1. Chapter 17 Markets with Asymmetric Information

2. ©2005 Pearson Education, Inc. Chapter 172 Introduction We can see what happens when some parties know more than others – asymmetric information Frequently a seller or producer knows more about he quality of the product than the buyer does Managers know more about costs, competitive position and investment opportunities than firm owners

3. ©2005 Pearson Education, Inc. Chapter 173 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

4. ©2005 Pearson Education, Inc. Chapter 174 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

5. ©2005 Pearson Education, Inc. Chapter 175 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

6. ©2005 Pearson Education, Inc. Chapter 176 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

7. ©2005 Pearson Education, Inc. Chapter 177 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

8. ©2005 Pearson Education, Inc. 8 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

9. ©2005 Pearson Education, Inc. Chapter 179 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.

10. ©2005 Pearson Education, Inc. Chapter 1710 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, 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

11. ©2005 Pearson Education, Inc. Chapter 1711 Market for Insurance If 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 can’t distinguish among insured, it will base premium on the average experience Some with low risk will choose not to insure and with raises the accident probability and rates

12. ©2005 Pearson Education, Inc. Chapter 1712 Market for Insurance A possible solution to this problem is to pool risks  Health insurance – government takes on role as with Medicare program  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

13. ©2005 Pearson Education, Inc. Chapter 1713 Importance of Reputation and Standardization Asymmetric Information and Daily Market Decisions  Retail sales – return policies  Antiques, art, rare coins – real or counterfeit  Restaurants – kitchen status

14. ©2005 Pearson Education, Inc. Chapter 1714 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  Standardization

15. ©2005 Pearson Education, Inc. Chapter 1715 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.

16. ©2005 Pearson Education, Inc. Chapter 1716 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?

17. ©2005 Pearson Education, Inc. Chapter 1717 Market Signaling Weak signal could be dressing 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.

18. ©2005 Pearson Education, Inc. Chapter 1718 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

19. ©2005 Pearson Education, Inc. Chapter 1719 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)

20. ©2005 Pearson Education, Inc. Chapter 1720 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

21. ©2005 Pearson Education, Inc. Chapter 1721 Model of Job Market Signaling If use signaling with education  y = education index (years of higher education)  C = cost of attaining educational level y  Group I  CI(y) = $40,000y  Group II  CII(y) = $20,000y

22. ©2005 Pearson Education, Inc. Chapter 1722 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

23. ©2005 Pearson Education, Inc. Chapter 1723 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 GII and wage = $20,000  Below y* signals GI and wage = $10,000

24. ©2005 Pearson Education, Inc. Chapter 1724 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

25. ©2005 Pearson Education, Inc. Chapter 1725 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) initially 0 which is the $100,000 base 10 year earnings  Continues to be zero until reach y*

26. ©2005 Pearson Education, Inc. Chapter 1726 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

27. ©2005 Pearson Education, Inc. Chapter 1727 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

28. ©2005 Pearson Education, Inc. Chapter 1728 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

29. ©2005 Pearson Education, Inc. 29 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

30. ©2005 Pearson Education, Inc. Chapter 1730 Signaling Education does increase productivity and provides a useful signal about individual work habits even if education does not change productivity.

31. ©2005 Pearson Education, Inc. Chapter 1731 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

32. ©2005 Pearson Education, Inc. Chapter 1732 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

33. ©2005 Pearson Education, Inc. Chapter 1733 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

34. ©2005 Pearson Education, Inc. Chapter 1734 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

35. ©2005 Pearson Education, Inc. Chapter 1735 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.

36. ©2005 Pearson Education, Inc. Chapter 1736 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 reduce profits.

37. ©2005 Pearson Education, Inc. Chapter 1737 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).

38. ©2005 Pearson Education, Inc. Chapter 1738 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.

39. ©2005 Pearson Education, Inc. Chapter 1739 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

40. ©2005 Pearson Education, Inc. Chapter 1740 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 10 public companies led by highest paid CEOs, there was negative correlation between CEO pay and company performance

41. ©2005 Pearson Education, Inc. Chapter 1741 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

42. ©2005 Pearson Education, Inc. Chapter 1742 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

43. ©2005 Pearson Education, Inc. Chapter 1743 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

44. ©2005 Pearson Education, Inc. Chapter 1744 Incentives in the Principal-Agent Framework Designing a reward system to align the principal 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

45. ©2005 Pearson Education, Inc. Chapter 1745 Incentives in the Principal-Agent Framework Designing a reward system to align the principal and agent’s goals--an example  Revenue also depends, in part, on the quality of parts and the reliability of labor.  High monitoring cost makes it difficult to assess the repair-person’s work