Signaling & Asymmetric Information

Signaling& Asymmetric Information Baye: Pages 450 – 456 in Chapter 12 • RIDDLE-- Puzzle of the always lying twin and the always truthful twin. • One gate is safe the other gate leads to death. • The problem is to determine truth through questions or actions. • Applicants to positions know more about themselves than they reveal • How can we sort between risk-takers and risk averse candidates? • Ask them?

Signaling in Educationand the Job Market • A. Michael Spence, “Job Market Signaling” QJE 1973 • Education is costly • Class rank and GPA give little info. • Why hire people with degrees? Why not just years of schooling? • Sheepskin effectsvs. years of education effects • Sort those who are quick at learning certain complex ideas

Does dressing better make you more productive? Only if you can fool yourself that you’re a different dude. But clothing choices are a signal of ability to interpret social norms It can be rational to invest in signals that help others value your work. Dressing For Success & Signaling?

Why is does it occur? To make people laugh? Perhaps To show a quick wit? Very likely Appropriate use of humor reveals being tuned in and with it. Joke Telling in Sales

AsymmetricInformation • Used car: Asymmetric Information--unequal or dissimilar knowledge among market participants. • But if someone is selling his or her car, isn't it likely that the car is no good: a lemon? • George Akerlof“The Market for Lemons: Quality, Uncertainty, and the Market Mechanism,” Journal of Economics, 1970.

Types of Equilibria • Ask prospective CEOs: Are you willing to take risks? • Pooling equilibrium -- cannot distinguish among applicants. [Used cars as pooling equilibrium] • Separating equilibrium -- distinguishes among applicants • A risk averse person would tend to select an offer which primarily paid a base salary • Whereas the risk-loving individual would tend to select an offer with more profit sharing. • Hence, an offer with a substantial performance premium creates a separating equilibrium.

Contract A has lower profit sharing rate and lower base rate than Contract B Both risk averse and risk loverpicks B over A This results in a pooling equilibrium. Sorting Managers with Incentives Indifference curve for the risk averse person Base Rate Salary Indifference curve for the risk lover B A Profit sharing points of Equal profit to the firm Profit Sharing Rate in  percentages

However, in the choice between job offer A and C The Risk Lover picks Contract C The Risk Averse picks Contract A A separating equilibrium. Sorting Managers with Incentives Indifference curve for the risk averse person Base Rate Salary Indifference curve for the risk lover C A Profit sharing points of Equal profit to the firm Profit Sharing Rate in  percentages

Adverse Selection • Adverse selection in health insurance the sick (or likely to be sick) want the most insurance • Game: A firm may decide to produce a HighorLow Qualityproducts and buyers pay a High Price or a Low Price. • They will tend to produce Low Quality products and receive Low Prices. • Adverse selection another lemon’s case -- only low quality items become available

Adverse SelectionGame Analysis BUYER • Maximin decision by seller firm is Low Quality product • Best for the buyer is a low price, but a high quality good. Worst is a High price but a Low quality good. • End in Low Quality, Low Price trap. High Price Low Price High Low 130 70 150 90 SELLER Payoffs are for the Seller only

Moral Hazard • Because most contracts are not complete, people alter their behavior • Moral Hazard = the incentive for an individual to take more risks when insured. • Motorcycles and Helmets • Wisconsin has no helmet law • Michigan has a helmet law • In which state do cyclists drive more carefully? • Fire insurance vs Property Insurance rates? • Fire is easier to verify than theft

Theories of Regulation • Governmental intervention into business occurs • When disasters hit • During economic turmoil or war • When political pressure for it increases • Or is it just randomly and inexplicably? • Many Theoriesabout regulation include: • Maximization of social welfare • Regulation is captured by industry • Consumer regulation • Parceling out benefits to some consumers and some producers

The "Problem" of Natural Monopoly Review: Natural Monopolies exhibit declining AC curves. When AC declines, MC must be less than AC. • In competition, P=MC. At that point, P < AC, so the competitive solution yields losses. • Hence, in an unregulated natural monopoly, we expect to see cyclical competition, as in the history of the railroads.

Solutions to the Natural Monopoly Problem 1. Prevent entry and subsidize at P = MC. 2. Nationalize, where often P < cost 3. Have open franchise bidding (where it is hoped P = AC) 4. Regulation:Prevent entry and set the price at P=AC • No need to subsidize • Do not produce “unwanted” goods

Suppose two industries • D1 and D2 • If P = MC, we could • subsidize both! PR AC AC D2 D1 P MC Q quantity

Sell at P and produce Q • but only D1 deserves to • be produced & sold • D2 is entirely beneath • the AC curve. • Regulation at P=AC • produces the correct • product. PR AC AC Subsidy D2 D1 P MC Q quantity

Regulation of Natural Monopolies:Crude History of Methods • Judicial regulation • responds to complaints. • Legislative regulation • may include, general laws or special charters, • laws on "acceptable business practices" or disclosure of information. • Franchise regulation • city or county contracts with a firm for service. • Problem if the economy of scale is larger in scope, plus the difficulty of re-contracting.

