1. Chapter 17 Markets with Asymmetric Information

2. ©2005 Pearson Education, Inc. Chapter 172 Topics to be Discussed Quality Uncertainty and the Market for Lemons Market Signaling Moral Hazard The Principal-Agent Problem Managerial Incentives in an Integrated Firm Asymmetric Information in Labor Markets: Efficiency Wage Theory

3. ©2005 Pearson Education, Inc. Chapter 173 Introduction We can see what happens when some parties know more than others – asymmetric information Frequently a seller or producer knows more about the quality of the product than the buyer does Managers know more about costs, competitive position and investment opportunities than firm owners

4. ©2005 Pearson Education, Inc. Chapter 174 Quality Uncertainty and the Market for Lemons Asymmetric 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 quality

5. ©2005 Pearson Education, Inc. Chapter 175 The Market for Used Cars Assume  Two kinds of cars – high quality and low quality  Buyers and sellers can distinguish between the cars  There will be two markets – one for high quality and one for low quality

6. ©2005 Pearson Education, Inc. Chapter 176 The Market for Used Cars High quality market  S H is supply and D H is demand for high quality Low quality market  S L is supply and D L is demand for low quality S H is higher than S L because owners of high quality cars need more money to sell them D H is higher than D L because people are willing to pay more for higher quality

7. ©2005 Pearson Education, Inc. Chapter 177 The Lemons Problem PHPH PLPL QHQH QLQL SHSH SLSL DHDH DLDL 5,000 50,000 10,000 DLDL Market price for high quality cars is $10,000. Market price for low quality cars is $5000. 50,000 of each type are sold.

8. ©2005 Pearson Education, Inc. Chapter 178 The Market for Used Cars Sellers know more about the quality of the used car than the buyer Initially buyers may think the odds are 50/50 that the car is high quality  Buyers will view all cars as medium quality with demand D M However, fewer high quality cars (25,000) and more low quality cars (75,000) will now be sold Perceived demand will now shift

9. ©2005 Pearson Education, Inc. 9 The Lemons Problem PHPH PLPL QHQH QLQL SHSH SLSL DHDH DLDL 5,000 50,000 10,000 DLDL Medium quality cars sell for $7500, selling 25,000 high quality and 75,000 low quality. The increase in Q L reduces expectations and demand to D LM. The adjustment process continues until demand = D L. DMDM 25,000 7,500 75,000 7,500 DMDM D LM

10. ©2005 Pearson Education, Inc. Chapter 1710 The Market for Used Cars With 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 market  Adverse selection occurs; the only cars on the market will be low quality cars

11. ©2005 Pearson Education, Inc. Chapter 1711 Market for Insurance Older individuals have difficulty purchasing health insurance at almost any price They know more about their health than the insurance company Because unhealthy people are more likely to want insurance, the proportion of unhealthy people in the pool of insured people rises Price of insurance rises so healthy people with low risk drop out – proportion of unhealthy people rises, increasing price more

12. ©2005 Pearson Education, Inc. Chapter 1712 Market for Insurance Ex: Auto insurance companies are targeting a certain population – males under 25 They know some of the males have low probability of getting in an accident and some have a high probability If they can’t distinguish among insured, they will base premium on the average experience Some with low risk will choose not to insure, which raises the accident probability and rates

13. ©2005 Pearson Education, Inc. Chapter 1713 Market for Insurance A possible solution to this problem is to pool risks  Health insurance – government takes on role as with Medicare program 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

14. ©2005 Pearson Education, Inc. Chapter 1714 Market for Insurance 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 borrowers

15. ©2005 Pearson Education, Inc. Chapter 1715 Importance of Reputation and Standardization Asymmetric Information and Daily Market Decisions  Retail sales – return policies  Antiques, art, rare coins – real or counterfeit  Home repairs – unique information  Restaurants – kitchen status

16. ©2005 Pearson Education, Inc. Chapter 1716 Implications of Asymmetric Information How 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  Standardization Chains that keep production the same everywhere – McDonald’s, Olive Garden

17. ©2005 Pearson Education, Inc. Chapter 1717 Implications of Asymmetric Information You look forward to a Big Mac when traveling, even if you would not typically buy one at home, because you know what to expect Holiday Inn once advertised “No Surprises” to address the issue of adverse selection

