Information and Risk in Contracts

Information and Risk in Contracts Chapter 11 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

A Sight to See, but Buyers Can’t Peek Here diamonds are being sorted by an employee of Diamond Trading Company (D.T.C.), a unit of DeBeers which markets most of the world’s supply of raw diamonds. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

What’s Next? After checking that the measurements and other specifications of the stones are all met, the person with the tweezers will put them into a small yellow box, seal it and put it in a safe place to wait for a buyer. The buyers turn up every five weeks for an event known as a “sight.” They are a very select group of approximately 100 wholesalers called sightholders. Sightholders who arrive at at DTC’s headquarters first hand over their payments (often electronically) and then examine the stones. In this chapter we examine how contracts can reduce the costs of information to the parties and thereby increase the economic value they create. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Trading Risks by Insuring The utility function at the right illustrates the idea of risk aversion. Current wealth is $100,000. The utility derived from $100,000 with certainty Is 216.2 units. The expected utility derived from a gamble where you win $100,000 with a probability of 50% or lose $100,000 with a probability of 50% is 123.6 units. This is a gamble you would not take. In fact, you would be willing to pay someone to take the gamble off your hands. This is the basis for insurance. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Trading Risks by Insuring You can free yourself from the gamble by purchasing insurance or incurring the cost of taking your own precautions. You will sacrifice some relatively small amount of money with certainty to avoid a massive loss from a random disaster like a house fire or major medical bills. Insurance is a contract that reallocates risk between the insurer and the insured. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Damage Provisions to Reallocate Risk Many contracts besides insurance reallocate risk between the parties. For example, the liquidated damages provisions discussed earlier are remedies for breach of contract, but they can also be set at levels that shift risk. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Market Transactions to Reallocate Risk A contract can reallocate risk, and market transactions may allow additional changes in the parties’ risk positions. Assume that I am to provide you with a fuel supply, possibly at prices that adjust with its market price. My costs will be more predictable if I hold derivatives. If the contract allows you to take less than the full supply, buying a “put” option will allow me to resell the excess at a predictable (but not necessarily profitable) price. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

ASYMMETRIC INFORMATION AND THE LEMON PROBLEM (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Asymmetric Information If one party to an agreement holds information that the other does not, the difference can affect both of their incentives and behaviors. In this situation of asymmetric information, the economic value their relationship could potentially create may be diminished if the uninformed party cannot easily learn or verify important information, or if the informed party cannot credibly convey it. Asymmetric information differs from incomplete information. Neither you nor I know for certain what the market price of some good will be a year from today when you want me to deliver it to you but we may both be able to make an educated guess based on the information available to each of us. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Conveying Information Credibly: The Logic of Lemons You’ve just purchased a new car for $20,000 and a month later need to sell the car. The car is worth $18,000 but potential buyers have no way of knowing that. They fear the car is a “lemon.” Suppose, in the mind of a buyer there is a 50-50 chance the car is worth $18,000 or $10,000. The expected value of your car is just $14,000. If your other option to store the car is worth $15,000 to you, then asymmetric information prevents an exchange from occurring. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Reducing the Scope of the Lemon Problem • There are several ways that the lemon problem can be overcome: • Someone who devises a way to find out a car’s true condition can capture some of the benefits of a transaction that will now take place. • The seller might offer a warranty that covers the cost of certain repairs. • Experience and reputation can also weaken the effects of asymmetric information. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Choosing Insurance Policies In the model of adverse selection, the seller cannot obtain reliable information from a number of buyers. Incentives to withhold or falsify facts can affect market equilibrium. As an example, consider that health insurers may be unable to determine a person’s underlying healthiness before writing a policy. This can make it difficult for insurers to price health insurance policies. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Some Evidence Adverse selection only occurs if high-risk persons insure themselves more heavily than low-risk persons. There is little evidence that this occurs and much evidence that it does not. For example, drivers who are more likely to have accidents typically purchase lower coverage. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Insurance and the Cost of Accidents An insured person’s incentive to behave in ways that raise the probability of a claim is known as moral hazard. Here “moral” is not a normative concept—comprehensive health insurance can encourage more frequent visits to the doctor that many people would view as prudent. Policyholders with full coverage for all medical services bear only the opportunity costs of time spent obtaining them. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Controlling Moral Hazard • Insurers can include provisions in their contracts to mitgate • against moral hazard: • Co-payment or coinsurance provisions stipulate that the policy will pay only some percentage of a claimed loss. • Deductibles are fixed amounts for which the policyholder is responsible. • Non-price exceptions, like those for prior authorization of medical procedures, appear in other contexts. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Inferring Unobservable Characteristics As graduation approaches you will surely get advice about job interviews. Does it make sense to spend time gathering information about the company you are interviewing with? having done so, you can engage in small talk with your interviewer about the company but this might take away from the time available to sell your skills to the employer? So, is it worth the time and effort? The point of small talk is not its subject matter but rather the fact that it takes place at all. It might serve as a signal that you are a self-starter and an efficient researcher. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Warranties and Education as Signals Offering a warranty with your used car may serve as a signal to potential buyers that it is not a “lemon.” The model of signals is at odds with the view that education is an investment in human capital that improves productivity, and the costs incurred by employers in finding the right persons to fill particular job slots. The evidence on higher education as a signal is mixed at best. For example, earnings of dropouts are between those of high school and college graduates. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

The Winner’s Curse A painting contractor once complained to his economist son about bidding for jobs. “On most of the ones I win my bid is too low—I make less than I expected and sometimes take an outright loss.” The painter faces what is called the winner’s curse. The winner of contracts like this one is typically the contractor whose estimate has the largest downward error. They win the bidbut end up making little on the job. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

DETERRING EXCESSIVE SEARCH FOR INFORMATION (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Duplicative Information and the DeBeers Puzzle A contract will often require one or both parties to uncover information. say you and Jones are both searching for the same person and for some reason you cannot coordinate your activities and share costs. Relative to the benefits, the resources the two of you have invested in the search will be excessive—more economic value could be created if, for example, you and Jones had made an agreement to share information and the people Jones might have hired were working at other jobs. This reasoning explains why DTC’s contracts do not allow buyers to inspect diamonds in advance. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Disclosure in Contracts A contract can contain information that is valuable to both the signing parties and outsiders. Sometimes the law requires that certain facts be disclosed in it. Disclosure is economically desirable where a failure to disclose would reduce the economic value the agreement can produce. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Information and Risk in Contracts