Seminar 1: Asymmetric Information

Seminar 1: Asymmetric Information Economics 2: Microeconomics Matthew Robson University of York

Concepts • Asymmetric Information: An imbalance of information across participants in an economic transaction • Moral Hazard: Where an action is taken which abuses an asymmetry of information • Principal-Agent Problem: • Asymmetric Information: the principal cannot observe the agents effort • Mismatched Incentives: divergence between the incentives and the preferences of the principal and the agent • Net and Gross Profit – All the fish in the sea denotes the gross amount, while those in the net are those that are important.

Question 1 • An owner of a bowling alley needs to hire a manager to operate the facility. • Because the owner lives far away they cannot observe the manager’s effort. The profit of the owner depends on the state of the economy and the manager’s effort level, as shown in the table below. • Bowling alley gross profit (excluding manager’s pay): • The manager’s utility with low effort is equal to their salary • The manager’s utility with high effort is equal to their salary minus 8,000

Question 1a) If the owner pays the manager a salary of £50,000, how much effort will the manager exert? • The manager’s utility from low effort = 50,000. • The managers effort from high effort = 50,000 – 8,000 = 42,000 • Therefore, the manager will choose low effort. What is the owner’s expected profit net of the manager’s salary? • With low effort the owner’s net expected profit is: (100,000*0.5) + (200,000*0.5) - 50,000 = £150,000

Question 1b) If the owner pays the manager a flat salary of £30,000 plus 10% of gross profits, how much utility will the manager receive for providing low effort and high effort? • Low Effort: • Expected Profits = ((100,000 * 0.5) + (300,000*0.5)) = 200,000 • Manager’s Utility = 30,000 + (200,000 * 0.1) = 50,000 • High Effort: • Expected Profits = ((200,000 * 0.5) + (400,000*0.5)) = 300,000 • Manager’s Utility = 30,000 + (300,000 * 0.1) – 8,000 = 52,000 How much effort will the manager exert? • The manager will exert high effort as 52,000 > 50,000

Question 1c) Is the owner better off paying the manager a flat salary of £50,000 or a flat salary of £30,000 with 10% gross profit sharing? • Flat Salary: • Manager provides low effort. • The expected profit is: ((100,000 * 0.5) + (300,000*0.5)) = 200,000 • Minus the manager’s salary of 50,000 gives a net profit of 150,000 • Flat Salary and Profit Sharing: • Manager provides high effort. • The expected profit is: ((200,000 * 0.5) + (400,000*0.5)) = 300,000 • Minus the manager’s salary of 30,000 + (300,000 * 0.1) = 60,000 gives a net profit of 240,000 • The owner is better off choosing: Flat Salary with Profit Sharing.

Question 1 - Extension • In Groups of 3 • Calculate the Manager’s Utility and Owners Expected Net Profit, for Low and High Effort, for Flat Rate and Flat Rate Plus 10% • In each A, B and C establish the optimal strategy of the Owner; giving the resulting payoffs. • How can the owner make more profits?

Question 1 – Extensive Form Game

Question 2a) Explain why incentive pay is used by employers. • Incentive pay is a solution to the problem of asymmetric information, and in particular moral hazard. • The employer is the Principal, while the employee is the Agent. • Private information on effort exerted is observed by the agent but not the principal. • Assume that effort is costly. Employers can observe the output produced, but cannot know with certainty how much effort is exerted. • So there are incentives for the agent to shirk. • Therefore, the principal uses incentive pay to shift some risk from the employer to the employee. Reducing the incentive to shirk.

Question 2a) Model: , where is output, is effort is the workers pay, a function of observed output are the workers costs, as a function of effort The employer chooses to maximise their utility: Subject to a participation constraint: where is reservation utility. (Note that even though effort is exerted by the worker, the employer sets the wage to achieve a level of effort which is optimal to the employer.)

Question 2a) The incentive compatibility constraint says that the contract the employer sets (based on ) must be preferable to any other contract the employee can achieve. for all Incentive pay is a solution to this problem. For example: where is a lump sum to satisfy incentive compatibility and participation constraints. is the wage rate equal to the marginal product at the desired effort level

Question 2b) Incentive pay has been used more recently in the public sector. Discuss: • What problems may be encountered if incentive pay were applied in the public sector Multitasking-Teachers don’t just produce A* students, they produce good citizens. Doctors don’t want to just see as many patients as possible, they want to improve health outcomes Implicit Incentives - Workers in public sector may not care about financial rewards, just want to help children, patients etc. A consequence of these traits of the public sector is that incentive schemes may • Not raise effort • Raise effort in one dimension (e.g .waiting times) at the cost of another dimension (e.g. quality of care)

Question 2b) ii) Provide evidence about the effectiveness of pay in the public sector Burgess et al. (2017) found that a public sector incentive scheme was effective in Jobcentre plus. • Jobcentre plus was organised into 11 regions and 90 districts • Performance targets were assessed at the district level • This team based scheme incentivised team work and cooperation • All workers in the incentivised district got the bonus if they hit the target • The incentive scheme was a step function (none paid below, then all paid for hitting the threshold) • But this varied with the number hit • There were multiple targets, addressing trade-offs between quantity and quality

Question 2b) Results showed: • Quality outputs didn’t fall, but they didn’t increase either • This was an improvement upon previous schemes which found a decline • The difference was this incentive scheme had multiple targets, to avoid the multi-tasking problem • Furthermore, it was shown to be effective in small teams only (perhaps due to free rider effects)

Seminar 1: Asymmetric Information