State commission regulation allows for bigger districts, and greater degree of expertise. The commission is political, staff is professional. Disputes between states handled in Fed Commissions Federal commission regulation typically confined to business across state lines Federal Energy Regulatory Commission 1920- (was Federal Power Commission) Federal Communications Commission 1934 - Civil Aeronautics Board 1938-1986 Interstate Commerce Commission 1887 - Federal Regulatory Commissions

Commissioners political beings Little initial knowledge of industry to avoid conflicts of interest Staff of Commission lawyers, accountants, economists, engineers Administrative law judges Long, long tenure on the job Size of staff relates to States attitudes to regulation Commissioners are elected or appointed by the Governor (Senate) Wisconsin has 3 appointed members 6 year terms staggered terms Public Service Commissionor Public Utility Commission Make Up of Commissions

1. The company petitions for revenue relief 2. They file the petition “case” before an administrative law judge 3. The company & the commission staff project expenses for a TEST YEAR Wisconsin uses a biennial rate case procedure The date of filing is given, and rates are reviewed every two years. The Rate Case Procedures {

Fair rate of return regulation is AC pricing. R = revenues E = expenses s = fair ROR RB = rate base, DEP = depreciation. Then find P such that: R(P) = E + s•{RB - DEP] The Rate Case Procedures

Debate Over Each Part of Case • REVENUE (R) • R would seem to be P • Q, where P is rate (per MwH) and Q is number of mega watt hours • But often at least there are 3 Classes • Residential customers, PR • Commercial customers, PC • Industrial customers, PI • R = PR • QR + PC • QC + PI • QI • Often the case ignores price elasticities -- that is, higher prices to one class of customers would likely alter their usage. Yet this is typically ignored.

EXPENSES (E) • Expenses are primarily a function of output, where Q = QR + QC + QI • In more recent times, consumer advocates have requested that some expenses be disallowed • Issue of whether to count expenses on projects that became abandoned • Issue of construction funds used in process • Issue of mismanagement • TEST YEAR • In inflationary periods, the past 12 months may understate costs • In periods of declining costs, the past 12 month may be pro-utility Wisconsin uses a forward test year

DEPRECIATION (DEP) • GAAP procedures, treated as an operating expense • Little debate, but the replacement cost of a plant may be much greater than the historical cost methods used. • TAXES • Treated as an operating expense • If product is inelastic, then the tax has little distortion • But a REGRESSIVE TAX P + TAX P D

Wisconsin uses historical cost • RATE BASE (RB) • Big area of disagreement • Original Cost Valuation • Replacement Cost Valuation (Fair Value) • Both usually are considered • If costs of plants are rising, then original cost is pro-consumer, and replacement cost is pro-utility • RATE OF RETURN (s) • Commissions look at surrounding states’ permissible rates of return • They look at rates of return to securities • They look at costs of capital, such as the Capital Asset Pricing Formula (CAPM)

Wisconsin Energy: price = $42.38 WE Energies cut its dividend in Oct 2000 so not a pure DDM firm. • ke = Rf + ·[E(km) - Rf] CAPM • CAPM = Capital Asset Pricing Model • e.g.,=.34 , Rf =.02, E(km) =.11, then • ke = .02 +.34(.11 - .02) = .0506 • D0 = $1.35, g =.02, ke=.0506 (like long term debt). • Then, DDM: P0 = D1/(ke –g) = (1.35)(1.02)/(.0506 - .02) = 1.38 / .0306 = $45.01 which is a bit MORE than the market predicts. • Perhaps dividend growth rate is expected to be less than 2%, or discount rate for the stock should be more than 5.06%, or the market knows that Wisconsin Energy’s dividend history is not constant growth.

Cost of Equity Financing: CAPM • Let x = proportion of money in market portfolio with =1 & (1- x)= proportion of money in riskless, zero beta portfolio, ß=0. • E(kp) = (1 - x)·Rf + x·E(km) • Expected return is a weighted average of risk free rate, Rf, and the expected market return, km • Also, ßp= (1- x)·0 + x·1 = x • Substituting ßp for x provides: • E(kp) = (1 - ßp)•Rf + ßp·E(km) or. • kp = Rf + ·[ E(km) - Rf ]A quick CAPM proof

Examples: Alliant Utilities (formerly Wisconsin Power and Light) Wisconsin Energy Madison Gas & Electric North Shore Water Commission Commission Grants Exclusive Territory http://www.alliant-energy.com/index.htm http://www.wisconsinenergy.com/http://www.mge.com/ http://www.northshorewc.com/Index.html

R(P) = E + s •{RB - DEP] Suppose a production decision is to be made One form uses a lot of capital, so RB rises Another form uses a lot of operating expenses, so E rises. Model: assume L, labor, is the only operating expense, and it is held constant Let K, capital, vary Suppose we permit a ROR of s > r. End up using more K The Averch-Johnson Effect A Problem with Regulated Prices R - wL s•K r•K K w/o Reg w/Reg

Theories of Regulation • Supply of Regulation - cost of production • costs of regulation • political sentiment toward regulation • technology of regulation (what can and cannot be monitored) • Demand for Regulation - interested participants • Industries -- size and financial strength • Consumers -- organization and voting power • Agents -- value of expanded powers to agencies of government

Demand Side Theories of Regulation • Consumer Protection • keep prices low & keep quality or safety high • Public Interest Theory of Regulation regulate natural monopolies because it improves welfare • Tragedy Theory of Regulation - response to crisis • Agency Theory of Regulation - help regulators • Producer Protection • Often called the “Capture Theory of Regulation” • The interest of the few is strong, so industries win and consumers lose

Monopoly & Regulatory Tilts Price Price PM PC Producer Protection Agency Political Support Consumer Protection D Q Profits

Maximize Agency Political Support • Support rises as Profits rise (from the industry) • Support rises as Prices fall (from the consumers) • Therefore the agency balances the interests of the parties • Tries not to make anyone too unhappy • Agencies which fail to accommodate can be eliminated (R.I.P. the Civil Aeronautics Board) • RESULT: share the wealth, or divide and conquer. • Can break consumer and producers into sub-groups, i.e., residential vs. commercial users of the product

Signaling & Asymmetric Information