MSU Weekend MBA Program – June 2, 2012

1. MSU Weekend MBA Program – June 2, 2012 Adverse Selection, Moral Hazard- Ch. 12, pgs 448-452: Ch. 6, pgs 223-226 Screening and Signaling - Ch. 12, pgs 452-454 Voluntary Disclosure – Not in book

2. Private Information/ Asymmetric Information • Definition: A situation that exist when some people have better information than others.

3. 2 Types of Asymmetric Information • Hidden Characteristics – things one party to a transaction knows about itself but which are unknown by the other party. • Hidden Action – actions taken by one party in a relationship that cannot be observed by the other party.

4. A) ADVERSE SELECTION • Definition Situation where individuals have hidden characteristics and in which a selection process results in a pool of individuals with undesirable characteristics.

5. Example 1: Used Car Market • The used car market for 1990 Honda Civics consists of 300 sellers and many, many risk-neutral buyers (call it an infinite # of buyers). 200 of the sellers have “lemons” (cars they have not taken care of very well) and 100 of the sellers have “peaches” (cars they have taken care of). All sellers with lemons have a reservation value of $1,000 and all sellers with peaches have a reservation value of $2,500. The maximum buyers are willing to pay for a 1990 Honda Civic if they know it is a lemon is $2,000 and the maximum buyers are willing to pay for a 1990 Honda Civic if they know it is a peach is $3,000.

6. Table for Example 1 Assume there are many, many buyers.

7. Supply and Demand for 1990 Honda Civics that are lemons. Equilibrium Price for a lemon is $2,000 and all 200 are sold. A. Assume Perfect Information (both Buyers and Sellers can tell a lemon from a peach) so no Adverse Selection SL DL

8. A. Assume Perfect Information (both Buyers and Sellers can tell a lemon from a peach) so no Adverse Selection • Supply and Demand for 1990 Honda Civics that are peaches. Equilibrium Price for a peach is $3,000 and all 100 are sold. SP DP

9. B. Assume Private Information (Sellers can tell a lemon from a peach but Buyers cannot). S

10. Demand for 1990 Honda Civics • What if the price is >$2500, say $2800? Buyers know that both lemons and peaches will be put on market so buyer’s expected value of a car on market is 200/300*$2000+100/300*$3000=$2,333. If buyers are risk neutral, the maximum they are willing to pay would be $2,333. Since price is >2,500, buyers will not buy car so QD=0. • What if the price is $2400? Buyers know that only lemons will be put on market so the maximum buyers are willing to pay is $2000. If price is $2,400, then buyers will not buy car so QD=0.

11. Demand for 1990 Honda Civics • What if the price is $2200? Buyers know that only lemons will be put on market so the maximum buyers are willing to pay is $2000. If price is $2,200, then buyers will not buy car so QD=0. • What if the price is $2000? Buyers know that only lemons will be put on market so the maximum buyers are willing to pay is $2000. If price is $2,000, buyers are indifferent between buying and not buying so QD=[0,∞]. • What if the price is $1,900? Buyers know that only lemons will be put on market so the maximum buyers are willing to pay is $2000. If price is $1,900, all buyers want to buy so QD=∞.

12. B. Assume Private Information (Sellers can tell a lemon from a peach but Buyers cannot) S D

13. What Happens in the End? • Only Lemons are sold even though the maximum the buyers are willing to pay for a peach is greater than the sellers’ reservation value (i.e., the “bad” drives the “good” out of the market).

14. Importance of other Assumptions • There are an infinite number of Buyers. • Buyers are risk neutral so are willing to pay their expected valuation for the car. • Everyone knows exactly the number of lemons and peaches and what buyers are willing to pay and sellers are willing to accept (reservation value).

15. What actions might be taken to minimize Adverse Selection problem? • Offer a Warranty (must be credible offer). • Have the car inspected by a mechanic. • Have the seller incur some reputational costs from selling a lemon http://cell-phones.shop.ebay.com/items/Bluetooth-Accessories__W0QQ_sacatZ80077

16. What does Adverse Selection have to do with the following? • The “value” of a new car decreasing significantly as soon as it is driven off the lot. • Purchasing a cell phone on ebay. • MSU use to allow their employees to change life insurance amounts once a year. We choose between 1 year’s salary, 2 years’ salary, $500,000 and $1,000,000. In a given year, MSU only allows their employees to increase their insurance by one increment each year– for example, an employee can go from 1 year to 2 years of salary in a given year or 2 years to $500,000 but cannot go from 1 year to $500,000 – unless the employee obtains a physical. This policy changed last year. Now you cannot change life insurance amounts unless you fill out a survey and if there are any concerns by the insurance company, they will require you to submit your medical records.

