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Chapter 17

Chapter 17. Markets with Asymmetric Information. Topics to be Discussed. Quality Uncertainty and the Market for Lemons Market Signaling Moral Hazard The Principal-Agent Problem Managerial Incentives in an Integrated Firm Asymmetric Information in Labor Markets: Efficiency Wage Theory.

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Chapter 17

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  1. Chapter 17 Markets with Asymmetric Information

  2. Topics to be Discussed • Quality Uncertainty and the Market for Lemons • Market Signaling • Moral Hazard • The Principal-Agent Problem • Managerial Incentives in an Integrated Firm • Asymmetric Information in Labor Markets: Efficiency Wage Theory Chapter 17

  3. Introduction • We can see what happens when some parties know more than others – asymmetric information • Frequently a seller or producer knows more about he quality of the product than the buyer does • Managers know more about costs, competitive position and investment opportunities than firm owners Chapter 17

  4. Quality Uncertainty and the Market for Lemons • Asymmetric information is a situation in which a buyer and a seller possess different information about a transaction • The lack of complete information when purchasing a used car increases the risk of the purchase and lowers the value of the car. • Markets for insurance, financial credit and employment are also characterized by asymmetric information about product quality Chapter 17

  5. The Market for Used Cars • Assume • Two kinds of cars – high quality and low quality • Buyers and sellers can distinguish between the cars • There will be two markets – one for high quality and one for low quality Chapter 17

  6. The Market for Used Cars • High quality market • SH is supply and DH is demand for high quality • Low quality market • SL is supply and DL is demand for low quality • SH is higher than SL because owners of high quality cars need more money to sell them • DH is higher than DL because people are willing to pay more for higher quality Chapter 17

  7. SH 10,000 DH SL 5,000 DL DL 50,000 50,000 The Lemons Problem PH PL Market price for high quality cars is $10,000 Market price for low quality cars is $5000 50,000 of each type are sold QH QL Chapter 17

  8. The Market for Used Cars • Sellers know more about the quality of the used car than the buyer • Initially buyers may think the odds are 50/50 that the car is high quality • Buyers will view all cars as medium quality with demand DM • However, fewer high quality cars (25,000) and more low quality cars (75,000) will now be sold • Perceived demand will now shift Chapter 17

  9. SH 10,000 7,500 DH SL 7,500 DM 5,000 DM DLM DL DL DLM 25,000 50,000 50,000 75,000 The Lemons Problem Medium quality cars sell for $7500 selling 25,000 high quality and 75,000 low quality The increase in QL reduces expectations and demand to DLM. The adjustment process continues until demand = DL. PH PL QH QL

  10. The Market for Used Cars • With asymmetric information: • Low quality goods drive high quality goods out of the market- the lemons problem. • The market has failed to produce mutually beneficial trade. • Too many low and too few high quality cars are on the market. • Adverse selection occurs; the only cars on the market will be low quality cars. Chapter 17

  11. Market for Insurance • Older individuals have difficulty purchasing health insurance at almost any price • They know more about their health than the insurance company • Because unhealthy people are more likely to want insurance, proportion of unhealthy people in the pool of insured people rises • Price of insurance rises so healthy people with low risk drop out – proportion of unhealthy people rises increasing price more Chapter 17

  12. Market for Insurance • If auto insurance companies are targeting a certain population – males under 25 • They know some of the males have low probability of getting in an accident and some have a high probability • If can’t distinguish among insured, it will base premium on the average experience • Some with low risk will choose not to insure and with raises the accident probability and rates Chapter 17

  13. Market for Insurance • A possible solution to this problem is to pool risks • Health insurance – government takes on role as with Medicare program • Problem of adverse selection is eliminated • Insurance companies will try to avoid risk by offering group health insurance policies at places of employment and thereby spreading risk over a large pool Chapter 17

  14. Market for Insurance • The Market for Credit • Asymmetric information creates the potential that only high risk borrowers will seek loans. • Can end up with lemon problem again • However, banks and credit agencies use credit histories to gauge risk of borrowers Chapter 17

  15. Importance of Reputation and Standardization • Asymmetric Information and Daily Market Decisions • Retail sales – return policies • Antiques, art, rare coins – real or counterfeit • Home repairs – unique information • Restaurants – kitchen status Chapter 17

