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Session 3 Review: Asymmetric
Information Adverse Selection
Economic concepts Adverse selection pertains to hidden characteristics, while
moral hazard pertains to hidden actions
When sellers have more information than buyers, surplus-generating trades may not occur
Akerlofs paper shows how a market can unravelcompletely because of adverse selection
Remedies
Examples Lemons x2
Cows
Credit scoring
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Adverse Selection Example: Cows in India
Farmers report easier to sell cows when
giving milk than when dry
Prospective buyers can: Test milk the animal
See that the animal can get pregnant
Prices are influenced
Differential between milking and dry cows is
smaller when theres a drought in sellers village
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Remedies for Adverse Selection
Market-based
Government
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Two Types of Asymmetric Information
Hidden fixed characteristics at the time ofcontracting; we call this adverse selection (lasttime) How good a driver are you?
How likely are you to stay healthy? How smart or hard-working are you?
Hidden actions following contracting; we call thismoral hazard (todays session) As CEO, are you going to seek long-term value or short-
term profits? As a sharecropper, are you going to work hard and
contribute complementary inputs?
Where do bureaucrats interests align?
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Asymmetric Information Moral Hazard
Economic concepts
Adverse selection pertains to hidden characteristics, while moralhazard pertains to hidden actions
In a principal-agent problem,
A conflict is present between the interests of the principal andthe interests of the agent;
Hidden actions by the agentor at least non-contractible actionscan prevent the action under the contract from being efficient;
Often the inefficiency arises because the principal wants to givethe agent incentives to perform, while the agent wants to be
insuredagainst losses Examples
CEO compensation
Bailouts
Bureaucrats
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Examples of Moral Hazard
i.e., principals and their respective agents
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A Canonical Model of Moral Hazard
Two people, a Principal P and an Agent A
A can contribute effort e or effort 0, or A can
drop out and receive u0.
Output equals 0 with probability 1 if effort is 0
Output equalsy with probability q if effort is e
Cost to A of contributing e is c
P can pay a wage w that depends on output butnot on effort
P chooses w(y) and w(0) to maximize expected
output minus expected wages
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Canonical Model, cont.
Ps profit: If effort = e:
If effort = 0:
As utility If effort = e:
If effort = 0:
Incentive compatibility: wages have tosuffice to motivate effort (incentives)
Individual rationality: wages have tosuffice to motivate participation (insurance)
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Canonical Model, cont.
IC:
P never wants to implement 0 effort, soignore IR0.
IC will always hold with equality
IRe:
IRe will always hold with equality, too
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Canonical Model, cont.
Substituting in,
If effort were contractible, P would pay a flatwage w to induce effort e; there would be noIC constraint; IR would be
Ifu is concave, its inverse is convex, sowages higher and profits lower under MH
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Market failure?
What ify is small, or u is very stronglyconcave?
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Canonical Model Comments
A dramatic oversimplification
Continuous effort choices, continuousoutcome possibilities
Many tasks
Repeated interactions (career concerns)
Reliance on others (teams)
Many ways to provide compensation Other preferences
Incentive problems for P, too
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Executive Compensation
Shareholders/Owners
Maximize Economic Performance
Board of Directors
Monitor Managers
Corporations Managers
Maximize personal benefits
Votes
Selects,
Delegates,Monitors
Accountable to
Accountable to
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Views of pay
Optimal contracting
Managerial power
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Facts
ExecuComp
7.89% of profits
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Facts
ExecuComp
7.89% of profits
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Facts
Average director compensation:
$152,626
(Enron: $380,000)
Perks
Reappointments, often on executive-drafted
slates
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Determinants of pay
Considerations (as discussed by Bebchuk and
Fried)
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Principal-Agent Problems and
Government
Prendergast, The Motivation and Bias of
Bureaucrats
What if bureaucrats care about their jobs?
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Three main results
Bureaucrats should be biased
Depending on the case, the optimal bias cango in either direction
Self-selection to bureaucracies is likely to bebifurcated
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Bailouts
What does it mean to be too big to fail?
Who is the principal, and who is the agent?
What is the desired solution?
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Limits to insurance
American companies are now failing at the rate of 500 a week.The wild cheering on the floor of the New York StockExchange and around the financial district last week did notspread much beyond Wall Street. Across the U.S. there is still
deepening gloom about the economy, and no single group ismore painfully aware of it than the beleaguered owners ofAmerican businesses. This year their ranks are being trimmedby bankruptcy faster than at any time since the Depression.I've long said that capitalism without bankruptcy is likeChristianity without hell. But it's hard to see any good news in
this.-- Chairman of Eastern Air Lines Frank Borman, 10/18/1982
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Bailouts in the future?
Our overriding goal in restructuring our financial architecture
should be that taxpayers never again have to save a failing
financial institution...
To address the moral hazard issue, the government needs
broad-based authority to liquidate any failing financialinstitution without going through the bankruptcy process,
which is not well-suited for such complex firms in the midst of
a financial crisis. We must send a clear signal to market
participants that whenever this process is put in motion, the
outcome is liquidation; we cannot leave any hope that wewould inject taxpayer dollars to preserve the failing firm in its
present form. Henry Paulson,NYTimes, 2/16/2010
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Summary
Economic concepts
Adverse selection pertains to hidden characteristics, while moralhazard pertains to hidden actions
In a principal-agent problem,
A conflict is present between the interests of the principal andthe interests of the agent;
Hidden actions by the agentor at least non-contractible actionscan prevent the action under the contract from being efficient;
Often the inefficiency arises because the principal wants to givethe agent incentives to perform, while the agent wants to be
insuredagainst losses Examples
CEO compensation
Bureaucrats
Bailouts