micro-chapter16.pdf

Chapter 16Asymmetric InformationIntroductionWe want to see what will happen when some parties know more than others asymmetric informationFrequently a seller or producer knows more about the quality of the product than the buyer doesManagers know more about costs,competitive position and investment opportunities than firm ownersThe Market for LemonsAsymmetric information is a situation in which a buyer and a seller possess different information about a transaction The lack of complete information when purchasing a used car increases the risk of the purchase and lowers the value of the car Markets for insurance,financial credit and employment are also characterized by asymmetric information about product qualityThe Market for Used CarsAssume Two kinds of cars high quality and low quality High-quality cars are worth$2000 while the low-quality cars$1000 for sellers Buyers are willing to pay$2400 for HQ cars and$1200 for LQ carsIf buyers and sellers can distinguish between the cars There will be two markets one for high quality and one for low qualityThe Market for Used CarsSuppose that sellers know more about the quality of the used car than the buyerInitially buyers may think the odds are 50/50 that the car is high quality Buyers will be willing to pay the expected value of the car*$2400+*$1200=$1800However,if the buyer offers$1800,only the lemons will be offered for saleIf the buyer was certain that he would get a lemon,the he wouldnt be willing to pay$1800The Market for Used CarsThe equilibrium price in this market would have to be somewhere between$1000 and$1200For a price in this range,only owners of lemons would offer their cars for sale,and buyers would therefore(correctly)expect to get a lemonIn this market,none of the high-quality cars get sold and all of them are“crowded out”In the extreme case,the whole market may be missingThe Source of Market FailureThere is an externality between the sellers of good cars and bad carsWhen an individual decides to try to sell a bad car,he affects the buyers perception of the quality of the average car on the marketThis lowers the price that they are willing to pay for the average car,and thus hurts the people who are trying to sell good carsIt is this externality that creates the market failureThe Market for Used CarsWith asymmetric information:Low quality goods drive high quality goods out of the market-the lemons problem The market has failed to produce mutually beneficial trade Too many low and too few high quality cars are on the marketMarket for InsuranceOlder individuals have difficulty purchasing health insurance at almost any priceThey know more about their health than the insurance companyBecause unhealthy people are more likely to want insurance,the proportion of unhealthy people in the pool of insured people risesPrice of insurance rises so healthy people with low risk drop out proportion of unhealthy people rises,increasing price moreMarket for InsuranceEx:Auto insurance companies are targeting a certain population males under 25They know some of the males have low probability of getting in an accident and some have a high probabilityIf they cant distinguish among insured,they will base premium on the average experienceSome with low risk will choose not to insure,which raises the accident probability and ratesAdverse SelectionThe phenomenon in which people make selections by making use of their private information and potentially hurt others is called“adverse selection”This term,which was originated from the insurance industry,has very broad applications Lemons in Major League BaseballRules in baseball changed so that after 6 years a player could either re-sign with their team or become a free agent and try to sign with another teamFree agents create a secondhand market in baseball players If a lemons market exists,free agents should be less reliable(disabled)than renewed contractsPlayer DisabilityDays on Disabled List per SeasonPre ContractPost ContractPercent ChangeAll Players4.7312.55165.4Renewed Players4.769.68103.4Free Agents4.6717.23268.9Lemons in Major League BaseballFindings Days on the disabled list increase for both free agents and renewed players Free agents have a significantly higher disability rate than renewed players This indicates a lemons marketHow to Solve the Adverse Selection Problem?Two major solutions:Contractual Design or Screening SignalingMarket for InsuranceA possible solution to adverse selection in the insurance market is to pool risks Health insurance government takes on role as with universal health plans in the developed countries Problem of adverse selection is eliminated Insurance companies will try to avoid risk by offering group health insurance policies at places of employment and thereby spreading risk over a large pool Set up the limit on the medical compensationCredit Market The Market for Credit Asymmetric information creates the potential that only high risk borrowers will seek loans Can end up with