Transcript Section C – Managerial and individual decision problems • Asymmetric information and risk – Main problems: adverse selection and moral hazard • Applications and case studies:

Section C
– Managerial and individual decision problems
•
Asymmetric information and risk
– Main problems: adverse selection and moral hazard
•
Applications and case studies: second hand car
markets, the supply of health care, managerial
incentives, hiring and contracting with employees
Suggested background reading
• Allen et al. 2009. Managerial Economics. Norton. Part 7:
Chapters 13-15
• Kreps, D. M. 2004. Microeconomics for Managers. Norton
Chapters 18-19 (16-17 provide more background)
• Frank, R. H. 2008. Microeconomics and behaviour. McGraw
Hill. Chapter 6
• Wall,S., Minocha, S. and Rees, B. 2010. International Business,
Pearson. Chapter 6
• Grimes, P, Register, C. and Sharp, A. 2009. Economics of Social
Issues, McGraw Hill. Chapter 15
• Rasmusen, E. 2007. Games and Information, Blackwell.
Chapters 7-9
Objectives
•
By the end of this section you should be able to:
–
–
–
Characterise decision making under risk
Use detailed examples to explain what is implied by the
concept of adverse selection. In the context of your
example, discuss how the problems associated with
adverse selection can be resolved.
Use detailed examples to explain what is implied by the
concept of moral hazard. In the context of your
example, discuss how the problems associated with
moral hazard can be resolved.
Risk
• Risk implies a chance of loss
– E.g. some exogenous chance of an investment
failing as well as some chance it will succeed
• Need to incorporate probabilities into the decision
problem
– Probabilities may be known or only defined subjectively
(uncertainty)
» How do people decide what to do?
Decision trees
Probability =0.1
Invest in
R&D
R&D succeeds
M+w
Chance
R&D fails
Probability = 0.9
Dr Punter
Don’t invest
M-c
M
Should Dr Punter invest? What would be a sensible decision rule?
Dr Punter’s decision
0.1
Invest in
R&D
R&D succeeds
M+w
Chance
R&D fails
0.9
Dr Punter
Don’t invest
M-c
M
Expected value of payoff from investing = 0.1(M+w) + 0.9(M-c)
Payoff from not investing = M (sure thing)
So perhaps should invest if: 0.1(M+w) + 0.9(M-c) > M
or: w > 9c
…………a simple rule………….but ignores attitudes to risk
Do attitudes to risk matter?
• Which gamble do you prefer:
• Gamble A:
– Win $100,000 probability 0.01
– Win nothing probability 0.99
• Gamble B:
– Win $2000 probability 0.5
– Win nothing probability 0.5
Do attitudes to risk matter?
• Gamble A:
– Win $100,000 probability 0.01
– Win nothing probability 0.99
• Expected value = $1,000
• Gamble B:
– Win $2000 probability 0.5
– Win nothing probability 0.5
• Expected value = $1,000
• If attitudes to risk don’t matter you should be indifferent
but are you?
– If indifferent you are risk neutral but if you have a preference
you are risk adverse or a risk lover
• In either case you shouldn’t use the expected value rule
• Maybe maximise expected utility instead
Asymmetric or hidden information
• For managers and consumers information is important
– E.g. information about rivals’ products, information about sellers
and buyers of their product
– There is a lot of information available (e.g. internet) but if
information is imperfect this can lead to problems e.g. if
information is asymmetric
• one side to an exchange knows more about some important detail than
the other – they have an informational advantage
• Analytical framework is the principal agent model (agency
theory)
– The side with the information is known as the agent - informed
– The side with limited information is known as the principle –
uninformed
• they are at an informational disadvantage
Adverse selection
• Adverse selection arises when an agent and a
principle are involved in a transaction but there is
asymmetric information about a fixed condition or
characteristic/type
– E.g. The quality of a product or an innate characteristic such as ability,
intelligence, reliability , attitude to risk
• the agent knows more than the principle about a characteristic (i.e.
quality) of the agent and;
• the information about the agent is relevant to the principle’s evaluation
of the transaction between them
Adverse selection
• Examples
– The riskiness of an investment for a venture capitalist (the
principle) due to uncertainty about the effectiveness of new
technology employed by an entrepreneur (the agent)
– The riskiness of employing a new worker because
uncertainty about their innate ability (productivity)
– The state of health of someone buying health insurance
• If principle offers a contract that is based on expected quality
this may only be acceptable to low quality agents  ADVERSE
SELECTION; bad drives out good
Basic idea underlying the adverse
selection problem
Principle
contracts
agent
Agent is a certain
type/quality agent knows
own type but
principle
does not
Outcome
depends
on type/quality
of agent
Adverse selection
• As principle doesn’t know agent’s type (e.g. high or
low quality) the contract will reflect this uncertainty payment based on expected (average) value rather
than actual value e.g. expected profitability of a new
venture, expected ability of an employee
– Proposed payment therefore less than value of high quality
agents so high quality agents likely to reject contract and
only lows will take contract; ADVERSE SELECTION - bad
drives out good
– Principle’s payoff is low unless revises the contract
downwards
A game theoretic illustration of the general
adverse selection problem
Payoffs
Principle Agent
accept
P1
c
H
AH
Chance
L
AL
high
negative
reject
0
0
accept
low
positive
reject
0
0
Principle, P: offers agent (A) a contract, c, based on average quality
Chance/Nature determines agent’s type/quality:
quality is high (H) or low (L); probability of each = ½
so principles expected payoff = ½ high + ½ low
Agent, A: knows own type: accepts contract if payoff is positive i.e. value of contract is
> 0, rejects contract otherwise (payoff = zero)
What kind of agent will accept the contract?
What will the principle’s payoff be?
