1. ECON6021 (Nov 17&19) Information Asymmetry

2. Informational economics zWhen a person buys medical insurance, the insuring company does not know whether the person is healthy. Nor does it know how well he is going to take care of himself after buying insurance. zThe former type of asymmetry information is called a hidden type problem, or adverse selection problem. zThe latter type of asymmetric information is called a hidden action problem, or moral hazard problem. But the notion of moral hazard has subsequently expanded. zInformation economics is the study of decision makings between agents when their information is asymmetric.

3. Adverse Selection

4. Why called “Adverse Selection”? zAdverse selection refers to a situation where a selection process (here market) results in a pool of products/individuals with economically undesirable characteristics. zWith “hidden type”, either (1) bad products drive out good products or (2) good products subsidize bad products (both receive the same price). zGresham’s law: bad money drives out good. Or, where two media of exchange come into circulation together the more valuable will tend to disappear.

5. Adverse selection: Used Cars (Lemons) Market Assumption: all of the above is commonly known in the following exercises.

6. Scenario I: Full Information zSuppose that every buyer and every seller know the type of the car they are negotiating. zThen both good cars and bad cars will be traded. zThere are simply two products (good and bad cars).

7. Scenario II: No Information zSuppose buyers don’t know the type of the cars they are interested. Also suppose no sellers know the type of the cars they own. Assume all agents are risk neutral. zExpected valuation of a car to buyers= 1/3 * $30K + 2/3 * $20K = $23.33K zExpected valuation of a car to sellers = 1/3 * $25K + 2/3 * $10K = $15K zBoth good cars and bad cars will be traded!

8. Scenario III: Asymmetric (Unequal) Information zSellers know the types of cars they own. But buyers don’t know the types of cars they are going to buy. zIs a buyer willing to pay at a price greater than $25K (say $26K)? zNo, because there is 2/3 of probability that the car is bad, and the expected valuation to the buyer=1/3*$30K + 2/3*$20K= $23.33K < the price

9. Scenario III: Asymmetric (Unequal) Information zIs a buyer willing to pay a price of $22K to buy a car? zNo, at such a low price, only bad cars owners will sell their cars. But bad cars are worth only $20K to the buyer. $22K is too high a price. zThe market price is even lower, at $20K or somewhat lower. Only bad cars will be traded. Good cars don’t find a buyer!!! zRemark: What matters is not the amount of information.

10. Scenario III: Asymmetric Information zGood cars may still find a buyer, if the probability of bad cars in the pool is low. zLet p be such prob. A buyer is willing to pay $25K if (1- p)x$30K + px$20K>$25K, or p<0.5. zGood cars of 2-3 years old will easily find a buyer, while good cars of 10 years old don’t find a buyer

11. Solving the Problems: zGuarantees & Warranties zLiability Laws zReputation of a store or the manufacturer zExperts--a disinterested party zStandards & Certifications zsignaling by the party who has more information [education, money burning, etc.]

12. Moral Hazard Recap: yWhen a person buys medical insurance, the insuring company does not know whether the person is healthy. Nor does it know how well he is going to take care of himself after buying insurance. yThe latter type of asymmetric information is called a hidden action problem, or moral hazard problem. That is, when people are insured by medical insurance, they tend to exert less effort to take care of themselves than the case they are uninsured. yWhy called moral hazard? People buy insurance for their houses, and then burn them and claim for compensation greater than the value of the houses.

13. Some knowledge about decisions under uncertainty zExpected value of a gamble=EV=p 1 v 1 +p 2 v 2 +…+p n v n where p i is the probability for the prize v i and p 1 +…+p n =1 zA gamble (game, or lottery) is fair if its expected value is zero. zSt. Petersburg paradox: a coin is flipped until a head appears. If the head first appears on the nth flip, the player is paid $2 n. How much are you willing to pay to play the game? zEV of the game =(1/2)x$2+(1/4)x$4+…(1/2 n )x$2 n +… =  zBut rarely are we willing to pay a few thousand dollars for such a game!! zThis is because people are generally risk averse! One prefers $1,000 to 1/2 probability of $2,000 and 1/2 probability of $0.

