Markets with Asymmetric Information

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لحعجصمح() عا با ‎Vopios‏ ® Quatiy Ouvertaiaty ocd the Market Por Lewous © Darket Giglio 1" Qord Wazad # Dke Pricmipd-Oyeut Problew 0۳ Oke S 

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‎Ouwertatciy‏ ریت6 ‎ced the Oorket Por Lewous‏ ‎& OD ke tock oP powplete inPoratiod Wwheo purchesiog a used var ‏هو‎ the risk oP the purchase ued lowers the volue oP the ‎pur. ‎0۳ Oke S ‎ 

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‎Ouwertatciy‏ ریت6 ‎ced the Oorket Por Lewous‏ ‎# Dke Ourket Por Osed Ours ‏یبن و‎ ‎* Owers und sellers con ‏معا انس‎ * DRere wil be tu warkets ‎0۳ Oke Oo ‎ 

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‎Ouwertatciy‏ ریت6 ‎ced the Oorket Por Lewous‏ ‎® Dke Darket Por Osed Cars © Dik ase ‏ماه‎ ‎* bow quoliy yoods drive high qualiy yoods cut oP the: worket. ‏صقي وص لمم صا جات" ‎Dke worket hos‏ ¢ ملس سس ‎٠ ‏وی ایکا تن ما له تما روم رو‎ ore vo the worket. ‎* Odverse seleviva voours; the vdly cars vo the wwarket will be low quelli cars. ‎0۳ Oke O ‎ 

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‘keopioatiogs DP Ospwwetric ٩۱۳۵ ‏>صادم‎ Dke Oorket Por ‏نج‎ مها ‎Oedicd‏ © مین و او وا و و ارام رز اه ‎kokters?‏ تام که ‎high wed low‏ © ‏حك‎ valy high risk people wil purckuse fesurcee. ° Odverse seleviiva would woke wedicdl icsurcace ۱ ‏.صاجاها"‎ 0۳ Oke SO 

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‘keopioatiogs DP Ospwwetric ٩۱۳۵ ‏>صادم‎ Dke Oorket Por ‏نج‎ © Dupwobile ‏نها‎ ‎© Quesiivas له ماو( مر و و ‎Oko‏ * امه و نج مه عم ‎adverse seleviiva‏ سس له امه و ‎delivery‏ * Wow ooo the yovernved reduce the part oP verse seleviiva to the ‏سح‎ iedusiqy? ۵ 0 

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‘keopioatiogs DP Ospwwetric ٩۱۳۵ ‏>صادم‎ ‎Darket Por Oreecht‏ دوا ا" ‎® Osixewetric iePorwatiod predies the potectict that oly high risk borrowers wil seek Iroc. ® Quesiiva Low oon credit histones kelp woke this oP credit? ‎0۳ Olde 0 ‎ 

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‘koplicaioas oP Osyxowetic IPorwatior ‎oP Reputativa ord‏ وا ‎D he‏ الا ‎Grocdardizaticc‏ ‏اع۵() راهظ) له مها ‎ic‏ ۰ ‎Oevisives‏ ‎Retal sues‏ * ‎@utiques, ut, rare voice‏ * ‎owe repos‏ ‎* Restaurcats ‎ 

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م۳٩‏ رسمجمرو) ان بش۳ نت ° Waw oon these producers provide high-cuetiy ypods Wwheo uspowetic iePorcvatiza wil ‏شيل‎ ‎put kigh-qualiy yoods through adverse selection. © Ouswer * Reputation 

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‘keopioatiogs DP Ospwwetric ٩۱۳۵ ‏>صادم‎ ® Qvuestivd © Ohy de pou book Porward ty o Big Dar wheo traveliog eved though pou would cever pousider bupiegy poe ot howe. a Lolita oo poe advertised “Ov Gurprises” to address the issue ve adverse selection. 