a lemons problem again However,banks and credit agencies use credit histories to gauge risk of borrowersProfit vs.NonprofitBlood donation vs.market supplyDonation as a screening deviceThere is something money cant buyMarket SignalingThe process of sellers using signals to convey information to buyers about the products qualityFor example,how do workers let employers know they are productive so they will be hired?Market SignalingWeak signal could be dressing well Is weak because even unproductive employees can dress wellStrong Signal To be effective,a signal must be easier for high quality sellers to give than low quality sellers Example Highly productive workers signal with educational attainment levelModel of Job Market SignalingAssume two groups of workers Group I:Low productivity Average Product&Marginal Product=L Group II:High productivity Average Product&Marginal Product=H The workers are equally divided between Group I and Group II Average Product for all workers=0.5H+0.5LModel of Job Market SignalingIf worker quality is easily observable,then firms would just offer a wage of H to the high-quality workers and L to low-ability workersWhat if the firm cant observe the marginal products?If the firm cannot distinguish the types of workers,then the best that it can do is to pay the expected wage,0.5H+0.5LEducation Level as A SignalSuppose that workers can acquire education as a signal for their abilitiesEducation has no effect on worker productivityFor the low-ability workers,the education cost is c1e1For the high-ability workers,the education cost is c2e2We assume that c2 0 since(H-L)c2e*If c2 c1,then there will be a pooling equilibrium21*cLHecLHEducationcostsLow-ability workersHigh-ability workersHLee*Welfare Implications of SignalingThe separating equilibrium is inefficient from a social point of viewHigh-quality workers pay for acquiring the signal but education doesnt increase productivityExactly the same amount of output is produced in the signaling equilibrium as would be if there were no signaling at allAgain,this inefficiency arises from an externality.Welfare Implications of SignalingIf both able and unable workers were paid their average product,the wage of the able workers would be depressed because of the presence of the unable workersThe high-ability workers have an incentive to invest in signals and this investment offers a private benefit but no social benefitSignaling doesnt always lead to inefficiencies.Some type of signals,such as the warranties,help to facilitate trade which would otherwise be missingSignalingEducation provides a useful signal about individual work habits and productivity even if that education does not change productivity.Market SignalingGuarantees and Warranties Signaling to identify high quality and dependability Effective decision tool because the cost of warranties to low-quality producers is too highReputation and StandardizationHow can these producers provide high-quality goods when asymmetric information will drive out high-quality goods through adverse selection?Reputation You hear about restaurants or stores that have good or bad service and quality Advertisement as signals for good reputation Standardization Chains that keep production the same everywhere McDonalds,Olive GardenMoral HazardExample:Moral hazard occurs in the case of insurance when the insured party whose actions are unobserved can affect the probability or magnitude of a payment associated with an event If my home is insured,I might be less likely to lock my doors or install a security system Individual may change behavior because of insurance moral hazardThe distinction between adverse selection vs.moral hazard:hidden information(ex ante)vs.hidden action(ex post)The Principal Agent ProblemOwners cannot completely monitor their employees employees are better informed than ownersThis creates a principal-agent problemwhich arises when agents pursue their own goals,rather than the goals of the principalThe Principal Agent ProblemCompany owners are principalsWorkers and managers are agentsOwners do not have complete knowledgeEmployees may pursue their own goals even at a cost of reduced profitsThe Sources of Agency ProblemsPrivate information on actions or behavior of agentsDifferent objective functions between principals and agentsA combination of these two problems lead to agency problemsThe Principal Agent ProblemThe Principal Agent Problem in Private Enterprises Most listed corporations have dispersed ownership shares Most large firms are controlled by management Monitoring management is costly(asymmetric information)The Principal Agent Problem Private EnterprisesManagers may pursue their own objectives Growth and larger market share to increase cash flow and therefore perks to the manager Utility from job,from profit,and from respect of peers,power to control corporation,fringe benefits,long job tenure,etc.The Principal Agent Problem Private EnterprisesLimitations to managers ability to deviate from