1. Markets with Asymmetric Information
Managerial Economics
ECON 511
Lecture 7
Markets with Asymmetric Information
Professor Changqi Wu 1

2. Topics for Today Quality uncertainty and the market for lemons
Solutions to adverse selection problem
Pricing strategy with presence of asymmetric information
Moral hazard problem within an organization and its solutions
Asymmetric information

3. 1. The Market for Used Cars
Qualities of used cars differ.
If buyers and sellers can distinguish between high and low quality cars
There will be two markets
Typically, buyers are less informed than sellers about the exact quality of a used car.
Asymmetric information

4. The Lemons Problem SH SL DH DL DM PH PL DLM DL QH QL 5,000 50,000
The market for high and low
quality cars when buyers and sellers
can identify each car
10,000 DM
75,000
25,000
With asymmetric information buyers will
find it difficult to determine quality. They lower
their expectations of the average quality of
used cars. Demand for low and high quality
used cars shifts to DM. PH PL
DLM
The increase in QL
reduces expectations and
demand to DLM. The adjustment process
continues until demand = DL. DL QH QL 12

5. The Market for Used Cars
A seller has the incentive to put the low quality used car in the market.
Buyers, anticipating that, are only willing to pay the price of a lemon for the used car.
Too many low and too few high quality cars are on the market.
Low quality goods drive high quality goods out of the market. The market has failed to produce mutually beneficial trade.
Asymmetric information

6. Asymmetric Information
one side of a transaction knows less than the other side
Information asymmetry leads to economic inefficiency
Two kinds of information asymmetry
One side of a transaction knows about herself, but the other side does not. It is called adverse selection.
One side can take actions that the other side cannot observe. It is called moral hazard.
Marriage can be a good example: before marriage, adverse selection: so live together. After marriage: action may change
Asymmetric information

7. Business Applications
Insurance
Is it possible for insurance companies to separate high and low risk policy holders?
If not, only high risk people will purchase insurance. Adverse selection would make medical insurance unprofitable.
The market for credit
Asymmetric information creates the potential that only high risk borrowers will seek loans.
How can credit histories help making this market more efficient and reduce the cost of credit?
Asymmetric information

8. 2. Resolving Adverse Selection Problem
Actions taken by the buyer: screening
The less informed party takes actions to learn about the true characteristics of the other side.
Action taken by a third party: appraisal
Actions taken by the seller: signaling
The better informed party takes actions to reveal her unobservable true characteristics.
Asymmetric information

9. 2.1. Screening
Screening is a process of actively collecting information.
Banks ask proofs of earnings before issuing credit cards.
Interviews for job candidates
Search cost and optimal searching
Asymmetric information

10. Economics of Beauty
Personal beauty is a better introduction than any letter.
--Aristotle B.C.
Asymmetric information

11. 2.2. Appraisal
The existence of searching costs creates market power to the seller. It causes economic inefficiency.
Economy of experience leads to the creation of specialized search agencies.
Credit rating agencies: Moody’s and Standard&Poor’s
Department stores serve as intermediaries to select goods on behalf of buyers
Government agencies act as market intermediate agents
Asymmetric information

12. 2.3. Market Signaling
It has to be costly to convey information and the costs must be different to different producers.
Guarantees and warranties: Signaling to identify high quality and dependability
Effective decision tool because the cost of warranties to low-quality producers is too high
Are you ready to give a diamond ring as the birthday present?
Asymmetric information

13. MBA as a Signal
Employers know that there are two kinds of people with different capabilities among the potential job candidates
Miss Smart is a quick learner and a diligent worker.
Mr Dumb is a slow and lazy worker
It costs money and effort to complete the MBA program
Implicit costs and chance of success differ between two kinds of candidates
Only smart people are willing to enroll into the MBA program
Asymmetric information

14. Firm as Information Provider
Companies have incentives to provide information to its potential customers.
Advertising produces two effects
Informative advertising
Persuasive advertising.
Advertising as a signal of product quality
Advertising of a firm is only effective if customers keep on buying its products.
Asymmetric information

15. 3. Quality of Goods and Pricing
Types of goods
Search goods: The quality of goods can be ascertained before a purchase
Experience goods: The quality of goods can be learnt after the purchase
Credence goods: The quality of goods is rarely learnt even after the consumption
Asymmetric information

16. Price as a Signal of Quality
You get what you have paid for?
One-shot purchase: high price signals high quality:
Only at a high price, high quality producers are willing to supply the goods.
If consumers comprise the informed and the uninformed, demand for high quality goods is stronger than that for the low quality ones.
Asymmetric information

