Managerial Economics: Applying the Tools Topic 10, Part 2

1. Managerial Economics: Applying the ToolsTopic 10, Part 2 Goods with different quality: Adverse selection Signaling equilibria Pooling equilibria Paul Kerin & Sam WylieMBS: Term 3, 2004

2. Mass markets with quality problems We’re considering mass markets forapparently homogenous goods = everyone produces goods that look the same BUT are not necessarily of the same quality COMPETITORS COMPANY MASS MARKET CUSTOMERS

3. Goods that differ in quality • In Strategy class: Competing firms will offer products differentiated by quality (Ferraris versus Corollas), just to reach different customer groups • In Man Ec: We look at products differentiated by quality, to talk about information problems: • Low quality goods and high quality goods in the market, but customers can’t tell them apart! • Low quality goods have a cost advantage • Producers of high-quality goods want to signal their quality

4. Example: The market for ‘lemons’ • You want to buy a used car • Apart from imperfect information, it’s a perfectly competitive market: there are lots of buyers and lots of sellers • To simplify, there is only one kind of used car on the market: three-year-old Holden Barinas • There is just one going price in the market: no one will pay more or sell for less than the going price • Buyers and sellers see the going price, and decide if they want to participate in the market • Unfortunately, there are really 2 qualities of cars on the market: good cars and lemons

5. Who knows what? The seller knows what type of car she is selling. (This is a generalisation.) What happens in the market depends on whether buyers can also tell the type of car

6. The market for ‘lemons’ – case 1: symmetric and perfect information= buyers know what type the car is

7. The market for ‘lemons’ – case 2: asymmetric information= buyers don’t know what type the car is

8. The market for ‘lemons’: case 2 – asymmetric information – P>$8K? • Suppose the buyer cannot tell a good car from a lemon before they buy • Will you buy if the price is at least $8,000? • NO! • At this price, every seller will want to sell. But this means that if you buy a car it has a 60% chance of being a lemon (worth $6,000 to you) and a 40% chance of being good (worth $10,000 to the buyer). So the expected value of a car to the buyer is $7,600. So you will not pay more than $8,000 for a car with an expected value of $7,600!

9. The market for ‘lemons’: case 2 – asymmetric information – $6K<P<$8K? • Suppose the buyer cannot tell a good car from a lemon before they buy • Will you buy if the price is between $6,000 and $8,000? • NO! • At this price, only the sellers of ‘lemons’ will want to sell. Every car being offered is a lemon and you will not pay more than $6000 • So we expect that the market will have a price of between $3,000 and $6,000, with only lemons sold

10. The market for ‘lemons’ – case 2: asymmetric information – outcomes

11. “Adverse selection” = a lower price means a lower quality of cars in the market The problem of adverse selection can lead to the complete collapse of the market for good cars Any evidence of such problems in the used car market? (Dutta, Strategies and Games) • The average car depreciated 37% in the first year. By the end of the second year it had depreciated 50%. (If you tried to sell your 1994 car in 1996, you would get only half the price that you had paid for it a mere two years before.) • Only about 1% of new (1 or 2 year old) cars are lemons, so most sales should be from people with changed circumstances.  Suppose you would pay 80% of new if there were no adverse selection • But if the price is only 80% of new, some people with changed circumstances decide to keep the car (give it to kids, drive it to their new home,…)  now cars for sale only worth 70%. • But if the price is only 70%, …

12. The Asian Fire sale and the market for “lemons” Khanna and Palepu, Harvard Business Review July-August 1999, 125-134 Asian crisis led to a serious liquidity crisis for many Asian firms • Created the need to sell off assets • large market for assets arose at the time of the crisis • However, in many of the countries experiencing crisis (especially Thailand and Indonesia) there is insufficient reliable public information on the value of an asset. (Inadequate accounting practices, inadequate government supervision, lack of transparency in record-keeping.) • buyer cannot know the true value of the asset, only the average value in market • certain assets that are worth more than average are pulled off the market, and average value keeps falling = market breakdown • “The few companies that have been buying in Asia, such as GE Capital in Thailand, are the ones that chose to build a direct understanding of the local markets in the years before the crisis.”