18. ©2005 Pearson Education, Inc. Chapter 1718 Lemons in Major League Baseball Rules 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 team Free agents create a secondhand market in baseball players  If a lemons market exists, free agents should be less reliable (disabled) than renewed contracts

19. ©2005 Pearson Education, Inc. Chapter 1719 Player Disability Days on Disabled List per Season Pre Contract Post Contract Percent Change All Players 4.7312.55165.4 Renewed Players 4.769.68103.4 Free Agents 4.6717.23268.9

20. ©2005 Pearson Education, Inc. Chapter 1720 Lemons in Major League Baseball Findings  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 market

21. ©2005 Pearson Education, Inc. Chapter 1721 Market Signaling The process of sellers using signals to convey information to buyers about the product’s quality For example, how do workers let employers know they are productive so they will be hired?

22. ©2005 Pearson Education, Inc. Chapter 1722 Market Signaling Weak signal could be dressing well  Is weak because even unproductive employees can dress well Strong 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 level

23. ©2005 Pearson Education, Inc. Chapter 1723 Model of Job Market Signaling Assume two groups of workers  Group I: Low productivity Average Product & Marginal Product = 1  Group II: High productivity Average Product & Marginal Product = 2  The workers are equally divided between Group I and Group II Average Product for all workers = 1.5

24. ©2005 Pearson Education, Inc. Chapter 1724 Model of Job Market Signaling Competitive Product Market  P = $10,000  Employees average 10 years of employment  Group I Revenue = $100,000 (10,000/yr. x 10 years)  Group II Revenue = $200,000 (20,000/yr. X 10 years)

25. ©2005 Pearson Education, Inc. Chapter 1725 Model of Job Market Signaling With Complete Information  w = MRP  Group I wage = $10,000/yr.  Group II wage = $20,000/yr. With Asymmetric Information  w = average productivity  Group I & II wage = $15,000/yr.

26. ©2005 Pearson Education, Inc. Chapter 1726 Model of Job Market Signaling If use signaling with education  y = education index (years of higher education) Assume all benefits encompassed in years of education  C = cost of attaining educational level y Tuition, books, opportunity cost, etc.  Group I  C I (y) = $40,000y  Group II  C II (y) = $20,000y

27. ©2005 Pearson Education, Inc. Chapter 1727 Model of Job Market Signaling Cost of education is greater for the low productivity group than for high productivity group  Low productivity workers may simply be less studious  Low productivity workers progress more slowly through degree program

28. ©2005 Pearson Education, Inc. Chapter 1728 Model of Job Market Signaling Assume education does not increase productivity with only value as a signal Find equilibrium where people obtain different levels of education and firms look at education as a signal Decision Rule:  y* signals G II and wage = $20,000  Below y* signals G I and wage = $10,000

29. ©2005 Pearson Education, Inc. Chapter 1729 Model of Job Market Signaling Decision Rule:  Anyone with y* years of education or more is a Group II person offered $20,000  Below y* signals Group I and offered a wage of $10,000 y* is arbitrary, but firms must identify people correctly

30. ©2005 Pearson Education, Inc. Chapter 1730 Model of Job Market Signaling How much education will individuals obtain given that firms use this decision rule? Benefit of education B(y) is increase in wage associated with each level of education B(y) is initially 0, which is the $100,000 base 10 year earnings  Continues to be zero until reach y*

31. ©2005 Pearson Education, Inc. Chapter 1731 Model of Job Market Signaling There is no reason to obtain an education level between 0 and y* because earnings are the same Similarly, there is no incentive to obtain more than y* level of education because once hit the y* level of pay, there are no more increases in wages

32. ©2005 Pearson Education, Inc. Chapter 1732 Model of Job Market Signaling How much education to choose is a benefit cost analysis Goal: obtain the education level y* if the benefit (increase in earnings) is at least as large as the cost of the education Group I:  $100,000 2.5 Group II:  $100,000 < $20,000y*, y* < 5

33. ©2005 Pearson Education, Inc. Chapter 1733 Model of Job Market Signaling This is an equilibrium as long as y* is between 2.5 and 5 If y* = 4  People in Group I will find education does not pay and will not obtain any  People in Group II will find education DOES pay and will obtain y* = 4 Here, firms will read the signal of education and pay each group accordingly

34. ©2005 Pearson Education, Inc. 34 Signaling Value of College Educ. $100K Value of College Educ. Years of College Years of College 0123456 0 123456 $200K $100K $200K C I (y) = $40,000y B(y) y* C II (y) = $20,000y Optimal choice of y for Group II Group II Group I Optimal choice of y for Group I

35. ©2005 Pearson Education, Inc. Chapter 1735 Signaling Education provides a useful signal about individual work habits and productivity even if that education does not change productivity.

