ch17 pindyck myslides

Chapter 17

Markets with Asymmetric Information

Chapter 17 2©2005 Pearson Education, Inc.

Topics to be Discussed

Quality Uncertainty and the Market for Lemons

Market SignalingMoral HazardThe Principal-Agent ProblemManagerial Incentives in an Integrated

FirmAsymmetric Information in Labor

Markets: Efficiency Wage Theory


Introduction

When one party has more information about relevant variables than the other, we have asymmetric information

Asymmetric information is all around us Sellers usually know more about the quality

of their product than buyers Workers know more about their own skills

and abilities than employers Managers know more about investment

opportunities than shareholders


The Market for Lemons

Ex: The market for used cars Two types of used cars – high quality and

low quality First, assume that buyers and sellers can

distinguish between the carsThere will be two markets – one for high quality

cars and one for low quality cars



SH is higher than SL because owners of high quality cars generally require a high price to sell them

Similarly, DH is higher than DL because consumers are generally willing to pay more for higher quality cars



PH PL

QH QL

SH

SL

DH

DL

$5,000

50,00050,000

$10,000

Price for low quality cars is $5000.

Price for high quality cars is $10,000.

50,000 of each type are sold.



Now assume sellers can distinguish between the cars but buyers cannot This will allow us to see the role of asymmetric

informationSince, under complete information, the same

number of high- and low-quality cars are sold, under asymmetric information buyers may think the odds that a car is high quality are 50/50 Since buyers can’t distinguish, they will view all cars

as medium quality (with demand DM)Keep in mind that no car is actually of medium

quality

8©2005 Pearson Education, Inc.


PH PL

QH QL

SH

SL

DH

DL

5,000

50,00050,000

10,000

DL

HQ cars are perceived as MQ and sell for $7500.

DM

25,000

7,500

DM

75,000

7,500

DH

LQ cars are perceived as MQ and sell for $7500.

25,000 HQ cars end up being sold.

75,000 LQ cars end up being sold.



Since only 25,000 HQ cars are sold while 75,000 LQ cars are sold, a buyer will change her subjective probability that the car is high quality to 25/75 from 50/50 Buyers will now view all cars as “low-medium”

quality (with demand DLM)



PH PL

QH QL

SH

SL

DH

DL

5,000

50,00050,000

10,000

DL

Price will drop below $7500.

DM

25,000

7,500

75,000

7,500

DM

DLM

DLM

Subjective probability of buying a HQ car will drop below 25/75.



You get the picture: as price drops, a buyer’s subjective probability of the proportion of HQ cars decreases, and this in turn causes price to drop even further

This vicious cycle will continue until the price drops to PL and all cars offered for sale are LQ. In well-functioning markets, this cycle takes a

very short time to complete



With asymmetric information: Low quality goods can drive high quality

goods out of the market - the lemons problem

The market can fail (in the above example, mutually beneficial trade for HQ cars does not occur)

Adverse selection occurs; in equilibrium, trade takes place mainly for lower quality goods


Market for Health Insurance

Ex: Health Insurance Older individuals have difficulty purchasing health

insurance at almost any price – Why?They know more about their own health than the

insurance company doesUnhealthy people are more likely to want insurance

than healthy people; therefore the proportion of unhealthy people in the pool of those insured rises

As the pool tilts toward unhealthy, prices rise; in turn the pool tilts even more toward unhealthy

Eventually, the only people left are the most unhealthy, and the price of insurance becomes extremely high


Market for Auto Insurance

Ex: Auto insurance Insurance companies know that some drivers

have a low probability of being in an accident and some have a high probability

If they can’t distinguish among drivers, they will base premiums on the average experience

Safe drivers will... (you complete the rest)


Market for Insurance

How do we solve the problem of asymmetric information?