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‎to Qupr Lea Ousebull‏ مورا ‎" Ospwwetc iPorwative ond the warket Por Pree uyeuts ‏اون رنه‎ exists, Pree ayeuts should ‎voutrarts. ‎ 

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)و۳۱ Days Oped oa Osubled List ‏جوم‎ 622+ ‎ee‏ یت سم اله 99۰ 99 همع ‎Ol Pkyers‏ ‎Reewedpaes &.7O 9.60 09‏ ‎Grae P.O? 47.698 9889‏ ‎۵» ‎ 

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‎to Qupr Lea Ousebull‏ مورا ‎# Picdicgs © Oups on the disubled bist iaoreuse Por bots Pree ‏کال ‎ee eed (tee‏ پیج ه ‏.اعكاوكه اد رل و ‏ع0 عبت 0۳ ‎ 

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‎to Qupr Lea Ousebull‏ مورا ‎® Qvuestivd ‎© ‏خإك‎ pou we veo pwr, Wht steps would pou take to reduce the uspuwetio ‏وس‎ ‎Por Pree ugeuts? ‎0۳ ۵۷» 0 ‎ 

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racket Giccraicry 0 171717255 to ‏جود‎ ‏له هیا ما مسا رورم‎ the ۱۲ oF oe ۳ ‏ا‎ | ‏از دقاف نز‎ wit ded ۱ 

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م6 ۲۵۱( اس رمسرن) ط ‎woust be easier Por‏ ۱ ‎high qualiy seers to que thee buy quot‏ ‎sellers.‏ ‎Exanple‏ و ‎productive workers sigcral wit‏ زرا 0۳ ۵ 60 

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م6 ۲۵۱( ۶ ) 6: ‏امین اعو() واصل خن اع()‎ © ‏ین‎ ‎* Pu ‏تحص‎ oP workers © Brow 1: Low procuciviy-PP & DP = ) © Brow M1: Wick prockucivip--PP & DP =O © Dhe workers ore equally ‏+جوسفوطا لت‎ Group 1 ord Group M1--@P Por oll workers Sas 0۳ Oke Od 

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م6 ۲۵۱( بنامی‌ن) اعطنو() ماصل خن اصله() عاممن) ) ۶ ین »© * Cowpritive Product Darket ۰ P= $10,000 ۰ ‏موه ربق‎ 10 pews oP ewer © Crap 1 Revene = $UOO, OOO ((0,OOVh,r. x qo) © Crap M1 Reveme = $800,000 (CO,OOVhr. X do) 0۳ 60-66 

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م6 ۲۵۱( © Oi Complete ‏مساو‎ ‏ره‎ - © Grow Iuxe = $40,000hr. ‏و‎ Grow Mwape = $60,000/r. @ Oi ‏ساكو ۱ تاو موم رو)‎ Pw = were productivity ® Gow 1& M wage = $46,000 وه ی 0۳ 

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م6 ۲۵۱( a Gicyeraterey Oi Educative to Reduce Osuwwwetriz “| ‏>كصنام ص رو أل‎ ‎educative index (Years oP higher edurctioc)‏ = ره مر ‎educative bevel‏ رجات تن بسن ع) و ‎Group 1--O,(v) 2 00,7‏ © ‎© Brow M--O,(v) = $20, OOO, ‎0۳ Obde OF ‎ 

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م6 ۲۵۱( ۰ Gicporatery Oi Educative to Reduce Osuwwwetria 4dePornvativs ® Ossuve educaive does oot oreo pooductivity © Decision (Rute: 9A sips By, vod wage = $80,000 مس امه 6 عوهت ‎Deb‏ * 900,00 0۳ Obte OS 

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۲ 9۳۹ 9 090 ped cece oe 3 ‏وه‎ Optard cho oP 4 7 ‏مه بر‎ v ‏مه جنر‎ 2 

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0 جیسب ل ۵ 1 سسا سورت 3 اا oO 

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Gicgerticry ® Ovsi/Pevehit Coswperisva © Devisiog nile works P pis between CO. urd 38 oP f= e * Brow 1 would chovse a svkool * Brow 11 would choose p* * Rule discriwicates vorrevily 0۳ Oke CO 

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Gicgerticry ® Gducaive does oreuse procuntivity ord provides « use signal about iccivichual work kabits. 0۳ Obte SS 

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م6 ۲۵۱( 1" ‏امه( له نون(‎ ۶ ‏ار را‎ n © GPPRevive devisiva tool becouse the vost oP ‏صا جصناج وس مستا‎ boww-cualiy producers is tow highs 