13. Information and market failure • Why do health insurance companies worry about healthy young married women? What is the outcome, if insurance companies raise the price of insurance to that group? • Why do insurance companies make you pay the first part of any claim (the deductible)? • Why is car insurance sometimes unavailable for younger drivers? • Are higher interest rates better for banks? • Adverse selection can also lead to ‘statistical discrimination’ and rationing

14. Gresham’s Law Imagine an economy in which the currency consists of gold coins. The holder of a coin is able to shave a bit of gold from it in a way that is undetectable without careful measurement; the gold so obtained can then be used to produce new coins. Imagine that some of the coins have been shaved in this fashion, while others have not. Then someone taking a coin in trade for goods will assess positive probability that the coin being given her has been shaved, and thus less will be given for it than if it was certain not to be shaved. The holder of an unshaved coin will therefore withhold the coin from trade; only shaved coins will circulate. “Bad Money Drives Out the Good”

15. Bad staplers drive out good • Suppose that there are firms producing good staplers and firms producing bad staplers • Customers can’t tell the two types of staplers apart  staplers are all sold for the same price • But producers of bad staplers have lower costs than producers of good staplers • If it’s a competitive market, firms keep entering so long as positive profits are being earned, and enter until profits are driven to zero • Bad stapler producers keep entering until their profits are nearly zero • But that means that producers of good staplers are losing money! • Firms producing good staplers exit the market (or switch to producing bad staplers)

16. Responses to adverse selection • Note that the problem of adverse selection harms the uninformed parties and some of the informed parties: • In the lemons example, it meant that buyers could not buy good cars • But also sellers of good cars could not get a reasonable price for their cars (even if the price is still above their WTS, the presence of lemons means they earn less) • Uninformed buyers may try to overcome the information asymmetry by ‘search’ • Informed sellers may try to overcome the problem by • Offering warranties • Other signaling strategies

17. Warranties and the market for ‘lemons’ Let’s go back to our used car market, and suppose that there are lots more buyers than sellers  the price rises to buyers’ WTP Sellers of good cars want to offer a warranty—but what kind of warranty? Ex: Let’s say the warranty is a $2000 payment in the event of a breakdown But if that warranty makes buyers willing to pay close to $10,000 instead of $6,000, sellers of lemons will want to offer the warranty, too  Customers shouldn’t assume the warranty means it’s a good car

18. Warranties Let’s return to our car market example Suppose that good cars never break down. However, a lemon has a high probability of breaking down (that is why it is a lemon). Say lemons break down with an 80% probability. (But cars only break down once) Fixing a broken down car is expensive – about $5,000. Suppose now that a car seller offers you the following deal – “Buy the car for $9,000. If it breaks down, the seller will fix your car for free.” Should you buy the car?

19. Warranties: good seller So if the buyer knew that it was a good car, she would accept the deal Don’t buy (0,0) Buyer Offer deal Breakdown (zero chance) Good seller (-$4,000; $?) Buy Don’toffer deal No breakdown (100%) (0, 0) ($1000,$1000)

20. Warranties: lemon seller But the buyer can infer sellers offering the deal are good, the seller of a lemon would not offer the deal Don’t buy (3000; 0) Buyer Offer deal Breakdown (80%) Lemon seller ($1,000;$?) Buy No breakdown (20%) Don’toffer deal (3000; 0) ($6,000;$?)

21. Warranties: lemon seller (cont’) Don’t buy (3000; 0) Buyer Offer deal Breakdown (80%) Lemon seller Expected payoff for lemon seller if buyer accepts offer is $2000. So if the lemon seller thinks that you will accept the deal, they will not offer it! Buy No breakdown (20%) Don’toffer deal (3000; 0)

22. Warranties: conclusion • So the warranty ‘works’ • Only the good sellers will offer the warranty • Buyers can buy the car with the warranty, sure that they are buying a good car (and will never need to use the warranty) • But it is not worth while for the sellers of ‘lemons’ to copy the warranty – their cars break down and the warranty costs more than the increased price that they receive for their cars • “The dog that didn’t bark:” • If good firms are offering a warranty • Then if a firm doesn’t offer a warranty, customers correctly infer that it’s a bad firm. Silence is informative!