17. What does Adverse Selection have to do with the following? • Why health and life insurance are often “tied” to employment. • Why some firms want to obtain DNA samples of potential employees. • Why Social Security is “mandatory”. • Why the large majority of babies adopted from China are girls. • Why investors are often concerned when private companies go public with an IPO. • Pool of card holders for a credit card company with high interest rates. • Hiring an academic from another university.

18. National Health Insurance Running for cover , The Economist , October 4, 2008 Mr Obama aims to expand coverage through a mix of new regulations, policy reforms and subsidies. Under his plan, insurers would no longer have the right to reject anyone as too ill or too costly. He would create a "National Health Insurance Marketplace" (akin to the regulated "connector" set up in Massachusetts) where individuals and firms could purchase either private insurance plans or public alternatives modelled on Medicare. In future all but the smallest of corporations would be required to offer insurance--or pay a stiff fine. Will it work? Mrs Clinton insisted it would not. Her main objection was that this plan did not contain a key feature shared by her plan and the Massachusetts reforms: an individual mandate, or legal requirement, to purchase cover. Under Mr Obama’s plan, the only personal mandate is that parents must buy insurance for their children. Fans of mandates argue that without compulsion, reform efforts will be upended by the problem of adverse selection. Young and healthy people opt not to buy coverage, leaving a sicker and so costlier risk pool.

19. National Health Insurance (cont) Mr Obama’s pragmatic, and politically clever, retort is that it is unreasonable to require individuals to purchase something whose cost cannot be known with certainty in advance. Therefore, he insists, he will take measures that will both expand the insurance market and reduce the overall cost of coverage by (he claims) some $2,500 per typical family over time. That will make it so attractive to individuals to buy insurance, say his advisers, that 98% of people will do so. This points to a few question-marks about Mr Obama’s plan. One is that nobody knows how big the problem of adverse selection will be in a system without mandates. But supporting his argument for pragmatism is the trouble that Massachusetts is finding in implementing its ambitious mandate. Although hefty subsidies are provided for the poorest and insurers have been pressured to offer cheaper plans, far more residents than expected have found insurance unaffordable and have therefore been granted waivers. One architect of the state’s plan says that unless costs are reined in rapidly, it "will fall apart in a couple of years".

20. What does Adverse Selection have to do with the following? • Why health and life insurance are often “tied” to employment. • Why some firms want to obtain DNA samples of potential employees. • Why Social Security is “mandatory”. • Why the large majority of babies adopted from China are girls. • Why investors are often concerned when private companies go public with an IPO. • Pool of card holders for a credit card company with high interest rates. • Hiring an academic from another university.

21. Adverse Selection when Hiring Suppose you are in the HR department of a company and are deciding which of two candidates to hire. The two candidates’ qualifications look identical except one candidate lost her prior job because the company she worked for went bankrupt and the other candidate lost her prior job because she was laid-off. Which candidate would you hire and why? Gibbons and Katz, Journal Of Labor Economics http://www.jstor.org/view/0734306x/di009532/00p0086m/0?currentResult=0734306x%2bdi009532%2b00p0086m%2b0%2c5755757D&searchUrl=http%3A%2F%2Fwww.jstor.org%2Fsearch%2FBasicResults%3Fhp%3D25%26si%3D1%26gw%3Djtx%26jtxsi%3D1%26jcpsi%3D1%26artsi%3D1%26Query%3Dkatz%2Band%2Bgibbons%26wc%3Don

22. 2 Types of Asymmetric Information • Hidden Characteristics – things one party to a transaction knows about itself but which are unknown by the other party. • Hidden Action – actions taken by one party in a relationship that cannot be observed by the other party.

23. B) MORAL HAZARD • Definition Situation where one party to a contract can take a hidden action that benefits him or her at the expense of another party. (This is the definition in the book which I think is restrictive.)

24. Firm Choosing to Produce Low Quality Product and Consumers are Aware it is Low Quality Assume Firm’s Marginal Cost is 20 and Total Fixed Costs are 100 if Firm Produces Low Quality Product. MC=AVC 15 Profits are 50*15-20*15-100=350 MRL

25. Firm Choosing to Produce High Quality Product and Consumers are Aware it is High Quality Assume Firm’s Marginal Cost is 20 and Total Fixed Costs are 150 if Firm Produces High Quality Product. MC=AVC MRH Profits are 60*20-20*20-150=650

26. Example of Moral Hazard What if Firm can choose to Produce Low or High Quality and Consumers cannot differentiate a Low Quality from a High Quality Product at the time they decide whether to Purchase? Assume consumers are aware of the “game”.