A game theoretic illustration of the general
adverse selection problem
Payoffs
Principle Agent
accept
P1
c
H
AH
Chance
L
AL
high
reject
0
accept
low
reject
0
negative
0
positive
0
What kind of agent will accept the contract?
Only low quality agents will accept the contract
What will the principle’s payoff be?
so the principles payoff will be lower than expected payoff - lower than
(½ high + ½ low)
Vicious circle of adverse selection
• If principle (buyer) understands that only low quality
agents (sellers) accept a contract based on average
quality, then offered payment (price) will be lowered
to reflect this adverse selection
– …….. if there are any intermediate quality agents they may
withdraw from the market as well – adverse selection gets
worse (more adverse)
• Market gets thinner and thinner
Moral hazard
• Moral hazard: asymmetric information about the action of
someone (the agent) that affects the welfare of another
person (the principle)
– But the choice of action cannot be specified in a contract – the
actions of the agent are not completely controllable or observable
• there is uncertainty because of ‘noise’ leading to confusion
– There is also some conflict between the interests of the agent and
principle
• The agent may have an incentive to lie about the action taken
to detriment of principle = Moral hazard
• Key issue is one of incentives
– the incentives faced by the agent may be influenced by the principle
via the structure of the transaction (e.g. through a contract)
Examples of scenarios in which moral
hazard may arise
• Insurance: An insurance company sells health
insurance to a firm and is concerned that the firm’s
employees may take less care over their health (e.g.
drinking and smoking) now they have insurance
• More insurance examples:
– how carefully an insured person drives
– How carefully an insured factory guards against fire or
theft
More examples of scenarios in which moral
hazard may arise
• Employment: A car mechanic is hired by the hour to fix a car,
and the owner of the car is concerned that the mechanic will
take a lot of long tea breaks but claim that the problem was
complicated
• More generally: An employee has a contract of employment
and is paid a fixed hourly or daily wage. The employer worries
about the amount of effort or care the worker will exert since
either gives the worker negative utility.
– The employer cannot observe effort or care but can observe output;
but there is no 1-to-1 relationship between effort/care and output
More examples of scenarios in which moral
hazard may arise
• Team work: Two students working on a team project worry
that the other team member will do very little work - but that
the team member will claim that s/he put in a lot of effort but
that what they tried to do proved very difficult and time
consuming because of problems finding relevant data
• Borrowing: How careful an entrepreneur will be with the
money loaned from a bank – the loan manager worries that
the entrepreneur will gamble with the funds – take too many
risks
Basic idea underlying the moral hazard
problem
Principle
contracts
agent
Agent performs action
which principle does
not see – agent prefers
a different action to
principle
Outcome
depends
on action
of agent
A game theoretic model of moral hazard in employment
contracts
• Worker: Action = Level of effort/care. More effort gives
negative utility to the worker; Utility depends on wage(+)
and effort/care(-)
– U = F(wage, effort/care)
– Wage is constant e.g. $100 a week
• Employer: Output = Q; employer prefers higher Q
A game theoretic model of moral hazard in employment
contracts
• Uncertainty about the environment and asymmetric
information about the worker’s action (choice of effort
level)
– Environment or state of the world can vary; may be good or bad
(e.g. bad if machinery breaks down, mistakes made, accidents
happen) - some probability of either
• In any given state of the world, more effort/care always leads to at least as
much Q as less effort; so employer prefers more effort/care
• But no 1 to 1 relationship between effort/care and Q; accidents can happen
even if very careful
• Low effort in good state of the world leads to a relatively high Q
– Employer observes neither state of the world nor the effort/care
• Can only calculate expected output based on probability of different states of
the world – for given level of effort
Game theoretic model of moral hazard
More effort
(less utility)
P
contract
A
Less effort
Uncertainty for the principle
State of world
Good or bad?
(more utility)
Good or bad?
Output?
Output?
Agent/worker prefers less effort
Principle/employer prefers more effort – output generally, but not always higher
Principle never knows what the state of the world was/is or the agent’s effort
as there is no 1-2-1 relationship between action/effort and output.
Moral hazard
Output
Agent/worker prefers less effort
Principle/employer prefers more effort:
State of world
50
More effort
(less utility)
P
contract
A
Less effort
Uncertainty for the principle
Good
Expected output = pgood50 + pBad40
Bad
40
Good
40
(more utility)
Expected output = pgood40 + pBad20
Bad
With wage constant what effort level do you think the
agent/worker will choose? What would you do?
20
Game theoretic model of moral
hazard
Output
State of world
50
More effort
P
contract
A
Less effort
Uncertainty for the principle
Good
Bad
Good
40
40
Bad
Effort doesn’t map cleanly to output so agent has an
incentive to make less effort/ be careless but lie: say made an
effort but the state of the world was ‘bad’ e.g. agent was unlucky
that accident/mistake happened – especially if pBad is low
20
Possible solutions to moral hazard
•
Motivation/incentives for the agent to perform the action
that benefits the principle e.g.
–
Material incentives such as promotion, higher pay, a better job,
payment by result, piecework
Social norms
Reputation so that the transaction is repeated
Cost sharing and exclusions in insurance
–
–
–
•
But it may not be possible to contract for compliance e.g. so
that a person who takes out health insurance takes care of
their health, or a mechanic works hard all day etc. because
of :
1.
2.
•
measurement, monitoring issues and;
uncertainty means that even if the desired actions are taken
outcome is not certain
Maybe the agent won’t take the job?
Summary
• 2 main problems associated with
asymmetric information
– Adverse selection
• Detailed examples: second hand car markets, hiring
in labour markets, markets for health care
– Moral hazard
• Detailed examples: management employment
contracts, wage contracts, markets for health care