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Oord Wuzard © Detercoinicny the Prewiue Por Cire ها ,0000 مر ان( و ‎a Pine:‏ ان لاد و ۰ 009 ‏وا‎ 990 Pire prevestion ۳۳۹ رس وا نیزر 6( + 9 ی 0۳ 

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Oord Wuzard © Oetercoiciegy the Prewiucn Por Pire Iesucnne © (ik the progres the prewiu is! * OOS x $100 ,OOO = $600 © Owe fosured pwoers purchase the fosurcae, the vues 1 pager hove oo fooeive to roo the proyrau, therePore the probubiliy oP loss is Od © $SOO prewine wil ‏صا لمجا‎ a lee bevouse the expevied bee is wt $1,000 (.00 x $400,000) 0۳ Obde OE 

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Redwicy Dord Wazard —Ooruntes oP ‏دم‎ Weal: ® Goer © Livestock buyers weet disease Pree ocd. ® Osxewetnc iPorcwolive exists © Dany states require wornties © Qwers od sellers ow pager hove oo iweciive to [0 (oer ® Qvesiva © Wow con this word hazard be reduced? 0۳ ‏ی‎ SO 

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Crisis ‏با‎ the Gaviegpe ood Dood Tecusiry ® Qvuestivd © Wow wey people kaow the Piccastd strech oP their booth? © Oky wi? © Deposit incurs, word hazard, ued Poiures ia the G&D iochustqy 0۳ Ore 0 

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Crisis ‏با‎ the Gaviegpe ood Dood Tecusiry © Cost of the G&L Bullous ©» 000+ ‏شش لسله۲‎ ۰ 3000 ‏مسا‎ )190( © Dexas dice--$PE btioa (1990) © Ogeay expetiures-$10O witos (1990) ® Qvuesiva © Yow con this word hazed be reduced? 0۳ Ore SO 

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Dee Pricvipa--@Bxeut Problew ® Oyewy Rettivashizy © Ove person's welPare depeods vo wht wovther persou does ® Oyen © Person who us # Priwipdl ‏مین و‎ whoww the unica ePPevts 9 ی 0۳ 

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Dee Pricvipa--@Bxeut Problew ® Oowpouy oweers we priuipus. © QDorkers ued wernnpers ue upeuts. © Owrers do wt hw cow plete ‏.ع ار‎ © Gwplovers way pursue their pw yous 0۳۷ ۵ FO 

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Dee Pricvipa--@Bxeut Problew © Dke @ricvipd--Oyeut robles ia Private Cuterprises 5 ‏باون‎ do oP doo ‏سكماك مامت امه‎ koe ‏مور‎ ID%. © Dost barge Pires ore ‏برط لام‎ Wanye weut. ® Ovsiorieg worngewedt is costly ‏جاعم مكرجه)‎ ۳۳ io). 0۳ 9 0 

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Dee Pricvipa--@Bxeut Problew ® Dke @ricmipd--@Oceut Problew ta Private Cuterprises © Mocners way pursue their pw vbievives. * Growts * Dil Prooa job لب 0۳ 

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Dee Pricvipa--@Bxeut Problew # Dke Pricwipdl--Oyeut Probes io Private Cuterprises CS) ee 7” ‏ل‎ ‎vbjevive ‏وه اه‎ * Gtockkollers co ‏اه‎ weoorners ¢ Daokevver ultecopis * Darket Por woonyers who ‏موه‎ ‎9 0۳ Obde PS 

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Dee Pricvipa--@Bxeut Problew ‎The Pricvipd--Oyeut Problew ia Public‏ ا" ‎Cuterprises‏ ‎Observations‏ ® ‎*Ounners’ yous way deviate Pro the‏ ‎Oversitht is dP Pict (uspereretriz‏ * ‎PS tox)‏ ‎Market Porces ore fockiesy‏ * ‏© ی 0۳ ‎ 

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Dee Pricvipa--@Bxeut Problew ® Dke Pricvipat--Oyedt Problew io Public Coterprises © ‏نا مرا‎ Oucagewed (Power * Ooungers choose uv public service posiios * Oocagertal job worket * Levistiive ond ageury ‏هه‎ (BBO & OM®) ۰ ‏وه روت مرن‎ 0۳ Obde PS 