27. What does Firm Do? Would firm select to produce High quality if the consumers believe that the firm is producing a high quality product? No because the firm could increase profits from 650 to 700 by producing a low quality product (given that consumer believe it is a high quality product).

28. If Consumers know game, would they believe the firm is producing a high quality product? Given that the firm has incentive to produce low quality no matter what the consumers believe the quality of the product, the consumers should believe that the firm produces the low quality product. In the end, the consumers believe it is low quality, the firm produces a low quality and firm’s profits are $350.

29. Other Situations/Topics involving Moral Hazard • Employee Compensation and Monitoring CEO PAY http://www.compensationresources.com/services/executive-compensation.php http://www.forbes.com/forbes/2011/0425/features-biggest-companies-bosses-ceo-show-me-money.html http://www.forbes.com/2010/01/21/state-of-ceo-leadership-governance-boards.html?partner=whiteglove_bing http://www.forbes.com/2009/04/22/executive-pay-ceo-leadership-compensation-best-boss-09-ceo_land.html D’Antonio’s Contract (MSU Football Coach) Geofencing

30. D’Antonio’s Contract

31. D’Antonio’s Contract (cont.)

32. Other Situations/Topics involving Moral Hazard • Employee Compensation and Monitoring CEO PAY http://www.compensationresources.com/services/executive-compensation.php http://www.forbes.com/forbes/2011/0425/features-biggest-companies-bosses-ceo-show-me-money.html http://www.forbes.com/2010/01/21/state-of-ceo-leadership-governance-boards.html?partner=whiteglove_bing http://www.forbes.com/2009/04/22/executive-pay-ceo-leadership-compensation-best-boss-09-ceo_land.html D’Antonio’s Contract (MSU Football Coach) Geofencing

33. Cell Phones The technology causing a stir is called "geofences," and here's how it might work: A struggling salesman veers off his route and slinks into a bar. Within moments, his boss knows he's there. The bartender didn't rat him out. It was his work-issued cell phone. By bringing it inside, the phone crossed a computer-generated "fence" drawn around the bar by the boss. A tracking chip in the phone triggered an e-mail that was sent back to the office: The salesman's drinking lunch again. Geofences, or computer-generated barriers, have become more popular as a way to boost productivity and cut waste. But they've also raised the eyebrows of workers, labor unions and privacy groups who, among other things, are concerned about the impact on morale. "It's basically telling employees: 'We don't trust you,' " said William Herbert, a New York labor attorney who has studied the so-called "human tracking" issue. Makers of the software, though, point to the money that can be saved by paying for actual hours worked and insist good workers have nothing to fear.

34. Other Situations/Topics involving Moral Hazard • Employee Compensation and Monitoring CEO PAY D’Antonio’s Contract (MSU Football Coach) Geofencing • Insurance (Unemployment, Life, Health, Disability) • Bailout

35. Bailout THE BAILOUT BALANCING ACT COULD WORK , Business Week , 9- 29-08 By refusing to pony up more money to save Lehman Brothers, the U.S. government took a high-stakes gamble over the weekend of Sept. 12-14. After committing $29 billion to the teardown of Bear Stearns and up to $200 billion in the nationalization of Fannie Maeand Freddie Mac, Washington looked at the plight of Lehman and just said no. Yet, not two days later, the Federal Reserve gave troubled insurer American International Group an $85 billion loan, effectively taking over the company. Who survives and who doesn't? Those decisions could usher in the end of the credit crisis--or they might mark the end of any hope for an economic recovery next year.

36. Bailout THE BAILOUT BALANCING ACT COULD WORK , Business Week , 9- 29-08 This new uncertainty in the outlook reflects the cost of stepping back from moral hazard. Policymakers know that moral hazard--which arises when institutions don't bear the full consequences of their actions--can never be eliminated. Rather, they view the problem as a trade-off between the risk that government bailouts could encourage financial imprudence and the danger that without them, an event such as the failure of AIG could collapse the system. In the case of Lehman, the Fed and Treasury took a gamble that Lehman's failure could be a major step toward healthier financial markets. As for AIG, the risk to the system was simply too great.

