1. Markets with Asymmetric Information
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 2

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

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

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

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. The Lemons Problem PH PL DH SH DL DL SL QH QL
Market price for high quality cars is $10,000
Market price for low quality cars is $5000
50,000 of each type are sold DH SH
50,000
10,000 DL DL SL
5,000
50,000 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. The Lemons Problem PH PL DH DM SH DLM DM SL DL DLM DL QH QL
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 DH DM SH
50,000
10,000
DLM DM SL
25,000
7,500
75,000
7,500 DL
DLM
5,000
50,000 DL 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 13

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 14

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 15

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 16

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 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 18

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 19

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 20

19. Days on Disabled List per Season
Player Disability
Days on Disabled List per Season
Pre Contract
Post Contract
Percent Change
All Players
4.73
12.55
165.4
Renewed Players
4.76
9.68
103.4
Free Agents
4.67
17.23
268.9
Chapter 17 22

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 23

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 25

22. Market Signaling Weak signal could be dressing well Strong Signal
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 26

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 27

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 28

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 29

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 30

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 31

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

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 41

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 42

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 43

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 44

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. 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.
D = MB
$2.00
$1.50
MC (no moral hazard)
100
$1.00
MC’ (w/moral hazard)
140
$0.50 50
Miles per Week
Chapter 17 48

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 49

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 52

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 53

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 54

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 55

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 56

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
Workers
CEOs
1970
$32,522
$1.3 Mil.
1999
$35,864
$37.5 Mil.
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

51. CEO Salaries How have they been able to do this?
Boards don’t typically have necessary information and independence to negotiate effectively
Managers have introduced forms of compensation that camouflage the extraction of rents from shareholders
Stock options (not counted as expenses)
Chapter 17

52. CEO Salaries
Rent extraction has increased as consultants are hired to determine appropriate pay for CEO
Firm usually wants to provide at least the average of other companies, so salaries have been rising rapidly
With publicity increasing, CEO salaries seem to be rising less rapidly
Chapter 17

53. The Principal – Agent Problem – Public Enterprises
Observations
Managers’ goals may deviate from the agencies goal (size)
Oversight is difficult (asymmetric information)
Market forces are lacking
Chapter 17 57

54. The Principal – Agent Problem
Limitations to Management Power
Managers choose a public service position
Managerial job market
Legislative and agency oversight (GAO & OMB)
Competition among agencies
Chapter 17 58

55. The Managers of Nonprofit Hospitals as Agents
Are non-profit organizations more or less efficient that for-profit firms?
725 hospitals from 14 hospital chains
Return on investment (ROI) and average cost (AC) measured
Chapter 17 59

56. The Managers of Nonprofit Hospitals as Agents
Return on Investment
1977
1981
For-Profit
11.6%
12.7%
Non-Profit
8.8%
7.4%
Chapter 17 60

57. The Managers of Nonprofit Hospitals as Agents
After adjusting for differences in services:
AC/patient day in nonprofits is 8% greater than profits
Conclusion
Profit incentive impacts performance
Cost and benefits of subsidizing nonprofits must be considered.
Chapter 17 61

58. Incentives in the Principal-Agent Framework
Designing a reward system to align the principal and agent’s goals--an example
Watch manufacturer
Uses labor and machinery
Owners goal is to maximize profit
Machine repairperson can influence reliability of machines and profits
Chapter 17 62

59. Incentives in the Principal-Agent Framework
Designing a reward system to align the principal and agent’s goals--an example
Revenue also depends, in part, on the quality of parts and the reliability of labor.
High monitoring cost makes it difficult to assess the repair-person’s work
Chapter 17 63

60. Incentives in the Principal-Agent Framework
Small manufacturer uses labor and machinery to produce watches
Goal to maximize profits
High monitoring costs keep owners from measuring the effort of the repairperson directly
Chapter 17

61. The Revenue from Making Watches
Poor Luck
Good Luck
Low Effort
(a = 0)
$10,000
$20,000
High Effort
(a = 1)
$40,000
Chapter 17 64

62. Incentives in the Principal-Agent Framework
Designing a reward system to align the principal and agent’s goals--an example
Repairperson can work with either high or low effort
Revenues depend on effort relative to the other events (poor or good luck)
Owners cannot determine a high or low effort when revenue = $20,000
Chapter 17 65

63. Incentives in the Principal-Agent Framework
Designing a reward system to align the principal and agent’s goals--an example
Repairperson’s goal is to maximize wage net of cost
Cost = 0 for low effort
Cost = $10,000 for high effort
w(R) = repairperson wage based only on output
Chapter 17 66

64. Incentives in the Principal-Agent Framework
Choosing a Wage
w = 0; a = 0; R = $15,000
R = $10,000 or $20,000, w = 0
R = $40,000; w = $24,000
R = $30,000; Profit = $18,000
Net wage = $2,000
w = R - $18,000
High effort
Chapter 17 67

