1. Chapter 15 Asymmetric Information

2. © 2014 Pearson Education, Inc. All rights reserved.15-2 Table of Contents 15.1 Adverse Selection 15.2 Reducing Adverse Selection 15.3 Moral Hazard 15.4 Using Contracts to Reduce Moral Hazard 15.5 Using Monitoring to Reduce Moral Hazard

3. © 2014 Pearson Education, Inc. All rights reserved.15-3 Introduction Managerial Problem –During the mortgage market meltdown that started in 2007, record numbers of mortgage holders defaulted on their loans. –Why did executives at these banks take risks that resulted in so much lost shareholder value? How can a firm compensate its corporate executives so as to prevent them from undertaking irresponsible and potentially devastating actions? Solution Approach –We need to examine how a manager’s incentives can lead to excessive risk taking. Empirical Methods –A party in a transaction may know less than the other party (asymmetric information) because of hidden characteristics or hidden actions. –A more-informed party may exploit the less-informed party, engaging in opportunistic behavior and creating two problems: adverse selection and moral hazard.

4. © 2014 Pearson Education, Inc. All rights reserved.15-4 15.1 Adverse Selection The Problems of Adverse Selection –If consumers lack relevant information, they may not engage in transactions to avoid being exploited by better informed sellers (adverse selection). –As a result, not all desirable transactions occur and potential consumer and producer surplus is lost. –In extreme cases, adverse selection may prevent a market from operating at all. Adverse Selection Cases –Two important examples of adverse selection problems are insurance and products of varying quality.

5. © 2014 Pearson Education, Inc. All rights reserved.15-5 15.1 Adverse Selection Adverse Selection in Insurance Markets –How would people react to a fair insurance rate (a rate for insurance equal to the average cost of health care for the entire population)? –Unhealthy people—people who expect to incur health care costs that are higher than average—would view this insurance as a good deal and many would buy it. –Healthy people, in contrast, would not buy it because the premiums would exceed their expected health care costs (unless they are extremely risk averse). –So a disproportionately large share of unhealthy people will buy the insurance (adverse selection). –The insurance company’s average cost of medical care for covered people exceeds the population average. The company makes a loss. Consequences of Adverse Selection in Insurance Markets –Adverse selection results in an inefficient market outcome: few healthy people are insured and insurer’s cost is high. The sum of CS and PS is not maximized. –This outcome could be changed with perfect information: healthy people would buy insurance at a lower premium, but the insurer must first verify they are healthy.

6. © 2014 Pearson Education, Inc. All rights reserved.15-6 15.1 Adverse Selection Products of Unknown Quality –Adverse selection often arises because sellers of a product have better information about the product’s quality than the buyer. –In a transaction of a used car, the seller knows whether his car is a lemon, but the buyer cannot know it (hidden characteristic). Consequences of Unknown Quality –If sellers have more information than buyers, adverse selection may drive high-quality products out of the market (Akerlof, 1970). Why? –Car buyers worry that a used car might be a lemon. They would be willing to pay only relatively low prices that reflect the possibility of getting a lemon. –However, sellers of excellent used cars do not want to sell their cars at such low prices. They do not enter the market. –Adverse selection has driven the high-quality cars out of the market, leaving only lemons.

7. © 2014 Pearson Education, Inc. All rights reserved.15-7 15.1 Adverse Selection Lemons Example –1,000 sellers cannot alter the quality of their used cars; 1,000 buyers are willing to pay $4,000 for a lemon and $8,000 for a good used car. –The demand curve for lemons, D L, is horizontal at $4,000 in panel a of Figure 15.1, and the demand curve for good cars, D G, is horizontal at $8,000 in panel b. –The reservation price of lemon owners is $3,000, so the supply curve for lemons, S L in panel a, is horizontal at $3,000 up to 1,000 cars, where it becomes vertical (no more cars are for sale at any price). –The reservation price of owners of high-quality used cars is v, which is less than $8,000. Panel b shows two possible values of v. If v = $5,000, the supply curve for good cars, S 1, is horizontal at $5,000 up to 1,000 cars and then becomes vertical. If v = $7,000, the supply curve is S 2. Equilibrium with Full & Symmetric Information –In panel a of Figure 15.1, the equilibrium in the lemons market (D L =S L ) is at e and 1,000 lemons sell for $4,000 each. In panel b, the equilibrium in the good-car market is at E and 1,000 good cars sell for $8,000 each. –This market is efficient: the goods go to the people who value them the most.