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The Oucagers ‏عام‎ " re wou prot oreizatios wore or bess EP Riciest that Por-proPit Pies? © PCS hospitals Prow IP hospital choices © Returg vo westedt (RO1) ood werage vet ‏رم‎ 0۳ Obde FO 

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The Oucagers ‏عام‎ Retura Ou ‏مزونه‎ ‎1972۶ 0 Por-ProPit 40.056 ۰ ۸۵ OvupreFit 0.0% cn a ع دی 0۳ 

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The Oucagers ‏عام‎ ۰ OPter udiustiog Por diPPereuves ist BEYVIDES. © OC/patieut day ic waprvPits is O% ‏وب‎ ‏مرن و‎ * PvP it ‏رز سر‎ perPornoe © Cost ond bevetits oP subsiciziagy ‏توص‎ 0۳ Ore FO 

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The Oucagers ‏عام‎ 8 dopedtives in the Provipo+-@Oyed )] ‏علج صوصب‎ © Designing 0 reward systes to dign the priccizd cod ogedt’s ‏ا ا‎ * Oaick woouPacturer ® Oses babor ond warkicery *¢ Owvers ud is to worxiwize probit * Ouchive ‏تاداع داد موی محر‎ oF wackices cod proPits 0۳ Obde FO 

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Dee Pricvipa--@Bxeut Problew 9 opedtves in the Pricipd-Oyeut Precvework © Oesiqatey a reward syste to dla the priavizal ord ‏امه مساو و ارت‎ * Revecue dso depeads, io pod, vo the ‏خا بلس‎ igh ‏وه اس رات‎ it diPPicul to ussess the nepui-person’s work 0۳ ۵» 0 

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Dee Pricvipa--@Bxeut Problew 1" dopedives in the Priovipo-Oqyedt Prawework © Designing 0 reward systes to dign the priccizd cod ogedt’s ‏امه وولو‎ ۰ ‏کت اه کشت وت موه مسق‎ or low ePPort ا م ‎eee ee)‏ * Ouwrers ‏مومس وی‎ o high or bow ePPort whe revenue = $20,000 0۳ Obte SO 

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Dee Pricvipa--@Bxeut Problew 1" dopedives in the Priovipo-Oqyedt Prawework © Designing 0 reward systes to dign the priccizd cod ogedt’s ‏امه وولو‎ * Qeparpersod ‏من نموت وا لس‎ vet oP post * Ovst = O Por fw ef Pot «+ ‏ون‎ = $00, OOO Por high ePPort * UAR) = reparpersos woe based oly vo mult 0۳ Obte SO 

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The Priccipd-Oryedt Problew ‎Pricwipal-@yeut (Pracvewors‏ نا رسب "ا ‎Chovsieny 0 Ou‏ © ‎*w =O; =O; R =$1S,000‏ ‎*R= $10,000 w $S0,000, w =O‏ ‎*R =$FO,O00; w =$EF OOO © R =$90,000; Profi = $19,000 © Ort wae = $C,000 ‏ی 0۳ ‎ 

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Dee Pricvipa--@Bxeut Problew 9 opedtves in the Pricipd-Oyeut Precvework ©» Choosing ‏ه‎ Duce *w =R- $10,000 * Ort wae = $2,000 © Wick ePPort 0۳ Obte SS 

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Dee Pricvipa--@Bxeut Problew ® Couhusion © apeaive structure thot rewards the vuloowe oF high levels oP ePPont coo induce oyeuts to vic7 Por the yous set by the priuvipals. 0۳ Obte SO 

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Dee Pricvipa--@Bxeut Problew ® Ospwwetic ‏جوا له ماه‎ Ocvsiqe ia the Toteyroted irc 0 41a integrated Pins, ‏موی مزر‎ kuave better (geyerwetriv) iPorwotive about productive thot ‏ویر موی اهر‎ 0۳ Ore SP 

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Dee Pricvipa--@Bxeut Problew ® Ospwwetic ‏جوا له ماه‎ Ocvsiqe ia the Toteyroted irc ‏ره‎ ‎Wow coo ‏هسحصه از مومت ی‎ ‌ Wow coo peor woongeweut ‏ای ریت‎ 0۳ Ore SO 