37. Bailout A cautionary tale from the future; Buttonwood , The Economist , 9-27-08 FINANCIAL authorities in America and Europe took sweeping powers yesterday to avert a financial crisis by imposing restrictions on markets. In their sights are a peculiar brand of speculators known as "long-buyers" who buy assets not to live off the income they generate but to profit from rising prices. "Some of these people buy homes that they have no intention of living in," said Lord Poohbah, chairman of Britain?s Financial Services Authority, "and others buy shares they plan to own for just days or weeks, rather than the prudent time period of several years." Their actions force prices up above fundamental valuation levels, critics say, causing some British tabloid newspapers to call leading fund managers "greedy pigs".

38. Bailout A cautionary tale from the future; Buttonwood , The Economist , 9-27-08 Particular criticism has been reserved for people dubbed "naked long-buyers", those who try to buy homes without putting up a deposit. "Such people are in effect renters with a free call option on rising house prices," said one financial analyst, "but they expect to be bailed out by taxpayers when house prices fall." Not only is this a clear case of moral hazard (the encouragement of irresponsible risk-taking) but their activities drive up house prices, putting them beyond the reach of hard-working families who have diligently saved up to put down a deposit. Also in the speculative category are "buy-to-letters" who buy a string of houses with borrowed money in the hope of making outsize gains.

39. Ways to Address Adverse Selection and Private Information Screening- An attempt by an uninformed party to sort individuals according to their characteristics. Signaling- An attempt by an informed party to send an observable indicator of his or her hidden characteristics to an uniformed party.

40. Examples of Screening • Screening to enable price discrimination (coupons, rebates, outlet malls,…) • Screening to sort different types of workers. • Choice of deductibles associated with different types of insurance. • Obtaining a physical to obtain a favorable life insurance policy.

41. Examples of Signaling • Obtaining an advanced degree such as an MBA or PhD. • Seller offering a warranty. • Labor contract negotiations/ Negotiating a compensation package.

42. Example 1: Signaling with a Warranty • Suppose there are sellers of lemons and sellers of peaches and buyers cannot tell a lemon from a peach (like the adverse selection example we did). Suppose a seller can obtain a price of $2,000 if he has a lemon and the buyer knows it’s a lemon and a price of $3,000 if he has a peach and the buyer knows it’s a peach. Finally, assume all sellers can credibly offer a warranty.

43. Example 1: Signaling with a Warranty • Let the probability of a lemon breaking down be .70 and the probability of a peach breaking down be .10. Suppose the warranty states that if the car breaks down, the seller will pay the buyer $1,500 to repair the car.

44. Example 1: Signaling with a Warranty • Will the seller with a lemon offer the warranty? Marginal Benefit (MB) from offering the warranty is $1,000. Marginal Cost (MC) from offering the warranty is .7*1500=$1,050. • Will the seller with a peach offer the warranty? Marginal Benefit (MB) from offering the warranty is $1,000. Marginal Cost (MC) from offering the warranty is .1*1500=$150. MB<MC for seller with lemon and MB>MC for seller with peach. Therefore, seller with peach can credibly signal to buyer that the car is a peach by offering the above warranty.

45. Example 2: Signaling in National Football League Contract Negotiations • Time Table for “Rookies” Draft Day - Late April Start of Training Camp – Early July Start of Regular Season – Late August

46. Example 2: Signaling in National Football League Contract Negotiations Draft • Prior to the draft, teams obtain information (size, strength, speed, character and intelligence) about players through interviews, pre-draft workouts and game films. • Each NFL team is given one draft pick in each round to select a player or trade. The order in which teams draft in each round depends on the teams’ performance the previous season. • The team that drafts the player has the “rights” to that player for at least a year.

47. Example 2: Signaling in National Football League Contract Negotiations Training Camp • Teams hold training camps so the players can learn the team’s offensive and defensive systems and achieve proper conditioning. Contract Negotiations • The majority of drafted players hire agents to negotiate their contracts. • Negotiations might occur in a series of meetings or a series of phone calls. • Drafted players sign what is termed a Standard Form Contract (SFC). These contracts are almost always non-guaranteed.

48. Example 2: Signaling in National Football League Contract Negotiations Guaranteed • Representative Contract Non-Guaranteed

49. Summary Statistics of Contract Data

50. Example 2: Signaling in National Football League Contract Negotiations What are the different manners by which a player can signal his private information? • Propose a contract with a small fraction of the compensation in guaranteed money (i.e., small signing bonus). • Propose a contract with a lot of incentive clauses in the contract. • Negotiate a short contract. • Hold out and miss part of training camp.