BSP1005 Lecture Notes 12 - Asymmetric Information

Semester II, AY2013-2014
NUS Business School

BSP1005 Managerial Economics
Lecture Note 12
ASYMMETRIC INFORMATION
By Jo Seung-Gyu
1
Outline
Introduction
Adverse Selection
Signaling and Screening
Introduction
Case of Auto Insurance
Job Market Signaling
Guarantees and Warranties
Other Signals
Moral Hazard
Introduction
Principal-Agent Problem
Compensation Scheme 1: Straight Wage
Compensation Scheme 2 Bonus Plan
Compensation Scheme 3; Revenue Sharing
asymmetric information Situation in which a buyer and a seller

possess different information about a transaction.
2
INTRODUCTON
Throughout most of our lectures thus far, we have assumed that all
the economic agents consumers, producers and governments
have perfect information about the economic environments that are
relevant for the choices they face. However, in many transactions,
one party may have better information than the other i.e. there may
be asymmetric information.
Transactions in markets with asymmetric information can
fundamentally alter how markets perform, yielding some type of
inefficiencies.
Example
Suppose a bum on the street approaches to you offering
Rolex watches for sale.
.
How much would you pay?

The amount you would like to pay it self-explains
why the watches must be all fakes
4
Introduction cont.
Two types of information asymmetry

(i)
Hidden Information (or Hidden Characteristics)

When one side of a transaction knows some characteristic of itself than the
other does not.
-
A bum at Orchard offering a golf jewelry for sale

Quality of used car
Health condition for life insurance
Driving habits for auto insurance
The potential inefficiency problem caused is called Adverse Selection.

(ii) Hidden Action
When one side of a transaction can take an action that affects the other side but
which the other side cannot directly observe.
-
Driving less carefully once insured

Auto repairman asks you who pays for the job
Tenured professors are poor in research
The potential inefficiency problem caused is called Moral Hazard.

5
Outline
Introduction
Adverse Selection
Introduction
Other Signals
Moral Hazard
Introduction
Adverse selection refers to a situation where a selection process

under asymmetric information results in a pool of individuals with
economically undesirable characteristics.
6
ADVERSE SELECTION
Introduction: a street bum selling Rolex watches
Recall the Orchard bum who was eager to sell you

the watch at, say, $200.
Ever wary, you voice some doubt about its genuineness.
The bum responds by throwing in a gold ring and offers
the package for $100.
Seeing this, you would be like, No, thank you.
You think, at that price they couldnt possibly be real
gold.
The fact that the bum was so eager to sell the Rolex
at such a low price is a sure indicator that the jewelry
was fake.
7
Introduction-cont.
Now, suppose there was a bum who had a windfall of

picking a genuine Rolex. Excited, he wants to sell it on
the street.
He would let it go at $1,000, a real good bargain. Yet no
one would show interest. It is a real Rolex! Yet you wont
even buy it at one hundredth of the price. Knowing this,
the bum wont even try to sell it and instead carries it
around.
Result? No genuine Rolex on the street at all!
The key feature is that one side the bum had the information
on watch while the other side you did not. And as a result,
Bad products drive out good products!
Such phenomenon is called Adverse Selection.
8
Introduction-cont.
Adverse selection refers to a situation where a selection process under

asymmetric information structure in this asymmetric information
structure, characteristics or types of the informed side are hidden, not
actions results in a pool of individuals with economically undesirable
characteristics.
It is sometimes called a lemon problem, called after the original paper
The market for lemons by George Akerlof who first addressed the issue
The Market for Lemons (Case of Used Cars)
Introduction cont.
George Akerlof, The market for Lemons: Quality Uncertainty

and the Market Mechanism, Quarterly Journal of Economics,
84, pp 488-500.
Suppose two kinds of used cars are availablehigh-quality cars and lowquality cars. Also suppose that both sellers and buyers can tell which kind of
car is which. There will then be two markets.
In reality, the seller of a used car knows much more about its quality than a
buyer does. (Buyers discover the quality only after they buy a car and drive
it for a while.)
When making a purchase, buyers therefore view all cars as medium
quality, in the sense that there is an equal chance of getting a high-quality
or a low-quality car. However, fewer high-quality cars and more low-quality
cars will now be sold.
As consumers begin to realize that most cars sold (about three-fourths of
the total) are low quality, their perceived demand shifts. This shifting
continues until only low-quality cars are sold.
10
Introduction-cont.
Left: The demand curve for high-quality cars is DH. However, as buyers lower their
expectations about the average quality of cars on the market, their perceived demand shifts
to DM.
Right: The perceived demand curve for low-quality cars shifts from DL to DM. As a result, the
quantity of high-quality cars sold falls from 50,000 to 25,000, and the quantity of low-quality
cars sold increases from 50,000 to 75,000.Eventually, only low quality cars are sold.
11
Introduction cont.
The Market for Credit