65. Incentives in the Principal-Agent Framework
Conclusion
Incentive structure that rewards the outcome of high levels of effort can induce agents to aim for the goals set by the principals.
Chapter 17 69

66. Managerial Incentives in an Integrated Firm
In integrated firms, division managers have better (asymmetric) information about production than central management
Two Issues
How can central management illicit accurate information
How can central management achieve efficient divisional production
Chapter 17 70

67. Managerial Incentives in an Integrated Firm
We will focus on firms that are integrated
Horizontally integrated
Several plants produce the same or related products
Vertically integrated
Form contains several divisions, with some producing parts and components that others use to produce finished products
Chapter 17

68. Managerial Incentives in an Integrated Firm
Possible Incentive Plans
Give plant managers bonuses based on either total output or operating profit
Would encourage mangers to maximize output
Would penalize managers whose plants have higher costs and lower capacity
No incentive to obtain and reveal accurate cost and capacity information
Chapter 17 72

69. Managerial Incentives in an Integrated Firm
Ask managers about their costs and capacities and then base bonuses on how well they do relative to their answers
Qf = estimate of feasible production level
B = bonus in dollars
Q = actual output
B = 10, (Qf - Q)
Incentive to underestimate Qf
Chapter 17

70. Managerial Incentives in an Integrated Firm
If manager estimates capacity to be 18,000 rather than 20,000. If the plant only produces 16,000 her bonus increases from $8000 to $9000
Don’t get accurate information about capacity and don’t insure efficiency
Bonus still tied to accuracy of forecast
Chapter 17 74

71. Managerial Incentives in an Integrated Firm
Modify scheme by asking managers how much their plants can feasibly produce and tie bonuses to it
Bonuses based on more complicated formula to give incentive to reveal true feasible production and actual output
If Q > Qf ;B = .3Qf + .2(Q - Qf)
If Q < Qf ;B = .3Qf - .5(Qf - Q)
Chapter 17

72. Managerial Incentives in an Integrated Firm
Assume true production limit is Q* = 20,000
Line for 20,000 is continued for outputs beyond 20,000 to illustrate the bonus scheme but dashed to dignify the infeasibility of such production
Bonus is maximized when firm produces at its limit of 20,000; the bonus is then $6000
Chapter 17

73. Incentive Design in an Integrated Firm
Bonus
($ per
year)
If Qf = 10,000,
bonus is $5,000
Qf = 30,000
Qf = 20,000
10,000
If Qf = 20,000,
bonus is $4,000
Qf = 10,000
8,000
6,000
If Qf = 30,000,
bonus is $6,000,
the maximum
amount possible.
4,000
2,000
Output
(units per year)
10,000
20,000
30,000
40,000
Chapter 17 78

74. Efficiency Wage Theory
In a competitive labor market, all who wish to work will find jobs for a wage equal to their marginal product.
However, most countries’ economies experience unemployment.
Chapter 17 79

75. Efficiency Wage Theory
The efficiency wage theory can explain the presence of unemployment and wage discrimination.
In developing countries, productivity depends on the wage rate for nutritional reasons.
Chapter 17 80

76. Efficiency Wage Theory
The shirking model can be better used to explain unemployment and wage discrimination in the United States.
Assumes perfectly competitive markets
However, workers can work or shirk.
Since performance information is limited, workers may not get fired.
Chapter 17 81

77. Efficiency Wage Theory
If workers paid market clearing wage w*, they have incentive to shirk
If get caught and fired, they can immediately get a job elsewhere for same wage
Firms have to pay a higher wage to make loss higher from shirking
Wage at which no shirking occurs is the efficiency wage
Chapter 17

78. Efficiency Wage Theory
All firms will offer more than market clearing wage, w*, say we (efficiency wage)
In this case workers fired for shirking face unemployment because demand for labor is less than market clearing quantity
Chapter 17

79. Unemployment in a Shirking Model
Demand for
Labor
Wage
Without shirking, the market wage
is w*, and full-employment exists at L*
No-Shirking
Constraint SL
The no-shirking
constraint gives
the wage necessary
to keep workers
from shirking.
At the equilibrium wage, We the
firm hires Le workers
creating unemployment of L* - Le. we Le w* L*
Quantity of
Labor
Chapter 17 88

80. Efficiency Wages at Ford Motor Company
Labor turnover at Ford
1913: 380%
1914: 1000%
Average pay = $2 - $3
Ford increased pay to $5
Chapter 17

81. Efficiency Wages at Ford Motor Company
Results
Productivity increased 51%
Absenteeism had been halved
Profitability rose from $30 million in 1914 to $60 million in 1916.
Chapter 17