8. © 2014 Pearson Education, Inc. All rights reserved.15-8 15.1 Adverse Selection Figure 15.1 Markets for Lemons and Good Cars

9. © 2014 Pearson Education, Inc. All rights reserved.15-9 15.1 Adverse Selection Equilibrium with Incomplete & Symmetric Information –If information is symmetric and buyers and sellers are equally ignorant about the quality of cars, EV = 0.5 x 8000 + 0.5 x 4000 = $6,000. A risk-neutral buyer and a seller would transact at $6,000. –This market is efficient: the goods go to the people who value them the most. Equilibrium with Asymmetric Information –When sellers know the quality but buyers do not, there are two possible equilibria. –If sellers value good cars at v = $5,000 and buyers consider EV = $6,000, all cars are sold at $6,000. The equilibrium points are f and F in Figure 15.1. In this case asymmetric information does not cause an efficiency problem, but it does have equity implications. –If sellers value good cars at v = $7,000, they will not sell them at $6,000. Buyers realize good cars cannot be found for less than $7,000. Then, the lemons drive good cars out of the market, only lemons are sold at $4,000 leading to an inefficient equilibrium.

10. © 2014 Pearson Education, Inc. All rights reserved.15-10 15.1 Adverse Selection Summary of the Lemons Problem –If buyers have less information about product quality than sellers do, the result might be a lemons problem in which high-quality cars do not sell even though potential buyers value the cars more than their current owners do. –The lemons problem does not occur if the information is symmetric. If buyers and sellers of used cars know the quality of the cars, each car sells for its true value in a perfectly competitive market. If, as with new cars, neither buyers nor sellers can identify lemons, all cars sell at a price equal to the EV. Varying Quality Under Asymmetric Information –If consumers cannot identify high-quality goods before purchase, they pay the same for all goods regardless of quality. –Firms do not produce top-quality goods if p is the same for High and Low quality. –The outcome is inefficient, assuming consumers are willing to pay more for top-quality goods.

11. © 2014 Pearson Education, Inc. All rights reserved.15-11 15.2 Reducing Adverse Selection Restricting Opportunistic Behavior –One method for solving adverse selection problems is to restrict the ability of the informed party to take advantage of hidden information. –Which type of restriction works best depends on the nature of the adverse selection problem, as we see below. Mandating Universal Coverage –Health insurance markets have adverse selection because low-risk consumers do not buy insurance at prices that reflect the average risk. –Such adverse selection can be eliminated by providing insurance to everyone or by mandating that everyone buy insurance. Laws to Prevent Opportunism –Product quality and product safety are known characteristics to sellers but not observed by buyers. –Product liability laws protect consumers from being stuck with nonfunctional or dangerous products.

12. © 2014 Pearson Education, Inc. All rights reserved.15-12 15.2 Reducing Adverse Selection Equalizing Information –Another method for solving adverse selection problems is to provide information to all parties. –There are three methods for reducing information asymmetries: screening, signaling, and third party. Screening Reduces Adverse Selection –Insurance companies screen potential customers based on their health records or medical exams. They collect information until marginal benefit and marginal cost from the extra information are equal. –Buyers of used cars test or drive the cars, bring a trusted mechanic, or buy only from sellers with good reputation. Reputation is not easy to get in markets where buyers or sellers trade only once, like in tourist areas.

13. © 2014 Pearson Education, Inc. All rights reserved.15-13 15.2 Reducing Adverse Selection Signaling Reduces Adverse Selection –An informed party may signal the uninformed party to eliminate adverse selection. However, signals work only when the recipients view them as credible. –Examples: A firm may distribute a favorable report on its product quality by an independent testing agency; a candidate for life insurance may present a health report signed by a doctor approved by the insurer; education is also a signal. Third Party Information Reduces Adverse Selection –If the information on quality provided by consumer groups, nonprofit organizations, and government agencies is credible, it can reduce adverse selection. –These groups and organizations also provide standards and certification. If these programs inexpensively and completely inform consumers and do not restrict the goods available, the programs are socially desirable.

14. © 2014 Pearson Education, Inc. All rights reserved.15-14 15.3 Moral Hazard Moral Hazard and Adverse Selection –Moral hazard problems come from hidden actions. For instance, renters driving rental cars off-road, workers loafing when the boss is not watching, and lawyers acting in their own interests instead of those of their clients. –We will focus on the insurance market and the principal-agent relationship. Moral Hazard in Insurance Markets –Many types of insurance are highly vulnerable to hidden actions by insured parties that result in moral hazard problems. –Example: A business insures merchandise in a warehouse against hazards such as fire and theft. If merchandise is not selling, the owner faces a significant financial loss. He may burn down the warehouse and make an insurance claim. –Example: If doctor’s visits are free and unlimited with health insurance, the insured may make ‘excessive’ visits.