17. Price as a Signal of Quality
Repeat purchases
At introductory stage, a low price signals a high quality product:
a low quality producer cannot generate repeat purchases.
A high price signal a high quality
a high quality producer is not afraid of contracting demand.
Asymmetric information

18. Key Learning Points
Information asymmetry hinders business transactions and leads to economic inefficiencies.
Adverse selection means one side of a transaction knows more about herself while other side does not.
Screening, appraisal and signaling are possible remedies for adverse selection problems.
Asymmetric information

19. 4. Moral Hazard
One party’s interest depends on the action of another party whose action cannot be observed. Two parties have a conflict of interest
Moral hazard problem in an economic organization often takes the form of principal-agent relationship.
Relationship between shareholders (bond holders) and managers is a kind of principal-agent relationship
Asymmetric information

20. Causes of Moral Hazard
Asymmetric information takes the form of unobservability of other party’s action
It is not like adverse selection, one side does not know the type of another side
There is a conflict of interest of stakeholders in an organization
Asymmetric information

21. Solutions to Moral Hazard
Improving monitoring mechanism
supervisors
Reconcile the conflict interests by establishing incentive compatible compensation scheme
Carrots
performance based pay: piece rate wage, stock options
Sticks
China’s economic reform follows the decentralization road. In banking sector decentralization led to disastrous effect. Zhu’s banking sector reform represents a recentralization effort
Asymmetric information

22. Why a Pilot is Paid more than … a Taxi Driver?
A taxi driver and a pilot of Boeing 747 jumbo jet may require different skills
Negligence of a pilot leads to a loss of many lives
A pilot is paid more than a taxi driver to encourage the former to do his job more carefully.

23. Efficiency Wage
Shareholders want all employees to devote their effort to maximize firm’s profit.
Employees want to maximize their net benefits. If the reward takes the form of fixed wage, the optimal course of action is to devote as little effort as possible.
One can use market mechanism to reduce the moral hazard in an organization
Efficiency wage is a wage level at which the unit output labor cost is minimized.
Unemployment becomes unavoidable when the ongoing wage is higher than the market clearing one.
Asymmetric information

24. An Efficiency Wage Model
Without shirking, the market wage
is w*, and full-employment exists at L*
Demand for
Labor w* L* SL
No-Shirking
Constraint
The no-shirking
constraint gives
the wage necessary
to keep workers
from shirking. we Le
At the equilibrium wage, We the
firm hires Le workers
creating unemployment of L* - Le.
Quantity of
Labor
Asymmetric information 88

25. Moral Hazard in MultipleTasks
An agent has incentives to put more effort on observable action and less on the unobservable action
Example: price and safety standard of electricity supply
Solution: using indicators that reflect the level of less observable effort
Asymmetric information

26. 5. Holdup Problem
Holdup is an action to exploit another party’s dependency
Hold-up occurs when transaction requires specific investments by one side or both sides
Relations between Nike and its subcontractors
Asset specificity causes opportunistic behavior
Holdup problem induces economic inefficiency
Asymmetric information

27. Contract Solution
Contracts can be used to detail the tasks and responsibilities of all parties under different contingencies.
A well written contracts can help to clarify ambiguities and reduce possible disputes
A contract should be verifiable and enforceable
Asymmetric information

28. Ownership Solution
A contract may not be specific enough to include all contingencies. In this case, we call that contract is incomplete.
If a contract is incomplete, ownership matters because the owner has the right to make decisions that are not explicitly spelt out in the contract
Ownership means the right to claim the residual benefits
The ownership arrangement is critical to economic efficiency in an organization.
Ownership arrangement also determines the organizational form of business.
Asymmetric information

29. Optimal Ownership Arrangement
Ownership should go to the party whose effort has the maximal impact on firm’s performance
Some examples
Employee share ownership plan (ESOP)
Stock options for senior management
Joint ownership in joint ventures
Asymmetric information

30. Holdup Problem in Joint Ventures
Chinese party needs capital, technology and know-how
Foreign party needs market access and networking
After forming a joint venture, both sides have incentives to take advantage of other party’s commitment
Joint ownership may mitigate the holdup problem in joint ventures
Asymmetric information

31. Asymmetric information

32. Key Learning Points
Management of an organization is about motivating people to achieve the goal of the organization
Because of the conflict of interest among stakeholders and the moral hazard problem, an organization may not be able to achieve its maximal potential.
Incentive compatible mechanisms can help managers motivate people by mitigating the moral hazard, thus, improve the economic efficiency in an organization.
Asymmetric information