How can a credit card company or bank distinguish high-quality borrowers (who
pay their debts) from low-quality borrowers (who dont)? Clearly, borrowers have
better informationi.e., they know more about whether they will pay than the
lender does.
Again, the lemons problem arises. Low-quality borrowers are more likely than highquality borrowers to want credit, which forces the interest rate up, which increases
the number of low-quality borrowers, which forces the interest rate up further, and so
on.
In fact, credit card companies and banks can, to some extent, use computerized
credit histories, which they often share with one another, to distinguish low-quality
from high-quality borrowers. Many people, however, think that computerized credit
histories invade their privacy. Should companies be allowed to keep these credit
histories and share them with other lenders?
We cant answer this question for you, but we can point out that credit Histories
perform an important function: They eliminate, or at least greatly reduce, the
problem of asymmetric information and adverse selectiona problem that might
otherwise prevent credit markets from operating. Without these histories, even the
creditworthy would find it extremely costly to borrow money.
12
The Market for Health Insurance
Introduction cont.
People who buy insurance know much more about their general health than any
insurance company. As a result, adverse selection arises, much as it does in the
market for used cars.
Because unhealthy people are more likely to want insurance, the proportion of
unhealthy people in the pool of insured people increases. This forces the price of
insurance to rise, so that more healthy people, aware of their low risks, elect not to
be insured. This further increases the proportion of unhealthy people among the
insured, thus forcing the price of insurance up more. The process continues until
most people who want to buy insurance are unhealthy.
At that point, insurance becomes very expensive, orin the extremeinsurance

companies stop selling the insurance.
One solution to the problem of adverse selection is to pool risks.
For health insurance, the government might take on this role, as it does with the
Medicare program. By providing insurance for all people over age 65, the
government eliminates the problem of adverse selection.
Likewise, insurance companies offer group health insurance policies at places of

employment. By covering all workers in a firm, whether healthy or sick, the
insurance company spreads risks and thereby reduces the likelihood that large
numbers of high-risk individuals will purchase insurance.
13
Introduction cont.
Think from the Reading (More Sex is Safer Sex)

Promiscuity vs Self-restraint:
Which one is more sinful for the epidemic of AIDS?
Two types of patrons in a club:

the high-risky & the low-risky
Public campaign for self-constraining
would affect the low-risky more than the high-risky
Thus, public campaign should induce the low-risky to be more active.
Examples?
14
Outline
Introduction
Adverse Selection

Introduction
Case of Auto Insurance Screening

Other Signals
Moral Hazard
Introduction
15
SIGNALING AND SCREENING
The informed side may want to send a signal about his/her own type, and
when it is believed to be credible such signal can resolve the adverse selection
problem(Signaling). Typical examples are guarantees or warranties.
The uninformed side may also provide an appropriate incentive scheme which
should be clever enough so that the informed side reveals true types
(Screening). Typical examples are different insurance premium based on
something observable, like no-accident discount.
Signaling and screening usually not necessarily coexist.
16
Signaling and Screening cont.
Screening: Case of Auto Insurance

If insurance company cant distinguish good drivers and lousy drivers, it will have
to base premium on the average experience. Then those with low risk will choose
not to insure, raising the accident probability of the pool and rates. Lousy drivers
drive out good drivers and adverse Selection problem may occur again.
Possible solutions? Compare the following two policies:
Policy A: This policy has a very high initial premium, but if the purchaser does not
have accidents the premium will drop substantially in subsequent years. If
the policyholder does have an accident, the premium will remain very high.
Policy B: This policy is priced lower than policy A, but regardless of whether or not
policyholder has accidents, the premium will not fall.
Good drivers would prefer A while lousy drivers would prefer B. The smart policy
design can help the drivers self-select.
17
Outline
Introduction
Adverse Selection
Introduction