A possible solution is to pool risks The government can take on this role, as

with MedicareProblem of adverse selection is eliminated


Market for Credit

Ex: Credit cards Asymmetric information regarding the ability

to repay debt Potential for lemons problem To solve this, banks and credit agencies use

credit histories, and even share credit histories, to gauge credit-worthyness


Importance of Reputation and Standardization

Asymmetric information is everywhere Antiques, art, rare coins – real or counterfeit? Restaurants – check the kitchen? Home repair – climb up to see job?


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

StandardizationChains that keep production the same everywhere

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


Market Signaling

Another way to alleviate the problem of asymmetric information is through market signaling Market signaling is the process by which

sellers send information to buyers about product quality

For example, a potential worker (selling labor) will usually submit a resume to the potential employer (buying labor), thereby signaling his/her ability and skills


Market Signaling

Not all signals are the same Dressing well for the interview is a weak

signalWeak because even unproductive employees

can dress well Having an advanced degree from a reputable

university is a strong signalTo be effective, a signal must be difficult for

sellers of LQ products to imitate Degree in Financial Engineering from Polytechnic


Model of Job Market Signaling

Simple model of signaling Two groups of workers Group I: Low productivity

Marginal (and average) product of labor = 1 unit per year

Group II: High productivityMarginal (and average) product of labor = 2 units per

year There is an equal number of Group I and Group II

workersAverage product of labor for all workers = 1.5 units

per year



Assume competitive markets (no profit) Price = $10,000/unit Employees average 10 years of employment Revenue from Group I worker = $100,000

(1 x $10,000 x 10 years) Revenue from Group II worker = $200,000

(2 x $10,000 X 10 years)



With Complete Information Wage = revenue from worker

Group I wage = $10,000/yr.Group II wage = $20,000/yr.

With Asymmetric Information Wage = average revenue from all workers

Group I & II wage = $15,000/yr.Group I workers essentially gain at the expense

of group II workers



Consider a potential signal: y = education index (e.g., years of education,

reputation of university, GPA, etc.) C(y) = cost of attaining educational level y

Direct costs tuition textbooks

Indirect costs opportunity cost of doing something else suffering through FE 601



Assume education is more costly for Group I for any level of y Why?

Low productivity workers may simply be less studious

Low productivity workers progress slower through degree programs

Group I CI(y) = $40,000y

Group II CII(y) = $20,000y



Assume education is only valuable as a potential signal Does not improve your skills

Can we find an equilibrium where Group I workers choose less education and Group II workers choose more education?

We have an equilibrium if we can identify a level y* such that Group I optimally chooses < y* and Group II chooses ≥ y* Employers will be able to tell workers apart based on

level of education



Some observations: Since y* is the only threshold and education is costly,

no one will choose y > y* and no one will choose y* > y > 0

y > y* sends the same signal as y = y*y* > y > 0 sends the same signal as y = 0

Ed level of y* signals GII and wage = $20,000/yr

Ed level of 0 signals GI and wage = $10,000/yr

Note that there is no 1 right solution to the level of y*, but for education to be an effective signal, firms must identify a correct solution



How much education will individuals obtain given that firms use this decision rule?

Benefit of education B(y) is the increase in wage associated with each level of education

B(y) is initially 0, which corresponds to the $100,000 base 10-year earnings B(y) continues to be zero until ed reaches y*



How much education to choose is a cost-benefit comparison Obtain education level y* if the benefit, B(y), is at least as

large as the cost, C(y). Group I:

No education if $100,000 < $40,000y* no education if y* > 2.5

Group II: No education if $100,000 < $20,000y* no education if y* > 5

Therefore, any level of y* between 2.5 and 5 will work in distinguishing Group I workers from Group II workers Make sure you understand this



Suppose y* = 4 People in Group I will find education is not

worthwhile, since $100,000 < $40,000×4Benefit lower than cost

People in Group II will find education is worthwhile, since $100,000 > $20,000×4

Benefit higher than cost

Therefore, y* = 4 is an effective separating equilibrium



Value ofCollege

Educ.