15. © 2014 Pearson Education, Inc. All rights reserved.15-15 15.3 Moral Hazard Moral Hazard in Principal-Agent Relationships –Principal-Agent problem or agent problem: when responsibilities are delegated, a principal contracts with an agent to take an action that benefits the principal. If the agent’s actions are hidden, moral hazard may result. –Example: A business owner (principal) hires an employee (agent) to work at a remote site and cannot observe whether the employee is working hard. The employee may shirk by not providing all the services they’re paid to provide. Reducing Moral Hazard using Efficient Contracts –The principal and agent can agree to an efficient contract: an agreement in which neither party can be made better off without harming the other party. –If the parties to the contract are risk neutral, efficiency requires that the combined profit of the principal and agent be maximized. –If one party is more risk averse than the other, efficiency requires that the less risk- averse party bear more of the risk. –In the previous example, efficiency occurs if the agent works extra hard so total profit is maximized, and if the agent (risk averse party) bears none of the risk.

16. © 2014 Pearson Education, Inc. All rights reserved.15-16 15.3 Moral Hazard Moral Hazard & Efficient Contracts: Ice Cream Shop –Paul (principal) owns many ice cream parlors across North America. He contracts with Amy (agent) to manage his Miami shop. Her duties include supervising workers, purchasing supplies, and performing other necessary actions. –The shop’s daily earnings depend on the local demand conditions and on how hard Amy works (Table 15.1). Demand can be high or low depending on weather conditions (50%) and Amy can put in normal or extra effort (valued $40 per day). –Paul is risk neutral because he can pull earnings from the many stores he owns. Amy, like most people, is risk averse. –We know an efficient contract requires Amy to bear no risk, but the outcome depends on symmetric and asymmetric information. Ice Cream Shop Efficient Contract & Symmetric Information –Moral hazard is not a problem if Paul can directly supervise Amy and agree that: Amy earns $200 per day if she works extra hard, but loses her job if she doesn’t. –Amy’s zero risk: She gets $200 independently of weather. –Amy’s incentive to work hard: She nets $160 (200-40), better than being fired. –Paul bears all risk: EV = $200; σ 2 = 10,000 (perfect monitoring row in Table 15.2) –Efficient contract: Profit maximized, risk averse agent bears no risk.

17. © 2014 Pearson Education, Inc. All rights reserved.15-17 15.3 Moral Hazard Table 15.1 Ice Cream Shop Profits

18. © 2014 Pearson Education, Inc. All rights reserved.15-18 15.3 Moral Hazard Table 15.2 Ice Cream Shop Outcomes

19. © 2014 Pearson Education, Inc. All rights reserved.15-19 15.3 Moral Hazard Ice Cream Shop Inefficient Contract & Asymmetric Information –Moral hazard is a problem if Paul cannot observe Amy’s effort. Both agree on a fixed-fee contract: Amy earns $100 per day. –Amy’s zero risk: She gets $100 independently of weather. –Amy’s incentive to work normally: If she works normally, she gets $100. But, if she works hard, she only nets $60 (100-40). –Paul bears all risk: EV = $100; σ 2 = 10,000 (fixed wage row in Table 15.2) –Inefficient contract: Profit is not maximized, although risk averse agent bears no risk. Moral Hazard and Selfish Doctors Study Case in China –Patients (principals) rely on doctors (agents) for good medical advice with respect to drug prescriptions. Do doctors act only in their patient’s best interests? –Lu (2011) found in China that doctors prescribed similarly whether or not a patient had insurance if the doctors received no compensation for prescriptions. However, if doctors were compensated, they prescribed drugs that cost 43% more on average for insured patients than for uninsured patients. –Thus, many of these doctors appeared to be motivated largely by self-interest.

20. © 2014 Pearson Education, Inc. All rights reserved.15-20 15.4 Using Contracts to Reduce Moral Hazard Contracts and Correct Incentives –A skillfully designed contract that provides strong incentives for the agent to act so that the outcome is always efficient may solve moral hazard problems. –We will focus on fixed-fee and contingent contracts. Fixed-Fee Contracts –Amy could pay Paul a fixed license fee to operate Paul’s shop. Paul bears no risk as he receives a fixed fee, Amy bears all the risk and gets the residual profit. –Paul makes $200 with certainty. –Amy’s incentive to work hard: She earns all the increase in expected profit from her extra effort. EV HARD = $160 > -$100 = EV NORMAL, σ 2 = 10,000 –Efficient contract: Licensing fee profit > fixed wage profit in Table 15.2 (360 > 200). However, it does not provide efficient risk bearing. –If Amy is nearly risk-neutral, she picks the license fee. If she’s highly risk- averse, she picks the fixed wage.

