chapter 17 markets with asymmetric information. ©2005 pearson education, inc. chapter 172...
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Chapter 17
Markets with Asymmetric Information
Chapter 17 2©2005 Pearson Education, Inc.
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 3©2005 Pearson Education, Inc.
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 4©2005 Pearson Education, Inc.
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 5©2005 Pearson Education, Inc.
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 6©2005 Pearson Education, Inc.
The Lemons Problem
PH PL
QH QL
SH
SL
DH
DL
5,000
50,00050,000
10,000
DL
Market price for high quality cars is $10,000
Market price for low quality cars is $5000
50,000 of each type are sold
Chapter 17 7©2005 Pearson Education, Inc.
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
8©2005 Pearson Education, Inc.
The Lemons Problem
PH PL
QH QL
SH
SL
DH
DL
5,000
50,00050,000
10,000
DL
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.
DM
25,000
7,500
75,000
7,500
DM
DLM
DLM
Chapter 17 9©2005 Pearson Education, Inc.
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 10©2005 Pearson Education, Inc.
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 11©2005 Pearson Education, Inc.
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 12©2005 Pearson Education, Inc.
Market for Insurance
A possible solution to this problem is to pool risks Health insurance – government takes on role
as with Medicare program 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 13©2005 Pearson Education, Inc.
Importance of Reputation and Standardization
Asymmetric Information and Daily Market Decisions Retail sales – return policies Antiques, art, rare coins – real or counterfeit Restaurants – kitchen status
Chapter 17 14©2005 Pearson Education, Inc.
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 Standardization
Chapter 17 15©2005 Pearson Education, Inc.
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 16©2005 Pearson Education, Inc.
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 17©2005 Pearson Education, Inc.
Market Signaling
Weak signal could be dressing wellStrong 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 18©2005 Pearson Education, Inc.
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 IIAverage Product for all workers = 1.5
Chapter 17 19©2005 Pearson Education, Inc.
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 20©2005 Pearson Education, Inc.
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 21©2005 Pearson Education, Inc.
Model of Job Market Signaling
If use signaling with education y = education index (years of higher
education) C = cost of attaining educational level y Group I CI(y) = $40,000y Group II CII(y) = $20,000y
Chapter 17 22©2005 Pearson Education, Inc.
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 23©2005 Pearson Education, Inc.
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 24©2005 Pearson Education, Inc.
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 25©2005 Pearson Education, Inc.
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 26©2005 Pearson Education, Inc.
Model of Job Market Signaling
There is no reason to 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 27©2005 Pearson Education, Inc.
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 28©2005 Pearson Education, Inc.
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
29©2005 Pearson Education, Inc.
Signaling
Value ofCollege
Educ.
$100K
Value ofCollege
Educ.
Years ofCollege
Years ofCollege
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
Optimal choice of y for Group II
Group IIGroup I
Optimal choice of y for Group I
Chapter 17 30©2005 Pearson Education, Inc.
Signaling
Education does increase productivity and provides a useful signal about individual work habits even if education does not change productivity.
Chapter 17 31©2005 Pearson Education, Inc.
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 32©2005 Pearson Education, Inc.
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 33©2005 Pearson Education, Inc.
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 34©2005 Pearson Education, Inc.
The Effects of Moral Hazard
Miles per Week
$0.50
50
Costper
Mile
$1.00
$1.50
$2.00
D = MB
MC’ (w/moral hazard)
With moral hazard insurance companies cannot
measure mileage. MC goes to$1.00 andmiles driven increases to 140
miles/week – Inefficient allocation.
140
MC (no moral hazard)
100
Chapter 17 35©2005 Pearson Education, Inc.
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 36©2005 Pearson Education, Inc.
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 37©2005 Pearson Education, Inc.
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 38©2005 Pearson Education, Inc.
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 39©2005 Pearson Education, Inc.
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 40©2005 Pearson Education, Inc.
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 41©2005 Pearson Education, Inc.
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 42©2005 Pearson Education, Inc.
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 43©2005 Pearson Education, Inc.
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 44©2005 Pearson Education, Inc.
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 45©2005 Pearson Education, Inc.
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