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Dee Pricvipa--@Bxeut Problew © Possible Ieveutive Plas © @oos bused va putput pr proPit © ill this plore provide oe iaediive Por ‏نحص‎ ‏و‎ 0-0 0۳ Obte SO 

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Dee Pricvipa--@Bxeut Problew © Possible Iaceuive (Places © @oous based va how close the wacagers yet tv their Porevusts oP ‏ام اوه نون‎ * Q, = estate oP Peusible production bevel * @ = bows ta ‏وا‎ ‎* Q= utd pulp * P= 10,000 - .S(Q, - G) ‏وی نا رشب و‎ Gp 0۳ ۵» 0 

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Dee Pricvipa--@Bxeut Problew © Possible Ieveutive Plas ‏و‎ Ooo stil fed to wruragy oF Porevest oF Q> Qi 3@ = OQ, + .O(Q- Q)) ۰ 0 > 0,0 = OQ, --S(Gp- Q) 0۳ Oke Od 

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Coane (Srr| |" @,=00,000, = ‏تس‎ eS one Z ۰6, 22,0 ¢ ‏اه کم هگ‎ Q, =80,000 1۳۹,260,000, 7 2” 6, 20 ‏سم‎ ۲ 0 zg io 7 0,000 4,75 ‏و‎ 2 8,000 c ‏م‎ ‎000 7 900 نوين ‎W000 80,000 90,000 F0,000 _(neprier)‏ © 0۳ 605-68 

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Ospwwetric IePorwativd to bobor Durkets: 8 40 po wpetiive bor warket, of who Wisk ‏صا‎ work will Pied jobs Por a wage equ to ® Wowever, wost ponines’ exposes pxperieuce woewplopwed. ی 0۳ 

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Ospwwetric IePorwativd to bobor Durkets: © OD he ‏روز‎ ware theory om expla the preseuve oP ucewplopwedt cod woe ‏اه‎ ‎© da develppingy ‏وج لصو شش ره‎ 0۳ Obde OF 

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Gud oP Chapter ۳ جصلدو روخان ]|2 

