Markets with Asymmetric Information Managerial Economics ECON 511 Lecture 7 Markets with Asymmetric Information Professor Changqi Wu 1

Topics for Today Quality uncertainty and the market for lemons Solutions to adverse selection problem Pricing strategy with presence of asymmetric information Moral hazard problem within an organization and its solutions Asymmetric information

1. The Market for Used Cars Qualities of used cars differ. If buyers and sellers can distinguish between high and low quality cars There will be two markets Typically, buyers are less informed than sellers about the exact quality of a used car. Asymmetric information

The Lemons Problem SH SL DH DL DM PH PL DLM DL QH QL 5,000 50,000 The market for high and low quality cars when buyers and sellers can identify each car 10,000 DM 75,000 25,000 With asymmetric information buyers will find it difficult to determine quality. They lower their expectations of the average quality of used cars. Demand for low and high quality used cars shifts to DM. PH PL DLM The increase in QL reduces expectations and demand to DLM. The adjustment process continues until demand = DL. DL QH QL 12

The Market for Used Cars A seller has the incentive to put the low quality used car in the market. Buyers, anticipating that, are only willing to pay the price of a lemon for the used car. Too many low and too few high quality cars are on the market. Low quality goods drive high quality goods out of the market. The market has failed to produce mutually beneficial trade. Asymmetric information

Asymmetric Information one side of a transaction knows less than the other side Information asymmetry leads to economic inefficiency Two kinds of information asymmetry One side of a transaction knows about herself, but the other side does not. It is called adverse selection. One side can take actions that the other side cannot observe. It is called moral hazard. Marriage can be a good example: before marriage, adverse selection: so live together. After marriage: action may change Asymmetric information

Business Applications Insurance Is it possible for insurance companies to separate high and low risk policy holders? If not, only high risk people will purchase insurance. Adverse selection would make medical insurance unprofitable. The market for credit Asymmetric information creates the potential that only high risk borrowers will seek loans. How can credit histories help making this market more efficient and reduce the cost of credit? Asymmetric information

2. Resolving Adverse Selection Problem Actions taken by the buyer: screening The less informed party takes actions to learn about the true characteristics of the other side. Action taken by a third party: appraisal Actions taken by the seller: signaling The better informed party takes actions to reveal her unobservable true characteristics. Asymmetric information

2.1. Screening Screening is a process of actively collecting information. Banks ask proofs of earnings before issuing credit cards. Interviews for job candidates Search cost and optimal searching Asymmetric information

Economics of Beauty Personal beauty is a better introduction than any letter. --Aristotle 384-322 B.C. Asymmetric information

2.2. Appraisal The existence of searching costs creates market power to the seller. It causes economic inefficiency. Economy of experience leads to the creation of specialized search agencies. Credit rating agencies: Moody’s and Standard&Poor’s Department stores serve as intermediaries to select goods on behalf of buyers Government agencies act as market intermediate agents Asymmetric information

2.3. Market Signaling It has to be costly to convey information and the costs must be different to different producers. 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 Are you ready to give a diamond ring as the birthday present? Asymmetric information

MBA as a Signal Employers know that there are two kinds of people with different capabilities among the potential job candidates Miss Smart is a quick learner and a diligent worker. Mr Dumb is a slow and lazy worker It costs money and effort to complete the MBA program Implicit costs and chance of success differ between two kinds of candidates Only smart people are willing to enroll into the MBA program Asymmetric information

Firm as Information Provider Companies have incentives to provide information to its potential customers. Advertising produces two effects Informative advertising Persuasive advertising. Advertising as a signal of product quality Advertising of a firm is only effective if customers keep on buying its products. Asymmetric information

3. Quality of Goods and Pricing Types of goods Search goods: The quality of goods can be ascertained before a purchase Experience goods: The quality of goods can be learnt after the purchase Credence goods: The quality of goods is rarely learnt even after the consumption Asymmetric information

Price as a Signal of Quality You get what you have paid for? One-shot purchase: high price signals high quality: Only at a high price, high quality producers are willing to supply the goods. If consumers comprise the informed and the uninformed, demand for high quality goods is stronger than that for the low quality ones. Asymmetric information