$100K

Value ofCollege

Educ.

Educationlevel

Educationlevel

0 1 2 3 4 5 6 0 1 2 3 4 5 6

$200K

$100K

$200KCI(y) = $40,000y

B(y)B(y)

y* y*

CII(y) = $20,000y

Group IIGroup I



Conclusion Education is valuable as a signal, even in the

absence of other benefitsIn reality, of course, education makes you more

productive


Market Signaling

Another example of market signaling: Guarantees and warranties Sellers of HQ products signal quality and the

cost to LQ producers of offering guarantees and warranties is too high


Moral Hazard

Moral hazard occurs when a party whose actions are unobserved can affect the probability or magnitude of an adverse event If your home is insured, you might be less likely to

lock doors or install a security system If you have a flat salary, you might decide to work

less hard Here we have hidden action rather than hidden

information


Moral Hazard

Ex: Determining the Premium for Fire Insurance Warehouse worth $100,000 Probability of a fire:

.005 if conduct a $50 fire-prevention program.01 if don’t conduct the program

If the insurance company cannot monitor the company’s decision whether to conduct the fire-prevention program, how does it set the premium?


Moral Hazard

With the program the premium is: 0.005 x $100,000 = $500

However, once insurance is purchased, the owners no longer have an incentive to run the program Probability of fire increases to 0.01 Premium increases to (0.01 x $100,000) =

$1000


The Principal-Agent Problem

This leads us to a discussion of agencyTypically, owners (principals) do not

continuously monitor managers (agents), so the managers can potentially take actions which are detrimental to the owners

This creates a principal-agent problem which arises when agents pursue their own goals, rather than the goals of the principal



Some examples of principals and agents Company owner (principal) wants to

maximize profits, managers and employees (agents) want to take it easy

U.S. residents (principals), politicians (agents)

Parents of a baby (principals), babysitter (agent)



A Principal-Agent Problem in the Private Sector: Management vs. Shareholders Ownership of most U.S. firms is not highly

concentrated It is costly to monitor managers, and when

ownership is diffuse the benefits don’t justify the costs for any 1 shareholder



Managers may pursue their own objectives Increase company size and market share,

which ultimately will lead to more respect and power

Increase own salary and bonuses Increase own job security



Limitations to managers’ ability to deviate from owners’ objectives Stockholders can oust managers with help

from board of directors Another firm may attempt a takeover Compensation can be structured to better

align managers’ and owners’ incentives



The problem of limited stockholder control shows up in executive compensation In 2002, Business Week reported that, on

average, CEOs of large corporations earn $13.1 million per year, and that the annual growth rate in executive compensation has been in double-digits


CEOs vs. All Workers: Salaries

All Workers Top 100 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*

*Based on 1/18/2003 NYT article


Incentives in the Principal-Agent Framework

When a principal-agent problem arises, the best solution is to design a reward system for the agent such that his/her incentives are aligned with the principal’s goals This usually involves tying the reward to

some observable variable



Ex: Watch manufacturer Uses labor and machinery Manufacturer’s goal is to maximize profit Machine repairperson can work with low effort

or high effortLow effort increases the probability that machines

will break down, thereby reducing profitsHigh effort reduces the probability that machines

will break down, thereby increasing profitsEffort is not observed (monitoring too costly)



Some other assumptions: Revenue also depends on other factors

besides repairperson’s effort Effort cannot be deduced from revenue level

This means that effort is not ex-post verifiable


The Revenue from Making Watches

Revenue

Poor Luck Good Luck

Low Effort

(a = 0)$10,000 $20,000

High Effort

(a = 1)$20,000 $40,000

effort not

ex-post

verifiable



Repairperson’s (agent’s) goal Maximize wage less the cost of effort

Assume cost = 0 for low effort, cost = $10,000 for high effort

Note that this goal implies that the repairperson is risk-neutral

Owner’s (principal’s) goal Maximize revenue less repairperson’s wage

Choose a payment scheme that will maximize profits Since effort is not observable, the wage can only be

set as a function of revenue, not effortw(R) = repairperson’s wage as a function of revenue



Lets compare two payment schemes: Scheme1: Fixed wage

w = 0 (why zero? How much does the wage need to be if cost is 0?)