Chapter 17 Markets with Asymmetric Information Topics to be Discussed  Quality Uncertainty and the Market for Lemons  Market Signaling  Moral Hazard  The Principal-Agent Problem Chapter 17 Slide 2 Topics to be Discussed  Managerial Incentives in an Integrated Firm  Asymmetric Information in Labor Markets: Efficiency Wage Theory Chapter 17 Slide 3 Introduction  We will study how imperfect information influences resource allocation and the price system. Chapter 17 Slide 4 Quality Uncertainty and the Market for Lemons  The lack of complete information when purchasing a used car increases the risk of the purchase and lowers the value of the car. Chapter 17 Slide 5 Quality Uncertainty and the Market for Lemons  The Market for Used Cars  Assume Chapter 17  Buyers and sellers can distinguish between high and low quality cars  There will be two markets Slide 6 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 Quality Uncertainty and the Market for Lemons  The Market for Used Cars  With Chapter 17 asymmetric information:  Low quality goods drive high quality goods out of the market.  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. Slide 8 Implications of Asymmetric Information The The Market Market for for Insurance Insurance  Medical Insurance  Question 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. Chapter 17 Slide 9 Implications of Asymmetric Information The The Market Market for for Insurance Insurance  Automobile Insurance  Questions Chapter 17  What impact does asymmetric information and adverse selection have on insurance rates and the delivery of automobile accident insurance?  How can the government reduce the impact of adverse selection in the insurance industry? Slide 10 Implications of Asymmetric Information  The Market for Credit  Asymmetric information creates the potential that only high risk borrowers will seek loans.  Question How can credit histories help make this market more efficient and reduce the cost of credit? Chapter 17 Slide 11 Implications of Asymmetric Information  The Importance of Reputation and Standardization  Asymmetric Decisions Chapter 17 Information and Daily Market  Retail sales  Antiques, art, rare coins  Home repairs  Restaurants Slide 12 Implications of Asymmetric Information  Question  How can these producers provide high-quality goods when asymmetric information will drive out high-quality goods through adverse selection.  Answer  Chapter 17 Reputation Slide 13 Implications of Asymmetric Information  Question  Why do you look forward to a Big Mac when traveling even though you would never consider buying one at home.  Holiday Inn once advertised “No Surprises” to address the issue of adverse selection. Chapter 17 Slide 14 Lemons in Major League Baseball  Asymmetric information and the market for free agents  If a lemons market exists, free agents should be less reliable (disabled) than renewed contracts. Chapter 17 Slide 15 Player Disability Days Spent on Disabled List per Season Precontract Postcontract Percentage Change All Players 4.73 12.55 165.4 Renewed players 4.76 9.68 103.4 Free agents 4.67 17.23 268.9 Chapter 17 Slide 16 Lemons in Major League Baseball  Findings  Days on the disabled list increase for both free agents and renewed players.  Free agents have a significantly higher disability rate than renewed players.  This Chapter 17 indicates a lemons market. Slide 17 Lemons in Major League Baseball  Question  If you are a team owner, what steps would you take to reduce the asymmetric information for free agents? Chapter 17 Slide 18 Market Signaling  The process of sellers using signals to convey information to buyers about the product’s quality helps buyers and sellers deal with asymmetric information. Chapter 17 Slide 19 Market Signaling  Strong Signal  To be effective, a signal must be easier for high quality sellers to give than low quality sellers.  Example  Chapter 17 Highly productive workers signal with educational attainment level. Slide 20 Market Signaling  A Simple Model of Job Market Signaling  Assume  Two groups of workers I: Low productivity--AP & MP = 1 Group II: High productivity--AP & MP = 2 The workers are equally divided between Group I and Group II--AP for all workers = 1.5 Group Chapter 17 Slide 21 Market Signaling  A Simple Model of Job Market Signaling  Assume  Competitive Product Market P = $10,000  Employees average 10 years of employment  Group I Revenue = $100,000 (10,000/yr. x 10)  Group II Revenue = $200,000 (20,000/yr. X 10) Chapter 17 Slide 22 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 Chapter 17 I & II wage = $15,000 Slide 23 Market Signaling  Signaling With Education to Reduce Asymmetric Information 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 Slide 24 Market Signaling  Signaling With Education to Reduce Asymmetric Information  Assume education does not increase productivity  Decision Chapter 17 Rule:  y* signals GII and wage = $20,000  Below y* signals GI and wage = $10,000 Slide 25 Signaling B(y) = increase in wage associated with each level of education Value