Price as a Signal of Quality Repeat purchases At introductory stage, a low price signals a high quality product: a low quality producer cannot generate repeat purchases. A high price signal a high quality a high quality producer is not afraid of contracting demand. Asymmetric information

Key Learning Points Information asymmetry hinders business transactions and leads to economic inefficiencies. Adverse selection means one side of a transaction knows more about herself while other side does not. Screening, appraisal and signaling are possible remedies for adverse selection problems. Asymmetric information

4. Moral Hazard One party’s interest depends on the action of another party whose action cannot be observed. Two parties have a conflict of interest Moral hazard problem in an economic organization often takes the form of principal-agent relationship. Relationship between shareholders (bond holders) and managers is a kind of principal-agent relationship Asymmetric information

Causes of Moral Hazard Asymmetric information takes the form of unobservability of other party’s action It is not like adverse selection, one side does not know the type of another side There is a conflict of interest of stakeholders in an organization Asymmetric information

Solutions to Moral Hazard Improving monitoring mechanism supervisors Reconcile the conflict interests by establishing incentive compatible compensation scheme Carrots performance based pay: piece rate wage, stock options Sticks China’s economic reform follows the decentralization road. In banking sector decentralization led to disastrous effect. Zhu’s banking sector reform represents a recentralization effort Asymmetric information

Why a Pilot is Paid more than … a Taxi Driver? A taxi driver and a pilot of Boeing 747 jumbo jet may require different skills Negligence of a pilot leads to a loss of many lives A pilot is paid more than a taxi driver to encourage the former to do his job more carefully.

Efficiency Wage Shareholders want all employees to devote their effort to maximize firm’s profit. Employees want to maximize their net benefits. If the reward takes the form of fixed wage, the optimal course of action is to devote as little effort as possible. One can use market mechanism to reduce the moral hazard in an organization Efficiency wage is a wage level at which the unit output labor cost is minimized. Unemployment becomes unavoidable when the ongoing wage is higher than the market clearing one. Asymmetric information

An Efficiency Wage Model Without shirking, the market wage is w*, and full-employment exists at L* Demand for Labor w* L* SL No-Shirking Constraint The no-shirking constraint gives the wage necessary to keep workers from shirking. we Le At the equilibrium wage, We the firm hires Le workers creating unemployment of L* - Le. Quantity of Labor Asymmetric information 88

Moral Hazard in MultipleTasks An agent has incentives to put more effort on observable action and less on the unobservable action Example: price and safety standard of electricity supply Solution: using indicators that reflect the level of less observable effort Asymmetric information

5. Holdup Problem Holdup is an action to exploit another party’s dependency Hold-up occurs when transaction requires specific investments by one side or both sides Relations between Nike and its subcontractors Asset specificity causes opportunistic behavior Holdup problem induces economic inefficiency Asymmetric information

Contract Solution Contracts can be used to detail the tasks and responsibilities of all parties under different contingencies. A well written contracts can help to clarify ambiguities and reduce possible disputes A contract should be verifiable and enforceable Asymmetric information

Ownership Solution A contract may not be specific enough to include all contingencies. In this case, we call that contract is incomplete. If a contract is incomplete, ownership matters because the owner has the right to make decisions that are not explicitly spelt out in the contract Ownership means the right to claim the residual benefits The ownership arrangement is critical to economic efficiency in an organization. Ownership arrangement also determines the organizational form of business. Asymmetric information

Optimal Ownership Arrangement Ownership should go to the party whose effort has the maximal impact on firm’s performance Some examples Employee share ownership plan (ESOP) Stock options for senior management Joint ownership in joint ventures Asymmetric information

Holdup Problem in Joint Ventures Chinese party needs capital, technology and know-how Foreign party needs market access and networking After forming a joint venture, both sides have incentives to take advantage of other party’s commitment Joint ownership may mitigate the holdup problem in joint ventures Asymmetric information

Asymmetric information

Key Learning Points Management of an organization is about motivating people to achieve the goal of the organization Because of the conflict of interest among stakeholders and the moral hazard problem, an organization may not be able to achieve its maximal potential. Incentive compatible mechanisms can help managers motivate people by mitigating the moral hazard, thus, improve the economic efficiency in an organization. Asymmetric information