21. © 2014 Pearson Education, Inc. All rights reserved.15-21 15.4 Using Contracts to Reduce Moral Hazard Contingent Contracts –Many contracts specify that the parties receive payoffs that are contingent on some other variable. –If monitoring is possible, contingency may be the action taken by the agent. –If monitoring is not possible, payoff may be contingent to the state of nature, profit sharing, bonuses & options, piece rates and commissions. State Contingent Contracts –In a state-contingent contract, one party’s payoff is contingent on only the state of nature (weather conditions determine low and high demand). –Contract: Amy pays a license fee of $100 if demand is low and $300 if demand is high, and keeps all extra earnings (state-contingent row in Table 15.2) –Amy’s incentive to work hard: Working normal she nets zero. She must work hard. –Amy bears no risk: EV HARD = $160 = EV NORMAL, σ 2 =0. –Paul bears all risk: EV = $200, σ 2 =10,000. –Efficient outcome: Profit is maximized, risk averse agent bears no risk.

22. © 2014 Pearson Education, Inc. All rights reserved.15-22 15.4 Using Contracts to Reduce Moral Hazard Profit Sharing –A profit-sharing contract: the payoff to each party is a fraction of the observable total profit (profit sharing row in Table 15.2). –Contract: Paul and Amy agree to split the earnings of the ice cream shop equally. –Amy’s incentive to work hard and risk: EV HARD = $160 > $100 = EV NORMAL, and σ 2 = 2,500 for both efforts. She prefers to work hard. –Paul earnings: EV = $200, and he is risk neutral. –Efficient outcome: Profit is maximized but risk averse agent bears risk. Paul prefers this contract to a fixed-fee contract. Amy works hard if her profit share > 20%. Bonuses –A principal offers the agent a bonus: extra payment if a performance target is hit. –Contract: Paul offers Amy a base wage of $100 and a bonus of $200 if the shop’s earnings (before paying Amy) exceed $300 (wage and bonus rows in Table 15.2) –Amy’s incentive to work hard: Working normal she nets $100. Working hard, EV HARD = $160 and σ 2 =10,000. Her choice depends on her risk-averse level. –If Amy is nearly risk neutral, she works hard (before last row in Table 15.2). –If Amy is highly risk-averse, she works normal (last row in Table 15.2). –Efficient outcome: Profit is maximized only if Amy is risk neutral.

23. © 2014 Pearson Education, Inc. All rights reserved.15-23 15.4 Using Contracts to Reduce Moral Hazard Options –An option gives the holder the right to buy up to a certain number of shares of the company at a given price (the exercise price) during a specified time interval. –An option provides a benefit to the executive (agent) if the firm’s stock price exceeds the exercise price and is therefore a bonus based on the stock price. Piece Rates and Commissions –Piece rate contract: agent receives a payment per unit of output produced. –Contract: Amy is paid for every serving of ice cream she sells. It gives her an incentive to work hard, but she bears the risk from fluctuations in demand. –Revenue-sharing contract or commissions: agent receives some share of revenues earned –Contract: Amy gets a 5% commission for every serving she sells. It gives her an incentive to work hard, but she bears the risk from fluctuations in demand. –Efficiency: Commissions provide an incentive for agents to work harder than they would with a fixed-rate contract. But, this incentive is not necessarily strong enough to offset the agent’s cost of extra effort and the agent bears some risk.

24. © 2014 Pearson Education, Inc. All rights reserved.15-24 15.5 Using Monitoring to Reduce Moral Hazard Problem and Monitoring Solution –Moral Hazard Problem: employees who are paid a fixed salary have little incentive to work hard if the employer cannot observe shirking. And if paid by the hour but employer but cannot observe how many hours they work, employees may inflate the number of hours they report working. –It pays to prevent shirking by carefully monitoring and firing employees who do not work hard if the cost of monitoring workers is low enough. Low Cost Monitoring Practices –Most common types of surveillance: tallying phone numbers called and recording the duration of the calls (37%), videotaping employees’ work (16%), storing and reviewing e-mail (15%), storing and reviewing computer files (14%), and taping and reviewing phone conversations (10%). –Nearly 75% of employers monitor and surveillance employees (81% in the financial sector). Firms usually monitor selected workers using spot checks. –A quarter of firms that monitor employees do not tell them.