36. ©2005 Pearson Education, Inc. Chapter 1736 Market Signaling 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

37. ©2005 Pearson Education, Inc. Chapter 1737 Moral Hazard Moral hazard occurs 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 hazard

38. ©2005 Pearson Education, Inc. Chapter 1738 Moral Hazard Determining the Premium for Fire Insurance  Warehouse worth $100,000  Probability of a fire:.005 with a $50 fire prevention program.01 without the program  If the insurance company cannot monitor to see if the program was run, how do they determine premiums?

39. ©2005 Pearson Education, Inc. Chapter 1739 Moral Hazard With the program the premium is:  0.005 x $100,000 = $500 Once insured owners purchase the insurance, the owners no longer have an incentive to run the program, therefore the probability of loss is 0.01 $500 premium will lead to a loss because the expected loss is now $1,000 (0.01 x $100,000)

40. ©2005 Pearson Education, Inc. Chapter 1740 Moral Hazard Moral hazard is not only a problem for insurance companies, but it alters the ability of markets to allocate resources efficiently Consider the demand (MB) of driving  If there is no moral hazard, marginal cost of driving is MC  Increasing miles will increase insurance premium and the total cost of driving

41. ©2005 Pearson Education, Inc. Chapter 1741 The Effects of Moral Hazard Miles per Week $0.50 50 Cost per Mile $1.00 $1.50 $2.00 D = MB MC’ (w/moral hazard) With moral hazard insurance, companies cannot measure mileage. MC goes to $1.00 and miles driven increases to 140 miles/week – inefficient allocation. 140 MC (no moral hazard) 100

42. ©2005 Pearson Education, Inc. Chapter 1742 Reducing Moral Hazard – Warranties of Animal Health Scenario  Livestock buyers want disease-free animals  Asymmetric information exists  Many states require warranties  Buyers and sellers no longer have an incentive to reduce disease (moral hazard)

43. ©2005 Pearson Education, Inc. Chapter 1743 The Principal – Agent Problem Owners cannot completely monitor their employees – employees are better informed than owners This creates a principal-agent problem which arises when agents pursue their own goals, rather than the goals of the principal

44. ©2005 Pearson Education, Inc. Chapter 1744 The Principal – Agent Problem Company owners are principals Workers and managers are agents Owners do not have complete knowledge Employees may pursue their own goals even at a cost of reduced profits

45. ©2005 Pearson Education, Inc. Chapter 1745 The Principal – Agent Problem The Principal – Agent Problem in Private Enterprises  Only 16 of 100 largest corporations have individual family or financial institution ownership exceeding 10%  Most large firms are controlled by management  Monitoring management is costly (asymmetric information)

46. ©2005 Pearson Education, Inc. Chapter 1746 The Principal – Agent Problem – Private Enterprises Managers 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.

47. ©2005 Pearson Education, Inc. Chapter 1747 The Principal – Agent Problem – Private Enterprises Limitations 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 firm

48. ©2005 Pearson Education, Inc. Chapter 1748 The Principal – Agent Problem – Private Enterprises The problem of limited stockholder control shows up in executive compensation  Business Week showed that average CEO earned $13.1 million and has continued to increase at a double-digit rate  For the 10 public companies led by the highest paid CEOs, there was negative correlation between CEO pay and company performance

49. ©2005 Pearson Education, Inc. Chapter 1749 CEO Salaries WorkersCEOs 1970$32,522$1.3 Mil. 1999$35,864$37.5 Mil. CEO compensation has gone from 40 times the pay of average worker to over 1000 times

50. ©2005 Pearson Education, Inc. Chapter 1750 CEO Salaries Although 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 contribution

51. ©2005 Pearson Education, Inc. Chapter 1751 CEO Salaries How have they been able to do this? 1.Boards don’t typically have necessary information and independence to negotiate effectively 2.Managers have introduced forms of compensation that camouflage the extraction of rents from shareholders  Stock options (not counted as expenses)