of College Educ. Value of College Educ. Group I $200K The education decision is based on benefits/cost comparison. How much education should a person obtain? Group II $200K CI(y) = $40,000y $100K CII(y) = $20,000y $100K B(y) 0 1 2 3 Optimal choice of y for Group I 4 y* 5 6 B(y) Years of College 0 1 2 Optimal choice of y for Group I 3 4 y* 5 6 Years of College Signaling •Benefits = $100,000 •Cost •CI(y) = 40,000y •$100,000<$40,000y* •y* > 2.5 •Choose no education Value of College Educ. $200K •Benefits = $100,000 •Cost •CII(yO)= 20,000y •$100,000<$20,000y* •y* < 5 •Choose y* Value of College Educ. $200K CI(y) = $40,000y $100K CII(y) = $20,000y $100K B(y) 0 1 2 3 Optimal choice of y for Group I 4 y* 5 6 B(y) Years of College 0 1 2 Optimal choice of y for Group I 3 4 y* 5 6 Years of College Signaling  Cost/Benefit Comparison  Decision rule works if y* is between 2.5 and 5  If Chapter 17 y* = 4  Group I would choose no school  Group II would choose y*  Rule discriminates correctly Slide 28 Signaling  Education does increase productivity and provides a useful signal about individual work habits. Chapter 17 Slide 29 Working into the Night  Question How can you signal to your employer you are more productive? Chapter 17 Slide 30 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 Slide 31 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. Chapter 17 Slide 32 Moral Hazard  Determining the Premium for Fire Insurance  Warehouse  Probability   Chapter 17 worth $100,000 of a fire: .005 with a $50 fire prevention program .01 without the program Slide 33 Moral Hazard  Determining the Premium for Fire Insurance  With  the program the premium is: .005 x $100,000 = $500  Once insured owners purchase the insurance, the owners no longer have an incentive to run the program, therefore the probability of loss is .01  $500 premium will lead to a loss because the expected loss is not $1,000 (.01 x $100,000) Chapter 17 Slide 34 The Effects of Moral Hazard MC is the marginal cost of driving. With no moral hazard and assuming insurance companies can measure miles driven MC = MB at $1.50 and 100 miles/week--efficient allocation. Cost per Mile With moral hazard insurance companies cannot measure mileage. MC to $1.00 and miles driven increases to 140 miles/week--inefficient allocation. $2.00 $1.50 MC $1.00 MC’ $0.50 D = MB 0 Chapter 17 50 100 140 Miles per Week Slide 35 Reducing Moral Hazard --Warranties of Animal Health  Scenario  Livestock buyers want disease free animals.  Asymmetric  Many information exists states require warranties  Buyers and sellers no longer have an incentive to reduce disease (moral hazard).  Question  How Chapter 17 can this moral hazard be reduced? Slide 36 Crisis in the Savings and Loan Industry  Question  How many people know the financial strength of their bank?  Why not?  Deposit insurance, moral hazard, and failures in the S&L industry Chapter 17 Slide 37 Crisis in the Savings and Loan Industry  Cost of the S&L Bailout  1,000+  $200  Texas billion (1990) alone--$42 billion (1990)  Agency  failed institutions expenditures--$100 million (1990) Question  How Chapter 17 can this moral hazard be reduced? Slide 38 The Principal--Agent Problem  Agency Relationship  One person’s welfare depends on what another person does  Agent  Person  who acts Principal  Person Chapter 17 whom the action effects Slide 39 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 and reduce profits. Chapter 17 Slide 40 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 Slide 41 The Principal--Agent Problem  The Principal--Agent Problem in Private Enterprises  Managers Chapter 17 may pursue their own objectives.  Growth  Utility from job Slide 42 The Principal--Agent Problem  The Principal--Agent Problem in Private Enterprises  Limitations to managers’ ability to deviate from objective of owners Chapter 17  Stockholders can oust managers  Takeover attempts  Market for managers who maximize profits Slide 43 The Principal--Agent Problem  The Principal--Agent Problem in Public Enterprises  Observations Chapter 17  Managers’ goals may deviate from the agencies goal (size)  Oversight is difficult (asymmetric information)  Market forces are lacking Slide 44 The Principal--Agent Problem  The Principal--Agent Problem in Public Enterprises  Limitations Chapter 17 to Management Power  Managers choose a public service position  Managerial job market  Legislative and agency oversight (GAO & OMB)  Competition among agencies Slide 45 The Managers of Nonprofit Hospitals as Agents  Are non profit organizations more or less efficient that for-profit firms?  