  16. Implications of Asymmetric Information • How can these producers provide high-quality goods when asymmetric information will drive out high-quality goods through adverse selection. • Reputation • You hear about restaurants or stores that have good or bad service and quality • Standardization • Chains that keep production the same everywhere – McDonalds, Olive Garden Chapter 17

  17. Implications of Asymmetric Information • You look forward to a Big Mac when traveling, even if you would not typically buy one at home, because you know what to expect. • Holiday Inn once advertised “No Surprises” to address the issue of adverse selection. Chapter 17

  18. Lemons in Major League Baseball • Rules in baseball changed so that after 6 years a player could resign with their team or become a free agent and try to sign with another team • Free agents create a secondhand market in baseball players • If a lemons market exists, free agents should be less reliable (disabled) than renewed contracts. Chapter 17

  19. Player Disability Chapter 17

  20. Lemons in Major League Baseball • Findings • Days on the disabled list increase for both free agents and renewed players. • Free agents have a significantly higher disability rate than renewed players. • This indicates a lemons market. Chapter 17

  21. Market Signaling • The process of sellers using signals to convey information to buyers about the product’s quality. • For example, how do workers let employers know they are productive so they will be hired? Chapter 17

  22. Market Signaling • Weak signal could be dressing well • Is weak because even unproductive employees can dress well • Strong Signal • To be effective, a signal must be easier for high quality sellers to give than low quality sellers. • Example • Highly productive workers signal with educational attainment level. Chapter 17

  23. Model of Job Market Signaling • Assume two groups of workers • Group I: Low productivity • Average Product & Marginal Product = 1 • Group II: High productivity • Average Product & Marginal Product = 2 • The workers are equally divided between Group I and Group II • Average Product for all workers = 1.5 Chapter 17

  24. Model of Job Market Signaling • Competitive Product Market • P = $10,000 • Employees average 10 years of employment • Group I Revenue = $100,000 • (10,000/yr. x 10 years) • Group II Revenue = $200,000 • (20,000/yr. X 10 years) Chapter 17

  25. Model of Job Market Signaling • With Complete Information • w = MRP • Group I wage = $10,000/yr. • Group II wage = $20,000/yr. • With Asymmetric Information • w = average productivity • Group I & II wage = $15,000 Chapter 17

  26. Model of Job Market Signaling • If use signaling with education • y = education index (years of higher education) • Assume all benefits encompassed in years of education • C = cost of attaining educational level y • Tuition, books, opportunity cost, etc. • Group I  CI(y) = $40,000y • Group II  CII(y) = $20,000y Chapter 17

  27. Model of Job Market Signaling • Cost of education is greater for the low productivity group than for high productivity group • Low productivity workers may simply be less studious • Low productivity workers progress more slowly through degree program Chapter 17

  28. Model of Job Market Signaling • Assume education does not increase productivity with only value as a signal • Find equilibrium where people obtain different levels of education and firms look at education as a signal • Decision Rule: • y* signals GII and wage = $20,000 • Below y* signals GI and wage = $10,000 Chapter 17

  29. Model of Job Market Signaling • Decision Rule: • Anyone with y* years of education or more is a Group II person offered $20,000 • Below y* signals Group I and offered a wage of $10,000 • y* is arbitrary, but firms must identify people correctly Chapter 17

  30. Model of Job Market Signaling • How much education will individuals obtain given that firms use this decision rule? • Benefit of education B(y) is increase in wage associated with each level of education • B(y) initially 0 which is the $100,000 base 10 year earnings • Continues to be zero until reach y* Chapter 17

  31. Model of Job Market Signaling • There is no reason the obtain an education level between 0 and y* because earnings are the same • Similarly, there is no incentive to obtain more than y* level of education because once hit the y* level of pay, there are no more increases in wages Chapter 17

  32. Model of Job Market Signaling • How much education to choose is a benefit cost analysis • Goal: obtain the education level y* if the benefit (increase in earnings) is at least as large as the cost of the education • Group I: • $100,000 < $40,000y*, y* >2.5 • Group II: • $100,000 < $20,000y*, y* < 5 Chapter 17

  33. Model of Job Market Signaling • This is an equilibrium as long as y* is between 2.5 and 5 • If y* = 4 • People in group I will find education does not pay and will not obtain any • People in group II will find education DOES pay and will obtain y* = 4 • Here, firms will read the signal of education and pay each group accordingly Chapter 17