52. ©2005 Pearson Education, Inc. Chapter 1752 CEO Salaries Rent extraction has increased as consultants are hired to determine appropriate pay for CEO Firm usually wants to provide at least the average of other companies, so salaries have been rising rapidly With publicity increasing, CEO salaries seem to be rising less rapidly

53. ©2005 Pearson Education, Inc. Chapter 1753 The Principal – Agent Problem – Public Enterprises Observations  Managers’ goals may deviate from the agencies’ goals (size)  Oversight is difficult (asymmetric information)  Market forces are lacking

54. ©2005 Pearson Education, Inc. Chapter 1754 The Principal – Agent Problem Limitations to Management Power  Managers choose a public service position  Managerial job market  Legislative and agency oversight (GAO & OMB)  Competition among agencies

55. ©2005 Pearson Education, Inc. Chapter 1755 The Managers of Non-Profit Hospitals as Agents Are non-profit organizations more or less efficient than for-profit firms?  725 hospitals from 14 hospital chains  Return on investment (ROI) and average cost (AC) measured

56. ©2005 Pearson Education, Inc. Chapter 1756 The Managers of Non-Profit Hospitals as Agents Return on Investment 19771981 For-Profit11.6%12.7% Non-Profit8.8%7.4%

57. ©2005 Pearson Education, Inc. Chapter 1757 The Managers of Non-Profit Hospitals as Agents After adjusting for differences in services:  AC/patient day in non-profits is 8% greater than profits  Conclusion Profit incentive impacts performance  Costs and benefits of subsidizing non-profits must be considered

58. ©2005 Pearson Education, Inc. Chapter 1758 Incentives in the Principal-Agent Framework Designing a reward system to align the principal’s and agent’s goals--an example  Watch manufacturer  Uses labor and machinery  Owners’ goal is to maximize profit  Machine repairperson can influence reliability of machines and profits

59. ©2005 Pearson Education, Inc. Chapter 1759 Incentives in the Principal-Agent Framework Designing a reward system to align the principal’s and agent’s 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 repairperson’s work

60. ©2005 Pearson Education, Inc. Chapter 1760 Incentives in the Principal-Agent Framework Small manufacturer uses labor and machinery to produce watches Goal is to maximize profits High monitoring costs keep owners from measuring the effort of the repairperson directly

61. ©2005 Pearson Education, Inc. Chapter 1761 The Revenue from Making Watches Poor LuckGood Luck Low Effort (a = 0) $10,000$20,000 High Effort (a = 1) $20,000$40,000

62. ©2005 Pearson Education, Inc. Chapter 1762 Incentives in the Principal-Agent Framework Designing a reward system to align the principal’s and agent’s goals--an example  Repairperson can work with either high or low effort  Revenues depend on effort relative to the other events (poor or good luck)  Owners cannot determine a high or low effort when revenue = $20,000

63. ©2005 Pearson Education, Inc. Chapter 1763 Incentives in the Principal-Agent Framework Designing a reward system to align the principal’s and agent’s goals--an example  Repairperson’s goal is to maximize wage net of cost  Cost = 0 for low effort  Cost = $10,000 for high effort  w(R) = repairperson’s wage based only on output

64. ©2005 Pearson Education, Inc. Chapter 1764 Incentives in the Principal-Agent Framework Choosing a wage:  w = 0; a = 0; R = $15,000  R = $10,000 or $20,000, w = 0  R = $40,000; w = $24,000 R = $30,000; Profit = $18,000 Net wage = $2,000  w = R - $18,000 Net wage = $2,000 High effort

65. ©2005 Pearson Education, Inc. Chapter 1765 Incentives in the Principal-Agent Framework Conclusion  Incentive structure that rewards the outcome of high levels of effort can induce agents to aim for the goals set by the principals

66. ©2005 Pearson Education, Inc. Chapter 1766 Managerial Incentives in an Integrated Firm In integrated firms, division managers have better (asymmetric) information about production than central management Two Issues  How can central management elicit accurate information?  How can central management achieve efficient divisional production?