14. Contracting between a risk neutral and risk averse agent zIn the absence of moral hazard, the risk neutral agent should bear all risk. zSuppose there are only two states: good and bad (each with 1/2 probability), and a joint venture between a risk neutral agent (N) and a risk averse agent (R) have a revenue of 150 and 100 under the two states. zConsider any contract stipulates that the agent get x at the good state and y at the bad state. N’s expected income is (150- x)/2+(100-y)/2=125-(x+y)/2. R’s expected income is (x+y)/2. zConsider another contract with a sure payment of (x+y)/2 at each state. The each party’s expected income remains unchanged. While N is indifferent to the change, R is strictly better off because risk is eliminated.

15. Principal-Agent Problem & Insurance zA risk neutral principal hires a risk averse agent to help him on a task. Suppose the agent’s effort affects the profits non- deterministically (e.g. farming). zWithout moral hazard, the optimal contract is to let the principal bear all the risk and the agent get a fixed income. [Optimal risk sharing] zBut in the presence of moral hazard, such a contract is infeasible in the sense that the agent will shirk. A tradeoff is to have a contract stipulating a bonus positively related to the profits generated. zThe above analysis can be extended to insurance. In the absence of moral hazard, the optimal insurance contract is a full insurance. zIn the presence of moral hazard, full insurance is no longer feasible. Insurance can only be partial [deductible, etc.]

16. Moral hazard as a verification problem zEven if actions are observable, as long as they are not verifiable to a third party, then a contract made contingent on these actions is not enforceable. zThe following insurance contract is not enforceable. “If you take good care of yourself, I’ll pay you $5,000 in case of a loss; otherwise, I won’t pay you any in case of a loss.” zHence, moral hazard may well be a result of incomplete contracts, rather than asymmetric information.

17. Moral hazard as a commitment problem zThe idea of moral hazard has subsequently expanded to account for related phenomena. zThe most discussed are commitment or time (in)consistency problem. zActions are observable and even verifiable and hence contractible. zHowever, when the undesirable action takes place, both parties of the contract will choose not to enforce it. Instead, they renegotiate the contract.

18. A Contract between Mother and Son zA contract between mother and son: “If the son goes to sleep by 10pm, he’ll receive no penalty; otherwise, he will be shot to death.” zEx ante, the mom wishes the contract enforceable so that, foreseeing the death penalty, the son will go to bed on time. zSuppose HK law allows this contract to be legal. zSuppose they can arrange videotaping so that the court can verify when the son goes to bed. zHowever, ex post in case the son doesn’t go to bed by 10pm, it would be in both parties’ interest to renegotiate the contract (no one likes to see the son die anyway).-->a time inconsistency problem (or commitment problem) zThe son knows this and hence does not go to bed by 10pm.

19. Moral hazard & Government Policy zMoral hazard as a time consistency problem is closely related to government policy, where government is one party of a contract and citizens (or firms) are another party. zAn interesting quote: “There are two types of countries in the world; those with deposit insurance, and those not knowing they have deposit insurance.”

20. Moral hazard in a natural disaster zSuppose residents near Yellow River are more vulnerable to attack of typhoons. zTwo states of nature: good state and bad state with probability 0.9 and 0.1. zIn good state: loss =0 zIn bad state: loss = $1m zResidency elsewhere no loss zmoving cost = $50k<expected loss=0.1x$1m=100k zin case of bad state, the government can step in to reduce the resident’s loss to $200k at a cost of $500k

21. Moral hazard in a natural disaster The efficient outcome is to have the resident move out. But the government cannot commit not to rescue the resident at the bad state (a benevolent government should rescue). Knowing this, the resident will not move out!

22. Remedies for moral hazard as a commitment problem zMandatory insurance zCoercion (force the resident to move at the outset) zdivided government makes discretion less likely zIn general, don’t postpone! Solve the problem now!!

23. Further Applications zWhy unemployment can be an equilibrium outcome zWhy there is equilibrium credit rationing zWhy debt financing and equity financing are different zWhy firms exist and what explains their boundaries (holdup problem) zWhy currency attack occurs even when the fundamentals are sound