objective of owners Stockholders can oust managers Takeover attempts if firm is poorly managed Market for managers who maximize profits those that perform get paid more so incentive to act for the firmCEO SalariesAlthough originally thought that executive compensation reflected reward for talent,recent evidence suggests managers have been able to manipulate boards to extract compensation out of line with economic contributionCEO SalariesHow have they been able to do this?1.Boards dont typically have necessary information and independence to negotiate effectively2.Managers have introduced forms of compensation that camouflage the extraction of rents from shareholders Stock options(not counted as expenses)CEO SalariesRent extraction has increased as consultants are hired to determine appropriate pay for CEOFirm usually wants to provide at least the average of other companies,so salaries have been rising rapidlyWith publicity increasing,CEO salaries seem to be rising less rapidlyIncentives in the Principal-Agent FrameworkDesigning a reward system to align the principals and agents goals-an example Examine the agency problem between the firm and machine repairperson Owners goal is to maximize profit Machine repairperson can influence reliability of machines and profitsIncentives in the Principal-Agent FrameworkDesigning a reward system to align the principals and agents goals-an example Revenue also depends,in part,on the quality of parts and the reliability of labor High monitoring costs make it difficult to assess the repairpersons workThe Revenue from Making WatchesPoor LuckGood LuckLow Effort(a=0)$10,000$20,000High Effort(a=1)$20,000$40,000Incentives in the Principal-Agent FrameworkRepairperson can work with either high or low effortRevenues depend on effort relative to the other events(poor or good luck)Owners cannot determine a high or low effort when revenue=$20,000Incentives in the Principal-Agent FrameworkRepairpersons goal is to maximize wage net of costCost=0 for low effortCost=$10,000 for high effortw(R)=repairpersons wage based only on outputIncentives in the Principal-Agent FrameworkChoosing a wage:1)w=0;a=0;R=$15,000 2)a.R=$10,000 or$20,000,w=0 2)b.R=$40,000;w=$24,000 R=$30,000;Profit=$30,000-$12,000=$18,000 Net wage=(1/2)*0+(1/2)*24,000-$10,000=$2,000 The repairperson will choose High effort under the second wage schemeIncentives in the Principal-Agent FrameworkConclusion Incentive structure that rewards the outcome of high levels of effort can induce agents to aim for the goals set by the principalsManagerial Incentives in an Integrated FirmIn integrated firms,division managers have better(asymmetric)information about production than central managementTwo Issues How can central management elicit accurate information?How can central management achieve efficient divisional production?Managerial Incentives in an Integrated FirmWe will focus on firms that are integratedHorizontally integrated Several plants produce the same or related productsVertically integrated Firm contains several divisions,with some producing parts and components that others use to produce finished productsManagerial Incentives in an Integrated FirmPossible Incentive Plans1.Give plant managers bonuses based on either total output or operating profitWould encourage managers to maximize outputWould penalize managers whose plants have higher costs and lower capacityNo incentive to obtain and reveal accurate cost and capacity informationManagerial Incentives in an Integrated Firm2.Ask managers about their costs and capacities and then base bonuses on how well they do relative to their answersQf=estimate of feasible production levelB=bonus in dollarsQ=actual outputB=10,000-.5(Qf-Q)Incentive to underestimate QfDont get accurate information about capacity and dont insure efficiencyManagerial Incentives in an Integrated FirmModify scheme by asking managers how much their plants can feasibly produce and tie bonuses to itBonuses based on more complicated formula to give incentive to reveal true feasible production and actual output If Q Qf,B=.3Qf+.2(Q-Qf)If Q Qf,B=.3Qf-.5(Qf-Q)Managerial Incentives in an Integrated FirmAssume true production limit is Q*=20,000 Line for 20,000 is continued for outputs beyond 20,000 to illustrate the bonus scheme but dashed to signify the infeasibility of such production Bonus is maximized when firm produces at its limit of 20,000;the bonus is then$6000Incentive Design in an Integrated FirmOutput(units per year)2,0004,0006,00010,000010,00020,00030,00040,000Bonus($peryear)8,000If Qf=30,000,bonus is$4,000,the maximumamount possible.Qf=30,000Qf=10,000If Qf=10,000,bonus is$5,000.Qf=20,000If Qf=Q*=20,000,bonus is$6,000.Efficiency Wage TheoryIn a competitive labor market,all who wish to work will find jobs for a wage equal to their marginal product However,most countries economies experience unemploymentEfficiency Wage TheoryThe efficiency wage theory can explain the presence of unemployment and wage discrimination