Then, effort = low, wL – cost(effortL) = 0

E[profit] = E[revenue] – E[wL] = $15,000 - $0 = $15,000

Scheme2: Bonus arrangement w = 0 if r = $10,000 or $20,000 w = $24,000 if r = $40,000 Then, repairperson will choose effort = high, since

E[wH] – cost(effortH) is $12,000 - $10,000 = $2000 but E[wL] – cost(effortL) is $0 - $0 = $0

Incentivize the repairperson to choose effort = high

E[profit] = E[revenue] – E[wH] = $30,000 - $12,000 = $18,000

Thus, both are better off under the bonus arrangement



Suppose there are many repairpersons, so there is a lot of competition for the job

If you are the watch manufacturer what payment scheme would you choose? Clearly, a fixed wage is not a good idea The bonus from previous slide is a better idea But even better:

w = 0 if revenue = $10,000 or $20,000w = $20,001 if revenue = $40,000 This scheme allows you to extract maximum

rents; E[profit] = $19,999.50



Conclusion A clever incentive structure can induce the

agent to aim for the goals set by the principal


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 elicit accurate

information? How can central management achieve

efficient divisional production?

Stop

here



We will focus on firms that are integratedHorizontally integrated

Several plants produce the same or related products

Vertically integrated Firm contains several divisions, with some

producing parts and components that others use to produce finished products



Possible Incentive Plans

1. Give plant managers bonuses based on either total output or operating profit

Would encourage managers 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



2. 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 = 10,000 - .5(Qf - Q)

Incentive to underestimate Qf



If manager estimates capacity to be 18,000 rather than 20,000, and 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



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)



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 signify the infeasibility of such production

Bonus is maximized when firm produces at its limit of 20,000; the bonus is then $6000


Incentive Design in an Integrated Firm

Output(units per year)

2,000

4,000

6,000

10,000

0 10,000 20,000 30,000 40,000

Bonus($ peryear)

8,000

If Qf = 30,000,bonus is $4,000,

the maximumamount possible.

Qf = 30,000

Qf = 10,000

If Qf = 10,000,bonus is $5,000.

Qf = 20,000

If Qf = Q* = 20,000,bonus is $6,000.


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



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



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



If workers are paid market clearing wage w*, they have incentive to shirk

If they 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



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


Without shirking, the market wageis w*, and full-employment exists at L*

Demand forLabor

w*

L*

Unemployment in a Shirking Model

Quantity of Labor

Wage

SL

No-ShirkingConstraint

The no-shirkingconstraint gives

the wage necessaryto keep workers

from shirking.

we

Le

At the equilibrium wage, We the firm hires Le workerscreating unemployment of L* - Le.


Efficiency Wages at Ford Motor Company

Labor turnover at Ford 1913: 380% 1914: 1000%

Average pay = $2 - $3Ford increased pay to $5


Efficiency Wages at Ford Motor Company

Results Productivity increased 51% Absenteeism was halved Profitability rose from $30 million in 1914 to

$60 million in 1916


Important concepts

Asymmetric informationLemons problemAdverse selectionPooling risksMarket signalingSeparating equilibriumMoral hazardPrincipalAgentPrincipal-agent problem


HomeworkQuestions for review: 4 Exercises: 5,8,9,10

Due in 2 weeks

Next week: final exam

ch17 pindyck myslides

Documents

dl2005 pearson education

high quality cars

low quality cars

job market signaling

group ii workers

quality goods

high quality

adverse selection