23. Evidence on warranties • From Dutta, Strategies and Games: • Of all used cars purchased, 20% are sold through new car dealerships and another 15% are sold through used car dealerships. Dealerships typically offer warranties on the used cars they sell • The average price of a used car in 1994 was about $11,500. The average private-party sale price on a used car was about $2,000 less than the average sale price at dealers

24. Signaling • The warranty is an example of a ‘signal’ that the ‘good’ seller can send to the buyer • In our example here the signal had no cost to the ‘good’ seller. This is not generally the case • For a signal to ‘work’ it requires three features • The cost to the ‘bad’ type must be high enough so that they do not want to pretend to be a ‘good’ type • It must be less costly to the ‘good’ type than to the ‘bad’ type. • Even given the cost, it must be better for the ‘good’ type to distinguish themselves than be mistaken for a ‘bad’ type

25. Bargaining revisited! • Signaling is not just a mass-market concept: It applies whenever you need to distinguish yourself from another type of person/firm/group Example: Back to bargaining. • We assumed complete information = all parties to an agreement know the WTP or WTS of each player • Observation: If there is incomplete information, your trading partner knows his WTP/WTS, but you don’t know it for sure • Why does that lead to delay? • Why might that rule out agreement, in some instances?

26. Other examples: the early career rat race • Suppose there are ordinary and talented workers • Your boss can observe the quality of your work but not how difficult you found the task • If everyone spends the same time, the talented workers will be recognised and gain promotion • So the ordinary workers work harder to try and ‘appear’ to be talented • So to distinguish themselves, the talented workers also have to work hard

27. The early career rat race: potential outcomes • Separating equilibrium. This is where the signal ‘works’. The talented workers work too hard but are recognised. The ordinary workers just give upor • Pooling equilibrium. In this situation, the ordinary workers work hard and talented workers work normally. The boss interprets ‘ordinary’ performance as a sure sign of lack of talent. But the boss cannot infer anything from exceptional work – because everyone is doing it!

28. Signaling = “lifting the fog” • Signaling can overcome information problems • But it’s costly to the ‘good’ type who is trying to distinguish herself from the ‘bad’ type • Choosing the wrong signal just means the ‘bad’ type will copy you. Despite the cost of the signal, there is no gain in information • So: it is important to carefully choose your signaling strategy. It needs to be low cost to you and high cost to others, so that it will be ‘believed’ and cannot be ‘jammed’ by the bad types

29. Pooling Equilibria = “preserving the fog” • If you’re a bad type (or you might be) you want the bad types and the good types to look the same • You mimic the ‘good’ type: • Follow the herd: Forecasters try and keep their forecast in line with the others; it’s more costly to make a mistake, if you’re the only one who makes it. • You make it harder to get clear information about your quality = ‘signal jamming’ • Create variability and complexity in performance measures • Bury information where possible: • If you refused a project, bury it so that no one finds out you might have been wrong (e.g. ET) • Refuse to collect more information (e.g. Continental Corporation refusing an extensive due diligence by a buyer)

30. How to find a credible signaling strategy • If the good types send a credible signal, what does that say about the equilibrium? • Customers (or business partners) believe you’re the good type when you send the signal  you get the “good deal” • Customers assume that if you didn’t send the signal, you’re the bad type  you get treated like a bad type  Spell out exactly what this will mean, in this situation. • What makes the signal credible? • Bad types don’t want to send it. (That is, they know they could fool customers by sending the signal, but it’s not worth it.) • Draw a decision tree, to find a signal that bad don’t want to send. • Last: check that good types are better off than in the pooling equilibrium (where customers can’t distinguish them from bad)

31. Signaling: warranties and the market for ‘lemons’ • Back to our used car market, but suppose that now there are only 30% lemons • There are lots more buyers than sellers  the price rises to buyers’ WTP. • What is the pooling equilibrium? • If good cars break down with a 5% probability and lemons break down with a 50% probability, what is the signaling equilibrium? • (Firms can offer warranties of the following form: If your car breaks down, I pay you $X) • Which equilibrium do the good sellers prefer?