Markets with Asymmetric Information

1
Lecture 7
Managerial Economics ECON 511

• Markets with Asymmetric Information

Professor Changqi Wu
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

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.

4
The Lemons Problem
PH
PL
QH
QL
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.

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.

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?

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.

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

10
Economics of Beauty

• Personal beauty is a better introduction than
  any letter.
• --Aristotle 384-322 B.C.

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 Moodys and
  StandardPoors
• Department stores serve as intermediaries to
  select goods on behalf of buyers
• Government agencies act as market intermediate
  agents

12
2.3. Market Signaling

• It has to be costly to convey information and the
  costs must be different to different producers.
• Guarantees and warrantiesSignaling 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?

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

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.

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

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.

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.

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.

19
4. Moral Hazard

• One partys 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

20
Causes of Moral Hazard

• Asymmetric information takes the form of
  unobservability of other partys 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

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

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 firms 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.

24
An Efficiency Wage Model
Wage
Quantity of Labor
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

26
5. Holdup Problem

• Holdup is an action to exploit another partys
  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

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

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.

29
Optimal Ownership Arrangement

• Ownership should go to the party whose effort has
  the maximal impact on firms performance
• Some examples
• Employee share ownership plan (ESOP)
• Stock options for senior management
• Joint ownership in joint ventures

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 partys
  commitment
• Joint ownership may mitigate the holdup problem
  in joint ventures

31
(No Transcript)
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.