725 hospitals from 14 hospital chains  Return on investment (ROI) and average cost (AC) measured Chapter 17 Slide 46 The Managers of Nonprofit Hospitals as Agents Return On Investment 1977 1981 For-Profit 11.6% 12.7% Nonprofit 8.8% 7.4% Chapter 17 Slide 47 The Managers of Nonprofit Hospitals as Agents  After adjusting for differences in services:  AC/patient than profits day in nonprofits is 8% greater  Conclusion  Profit incentive impacts performance  Cost and benefits of subsidizing nonprofits must be considered. Chapter 17 Slide 48 The Managers of Nonprofit Hospitals as Agents  Incentives in the Principal-Agent Framework  Designing a reward system to align the principal and agent’s goals--an example Chapter 17  Watch manufacturer  Uses labor and machinery  Owners goal is to maximize profit  Machine repairperson can influence reliability of machines and profits Slide 49 The Principal--Agent Problem  Incentives in the Principal-Agent Framework  Designing a reward system to align the principal and agent’s goals--an example Chapter 17  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 Slide 50 The Revenue from Making Watches Poor Luck Good Luck Low effort (a = 0) $10,000$20,000 High effort (a = 1)$20,000$40,000 Chapter 17 Slide 51 The Principal--Agent Problem  Incentives in the Principal-Agent Framework  Designing a reward system to align the principal and agent’s goals--an example Chapter 17  Repairperson can work with either high or low effort  Revenues depend on effort relative to the other events (poor or good luck)  Owners cannot determine a high or low effort when revenue = $20,000 Slide 52 The Principal--Agent Problem  Incentives in the Principal-Agent Framework  Designing a reward system to align the principal and agent’s goals--an example Chapter 17  Repairperson’s goal is to maximize wage net of cost  Cost = 0 for low effort  Cost = $10,000 for high effort  w(R) = repairperson wage based only on output Slide 53 The Principal--Agent Problem  Incentives in the Principal-Agent Framework  Choosing a Wage w = 0; a = 0; R = $15,000  R = $10,000 or $20,000, w = 0  R = $40,000; w = $24,000  R = $30,000; Profit = $18,000 Net wage = $2,000 Chapter 17 Slide 54 The Principal--Agent Problem  Incentives in the Principal-Agent Framework  Choosing  a Wage w = R - $18,000 Net wage = $2,000 High effort Chapter 17 Slide 55 The Principal--Agent Problem  Conclusion  Incentive structure that rewards the outcome of high levels of effort can induce agents to aim for the goals set by the principals. Chapter 17 Slide 56 The Principal--Agent Problem  Asymmetric Information and Incentive Design in the Integrated Firm  In integrated firms, division managers have better (asymmetric) information about production than central management Chapter 17 Slide 57 The Principal--Agent Problem  Asymmetric Information and Incentive Design in the Integrated Firm  Two Chapter 17 Issues  How can central management illicit accurate information  How can central management achieve efficient divisional production Slide 58 The Principal--Agent Problem  Possible Incentive Plans  Bonus  Chapter 17 based on output or profit Will this plan provide an incentive for accurate information? Slide 59 The Principal--Agent Problem  Possible Incentive Plans  Bonus based on how close the managers get to their forecasts of output and profits  Qf = estimate of feasible production level  B = bonus in dollars  Q = actual output  B = 10,000 - .5(Qf - Q)  Incentive Chapter 17 to underestimate Qf Slide 60 The Principal--Agent Problem  Possible Incentive Plans  Bonus Chapter 17 still tied to accuracy of forecast  If Q > Qf ;B = .3Qf + .2(Q - Qf)  If Q < Qf ;B = .3Qf - .5(Qf - Q) Slide 61 Incentive Design in an Integrated Firm Bonus ($ per year) 10,000 If Qf = 10,000, bonus is $5,000 Qf = 30,000 Qf = 20,000 If Qf = 20,000, bonus is $4,000 Qf = 10,000 8,000 6,000 If Qf = 30,000, bonus is $6,000, the maximum amount possible. 4,000 2,000 0 Chapter 17 10,000 20,000 30,000 40,000 Output (units per year) Slide 62 Asymmetric Information in Labor Markets: 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. Chapter 17 Slide 63 Asymmetric Information in Labor Markets: Efficiency Wage Theory  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. Chapter 17 Slide 64 Asymmetric Information in Labor Markets: Efficiency Wage Theory  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. Chapter 17 Slide 65 Unemployment in a Shirking 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 Chapter 17 L* Quantity of Labor Slide 66 Efficiency Wages at Ford Motor Company  Labor turnover at Ford 1913: 380% 1914: 1000% Chapter 17  Average pay = $2 - $3  Ford increased pay to $5 Slide 67 Efficiency Wages at Ford Motor Company  Results Productivity increased 51% Absenteeism had been halved Profitability rose from $30 million in 1914 to $60 million in 1916. Chapter 17 Slide 68 Summary  Asymmetric information creates a market failure in which bad products tend to drive good products out of the market.  Insurance markets frequently involve asymmetric information because the insuring party has better information about the risk involved than the insurance company. Chapter 17 Slide 69 Summary  Asymmetric information may make it costly for the owners of firms to monitor accurately the behavior of the firm’s manager.  Asymmetric information can explain why labor markets have substantial unemployment when some workers are actively seeking work. Chapter 17 Slide 70 End of Chapter 17 Markets with Asymmetric Information