67. ©2005 Pearson Education, Inc. Chapter 1767 Managerial Incentives in an Integrated Firm We will focus on firms that are integrated Horizontally integrated  Several plants produce the same or related products Vertically integrated  Firm contains several divisions, with some producing parts and components that others use to produce finished products

68. ©2005 Pearson Education, Inc. Chapter 1768 Managerial Incentives in an Integrated Firm Possible Incentive Plans 1.Give plant managers bonuses based on either total output or operating profit  Would encourage managers to maximize output  Would penalize managers whose plants have higher costs and lower capacity  No incentive to obtain and reveal accurate cost and capacity information

69. ©2005 Pearson Education, Inc. Chapter 1769 Managerial Incentives in an Integrated Firm 2.Ask managers about their costs and capacities and then base bonuses on how well they do relative to their answers Q f = estimate of feasible production level B = bonus in dollars Q = actual output B = 10,000 -.5(Q f - Q)  Incentive to underestimate Q f

70. ©2005 Pearson Education, Inc. Chapter 1770 Managerial Incentives in an Integrated Firm If manager estimates capacity to be 18,000 rather than 20,000, and if the plant only produces 16,000, her bonus increases from $8000 to $9000  Don’t get accurate information about capacity and don’t insure efficiency Bonus still tied to accuracy of forecast

71. ©2005 Pearson Education, Inc. Chapter 1771 Managerial Incentives in an Integrated Firm Modify scheme by asking managers how much their plants can feasibly produce and tie bonuses to it Bonuses based on more complicated formula to give incentive to reveal true feasible production and actual output  If Q > Q f,B =.3Q f +.2(Q - Q f )  If Q  Q f,B =.3Q f -.5(Q f - Q)

72. ©2005 Pearson Education, Inc. Chapter 1772 Managerial Incentives in an Integrated Firm Assume 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 $6000

73. ©2005 Pearson Education, Inc. Chapter 1773 Incentive Design in an Integrated Firm Output (units per year) 2,000 4,000 6,000 10,000 0 20,00030,00040,000 Bonus ($ per year) 8,000 If Q f = 30,000, bonus is $4,000, the maximum amount possible. Q f = 30,000 Q f = 10,000 If Q f = 10,000, bonus is $5,000. Q f = 20,000 If Q f = Q* = 20,000, bonus is $6,000.

74. ©2005 Pearson Education, Inc. Chapter 1774 Efficiency Wage Theory In 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 unemployment

75. ©2005 Pearson Education, Inc. Chapter 1775 Efficiency Wage Theory The efficiency wage theory can explain the presence of unemployment and wage discrimination  In developing countries, productivity depends on the wage rate for nutritional reasons

76. ©2005 Pearson Education, Inc. Chapter 1776 Efficiency Wage Theory The shirking model can be better used to explain unemployment and wage discrimination in the United States  Assumes perfectly competitive markets  However, workers can work or shirk  Since performance information is limited, workers may not get fired

77. ©2005 Pearson Education, Inc. Chapter 1777 Efficiency Wage Theory If workers are paid market clearing wage w*, they have incentive to shirk If they get caught and fired, they can immediately get a job elsewhere for same wage Firms have to pay a higher wage to make loss higher from shirking Wage at which no shirking occurs is the efficiency wage

78. ©2005 Pearson Education, Inc. Chapter 1778 Efficiency Wage Theory All firms will offer more than market clearing wage, w*, say w e (efficiency wage) In this case, workers fired for shirking face unemployment because demand for labor is less than market clearing quantity

79. ©2005 Pearson Education, Inc. Chapter 1779 Without shirking, the market wage is w *, and full-employment exists at L * Demand for Labor w* L* Unemployment in a Shirking Model Quantity of Labor Wage SLSL No-Shirking Constraint The no-shirking constraint gives the wage necessary to keep workers from shirking. wewe LeLe At the equilibrium wage, W e the firm hires L e workers creating unemployment of L* - L e.

80. ©2005 Pearson Education, Inc. Chapter 1780 Efficiency Wages at Ford Motor Company Labor turnover at Ford  1913: 380%  1914: 1000% Average pay = $2 - $3 Ford increased pay to $5

81. ©2005 Pearson Education, Inc. Chapter 1781 Efficiency Wages at Ford Motor Company Results  Productivity increased 51%  Absenteeism was halved  Profitability rose from $30 million in 1914 to $60 million in 1916