Transcript Managerial Economics ECON 511 Lecture 7 Markets with Asymmetric Information Professor Changqi Wu Topics for Today  Quality uncertainty and the market for lemons  Solutions to adverse selection problem  Pricing.

Managerial Economics
ECON 511
Lecture 7
Markets with
Asymmetric Information
Professor Changqi Wu
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
Slide 2
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
Slide 3
The Lemons Problem
PH
The market for high and low
quality cars when buyers and sellers
can identify each car
PL
SH
10,000
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.
The increase in QL
reduces expectations and
demand to DLM. The adjustment process
continues until demand = DL.
DH
SL
DM
5,000
DM
DLM
DLM
DL
DL
25,000
50,000
QH
50,000
75,000
QL
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
Slide 5
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.
Asymmetric information
Slide 6
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
Slide 7
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
Slide 8
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
Slide 9
Economics of Beauty
Personal beauty is a better
introduction than any letter.
--Aristotle 384-322 B.C.
Asymmetric information
Slide 10
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
Slide 11
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
Slide 12
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
Slide 13
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
Slide 14
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
Slide 15
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
Slide 16
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
Slide 17
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
Slide 18
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
Slide 19
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
Slide 20
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
Asymmetric information
Slide 21
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.
Slide 22
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
Slide 23
An Efficiency Wage Model
Wage
Without shirking, the market wage
is w*, and full-employment exists at L*
No-Shirking
Constraint
SL
Demand for
Labor
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
w*
Le
Asymmetric information
L*
Quantity of
Labor
Slide 24
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
Slide 25
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
Slide 26
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
Slide 27
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
Slide 28
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
Slide 29
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
Slide 30
Distribution of Equity Shares of Foreign Partners
50
45
40
30
25
20
15
10
5
100
97
94
91
88
85
82
79
76
73
70
67
64
61
58
55
52
49
46
43
40
37
34
31
28
25
22
19
16
13
10
7
4
0
1
No. of joint ventures
35
Equity sha re s of fore ign pa rtne rs (%)
Asymmetric information
Slide 31
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
Slide 32