  34. CI(y) = $40,000y CII(y) = $20,000y B(y) B(y) 0 1 2 3 4 5 6 1 2 3 4 5 6 0 Years of College Optimal choice of y for Group I Optimal choice of y for Group II Signaling Group I Value of College Educ. Value of College Educ. Group II $200K $200K $100K $100K Years of College y* y*

  35. Signaling • Education does increase productivity and provides a useful signal about individual work habits even if education does not change productivity. Chapter 17

  36. Market Signaling • Guarantees and Warranties • Signaling to identify high quality and dependability • Effective decision tool because the cost of warranties to low-quality producers is too high Chapter 17

  37. Moral Hazard • Moral hazard occurs when the insured party whose actions are unobserved can affect the probability or magnitude of a payment associated with an event. • If my home is insured, I might be less likely to lock my doors or install a security system • Individual may change behavior because of insurance – moral hazard Chapter 17

  38. Moral Hazard • Determining the Premium for Fire Insurance • Warehouse worth $100,000 • Probability of a fire: • .005 with a $50 fire prevention program • .01 without the program • If the insurance company cannot monitor to see if he program was run, how do they determine premiums? Chapter 17

  39. Moral Hazard • With the program the premium is: • .005 x $100,000 = $500 • Once insured owners purchase the insurance, the owners no longer have an incentive to run the program, therefore the probability of loss is .01 • $500 premium will lead to a loss because the expected loss is now $1,000 (.01 x $100,000) Chapter 17

  40. Moral Hazard • Moral hazard is not only a problem for insurance companies, but it alters the ability of markets to allocate resources efficiently. • Consider the demand (MB) of driving • If there is no moral hazard, marginal cost of driving is MC • Increasing miles will increase insurance premium and the total cost of driving Chapter 17

  41. MC (no moral hazard) MC’ (w/moral hazard) D = MB 100 140 The Effects of Moral Hazard Cost per Mile With moral hazard insurance companies cannot measure mileage. MC goes to$1.00 and miles driven increases to 140 miles/week – Inefficient allocation. $2.00 $1.50 $1.00 $0.50 50 Miles per Week Chapter 17

  42. Reducing Moral Hazard – Warranties of Animal Health • Scenario • Livestock buyers want disease free animals. • Asymmetric information exists • Many states require warranties • Buyers and sellers no longer have an incentive to reduce disease (moral hazard). Chapter 17

  43. The Principal – Agent Problem • Owners cannot completely monitor their employees – employees are better informed than owners • This creates a principal-agent problem which arises when agents pursue their own goals, rather than the goals of the principal. Chapter 17

  44. The Principal – Agent Problem • Company owners are principals. • Workers and managers are agents. • Owners do not have complete knowledge. • Employees may pursue their own goals even at a cost of reduce profits. Chapter 17

  45. The Principal – Agent Problem • The Principal – Agent Problem in Private Enterprises • Only 16 of 100 largest corporations have individual family or financial institution ownership exceeding 10%. • Most large firms are controlled by management. • Monitoring management is costly (asymmetric information). Chapter 17

  46. The Principal – Agent Problem – Private Enterprises • Managers may pursue their own objectives. • Growth and larger market share to increase cash flow and therefore perks to the manager • Utility from job from profit and from respect of peers, power to control corporation, fringe benefits, long job tenure, etc. Chapter 17

  47. The Principal – Agent Problem – Private Enterprises • Limitations to managers’ ability to deviate from objective of owners • Stockholders can oust managers • Takeover attempts if firm is poorly managed • Market for managers who maximize profits – those that perform get paid more so incentive to act for the firm Chapter 17

  48. The Principal – Agent Problem – Private Enterprises • The problem of limited stockholder control shows up in executive compensation • Business Week showed that average CEO earned $13.1 million and has continued to increase at a double-digit rate • For 10 public companies led by highest paid CEOs, there was negative correlation between CEO pay and company performance Chapter 17

  49. CEO Salaries • CEO compensation has gone from 40 times the pay of average worker to over 1000 times Chapter 17

  50. CEO Salaries • Although originally thought that executive compensation reflected reward for talent, recent evidence suggests managers have been able to manipulate boards to extract compensation out of line with economic contribution Chapter 17

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