25. © 2014 Pearson Education, Inc. All rights reserved.15-25 15.5 Using Monitoring to Reduce Moral Hazard Monitoring May be Counterproductive –For some jobs, however, monitoring is counterproductive or not cost effective. Monitoring may lower employees’ morale, which in turn reduces productivity. –Example: Northwest Airlines took the doors off bathroom stalls to prevent workers from staying too long in the stalls. When new management eliminated this policy, productivity increased. Monitoring Difficulties –As telecommuting increases in the work place, monitoring workers may become increasingly difficult. –A firm’s board of directors is supposed to represent shareholders (principals) by monitoring senior executives (agents). Are they good in monitoring? –No. In a study of firms in which senior executives engaged in illegal price- fixing, exposing the firm to significant legal liability, it was found that these executives were more inclined to recruit directors who were likely to be inattentive monitors.

26. © 2014 Pearson Education, Inc. All rights reserved.15-26 15.5 Using Monitoring to Reduce Moral Hazard Hostages –When direct monitoring is very costly, firms often use contracts containing various financial incentives to reduce the amount of monitoring that is necessary. These incentives act as a hostage for good behavior. –Hostage incentives are bonding, deferred payments, and efficiency wages. Bonding to Reduce Monitoring Efforts –One way to ensure agents behave well is to require them to deposit funds guaranteeing their good behavior. –Example: an employer (principal) may require an employee (agent) to provide a performance bond, an amount of money that will be given to the principal if the agent fails to complete certain duties or achieve certain goals. –Posting bonds is common in couriers who transport valuable shipments or guards who watch over them, and construction contractors. –1 st problem: If the employee fears the employer will opportunistically retain the bond, it will not deposit it. Solution, firm reputation & independent verification. –2 nd problem: The employee may not have enough wealth.

27. © 2014 Pearson Education, Inc. All rights reserved.15-27 15.5 Using Monitoring to Reduce Moral Hazard Deferred Payments to Reduce Monitoring Efforts –Firms can post bonds for their employees through the use of deferred payments. –Example: A firm pays new workers a low wage for some initial period. Then, workers who are caught shirking are fired, good workers remain at higher wages. –Example: The firm provides a retirement pension that rewards only workers who stay with the firm for a sufficiently long period of time. –Problem: Employers may fire good workers to avoid paying higher wages or retirement pensions. Solution: firm reputation & independent verification. Efficiency Wages to Reduce Monitoring Efforts –Managers can often reduce employee shirking by paying an efficiency wage: an unusually high wage above the worker’s opportunity cost. –Incentive to reduce shirking: if the worker is fired and finds another job, the amount offered elsewhere is less than the efficiency wage. Worker works hard. –Firm increases profit if the saving from reducing shirking exceeds the cost of the higher wage (marginal benefit > marginal cost).

28. © 2014 Pearson Education, Inc. All rights reserved.15-28 15.5 Using Monitoring to Reduce Moral Hazard After-the-Fact Monitoring –So far we’ve concentrated on monitoring by employers looking for undesirable behavior as it occurs. –However, it is often easier to detect the effects of shirking or other undesirable actions after they occur. Punishment Discourages Shirking –Example: An employer can check the amount that an employee produces or quality of work after it is completed. If shirking is detected after the fact, the offending employee may be fired or disciplined. This punishment discourages shirking in the future. –If an insurance company determines after the fact that an insurance claim resulted from behavior rather than chance, the firm may refuse to pay. This punishment reduces opportunistic behavior.

29. © 2014 Pearson Education, Inc. All rights reserved.15-29 Managerial Solution Managerial Problem –Why did executives at these banks take risks that resulted in so much lost shareholder value? How can a firm compensate its corporate executives so as to prevent them from undertaking irresponsible and potentially devastating actions? Solution –It seems managers of these banks took excessive risks because their risky actions were hidden, they were compensated for success, and not substantially penalized for failure. –One solution is to provide incentives that penalize them relatively more for failure, a combination of fixed salary with bonus and the penalty of firing the executive if the firm has a loss. –Another is to increase independent monitoring of executive payment contracts. Moral hazard was common partly because these contracts were designed by senior executives themselves. If shareholders had symmetric information, they would have objected, but few shareholders had the time, ability, or sufficient information to scrutinize executive compensation contracts.