for the owners or top management today is to manage in an atmosphere of diminished authority. Authority has to be gained by persuading lower managers and workers that the workplace is an attractive one and one that they would hate to lose. To do this, top management has to ensure that work is enriching, that responsibilities are handed down, and rich bonds develop among workers and between themselves and workers". Only by such methods can management set incentives in the hope of enticing full revelation of information by employees.

The need for setting incentives for information revelation is not new, its not just an artefact of the so-called knowledge economy. In discussing the factory system of the industrial revolution Joel Mokyr observes that "[p]utting all workers under one roof ensured repeated interaction and personal contact provides maximal bandwidth to maximize the chances that the information will be transmitted fully and reliably. Inside a plant agents knew and could trust each other, and this familiarity turned out to be an efficient way of sharing knowledge." (The Gifts of Anthena: 141) This is an interesting example of using social based incentives to help deal with a asymmetric information problem.

Asymmetric information is therefore the result of the importance of knowledge in the production process. As long as no one person can know the entire production process then situations of asymmetric information must occur. The division of labour is limited not only by the size of the market but also by the size of the knowledge set required to carry out the best-practice mode of production. The smaller the knowledge set, the less the division of labour and the less is the "problem" of asymmetric information.