Other Signals
Moral Hazard
Introduction
18
Signaling in Job Markets

Michael A Spence , Job Market Signaling, Quarterly Journal of Economics, 87, pp.
355-374.
When you hire/interview employee, you are not sure about their true ability.
Potential adverse selection risk exists.
Dressing well for the job interview might convey some information.
Not a good signal since it can be easily mimicked. To be effective, a
signal must be easier for high-productivity people to give than for
low-productivity people to give, so that high-productivity people are
more likely to give it.
Nobel Laureate Michael Spence introduced the idea of using education as
signal to get around the adverse selection problem in job markets.
More productive people are more likely to attain high levels of education
in order to signal their productivity to firms and thereby obtain betterpaying jobs.
19
Job Market Signaling cont.
A scenario
20
A Model
A recruiter is hiring a manager:
Two types of job candidates: High quality and Low quality with 50:50 chance
Types are known only to the candidates but not to the recruiter.
If hired, the job continues for 10 years.
If candidates types are identifiable,

Recruiter is to offer annual salaries as follows (based on their
productivities):
High quality candidates: $20,000/year
Low quality candidates: $10,000/year
If candidates types are not identifiable?
Due to incompleteness of information, all candidates may pretend as if
they were of high quality firms profits lower than expected firm
recruiter would offer lower salary only low quality candidates will apply:
21
adverse selection problem arises!
Education as a Signal
Now you can offer a high quality candidate salary ($20,000/year) if she studies for more
than N* school program years in higher education (after college)
Disutility (or Cost) per class
High quality people find education easier, therefore less costly to them than to low
quality people
High quality candidates: $20,000 per higher school year
Low quality candidates: $40,000 per higher school year
For the above mechanism to sort out the candidates types, the following conditions
needs to hold:
22
(a) Incentive Compatibility (IC) for Low Quality Candidates
Low-quality candidates should not have incentive to send the signal.

That is,
L(study N years to mimic high type) = $200,000 $40,000N
< L(no higher education) = $100,000
or
(wage gains from
mimicking high quality)
= $200,000 - $100,000
= $100,000
<
(Cost of mimicking
high quality)
= $40,000N
Then, N should be: N > 2.5

23
(b) Individual Rationality (IR) Condition for High Quality Candidates:
High-quality candidates should have an incentive to send the signal.

That is,
H(study N years to signal the true type) = $200,000 $20,000N
> H(no higher education) = $100,000
or
(wage gains revealing
High-quality type)
= $200,000 - $100,000
= $100,000
>
(Cost of mimicking
high quality)
= $20,000N
Then, N should be: N < 5

24
Equilibriums
We will have two kinds of equilibriums, depending on the recruiters
requirement for the length of N*.
Separating Equilibrium (Candidates types are revealed.)

2.5 < N* < 5, then only high quality candidates get higher education.
Pooling Equilibrium (Candidates types are not revealed.)
N*> 5 neither type gets higher education
N*< 2.5 both types gets higher education
25
Outline
Introduction
Adverse Selection
Introduction

Other Signals
Moral Hazard
Introduction
26

Consider the markets for such durable goods as televisions, stereos,
cameras, and refrigerators. Many firms produce these items, but some brands
are more dependable than others. If consumers could not tell which brands tend
to be more dependable, the better brands could not be sold for higher prices.
Firms that produce a higher-quality, more dependable product must therefore
make consumers aware of this difference. But how can they do it in a convincing
way?
The answer is guarantees and warranties.
Guarantees and warranties effectively signal product quality because an

extensive warranty is more costly for the producer of a low-quality item than
for the producer of a high-quality item. The low-quality item is more likely to
require servicing under the warranty, for which the producer will have to pay.
In their own self-interest, therefore, producers of low-quality items will not
offer extensive warranties.
Thus consumers can correctly view extensive warranties as signals of high

quality and will pay more for products that offer them.
27
Other Signals?
You want to sell your 2 year old car through a newspaper classified section.
o Whats the buyers concern?
o Whats your concern? How would you get out of the dilemma?
I am moving out of the country
My wife/mom says this sports car is dangerous
Can you tell why your not so successful salesman friend is in an Armani?
More sex is safer sex from the reading
28
Outline
Introduction
Adverse Selection
Introduction
Other Signals
Moral Hazard
Introduction
29
MORAL HAZARD
Introduction
What is moral hazard problem?

Moral hazard occurs when the insured party whose actions are
unobserved can affect the probability or magnitude of a payoff
associated with an event.
If my home is insured, I might be less likely to lock my doors or
install a security system
When your car is insured, you would be less cautious in
passing the red Mustang on AYE.
30
Introduction-cont.
Example: Fire Insurance

You own a warehouse worth $100,000.
Probability of a fire is knows to be
0.005 with a fire prevention program

costing $50 to run
0.01 without the program
With the program the actuarially fair premium is:

0.005 x $100,000 = $500
Once you purchase the insurance, you no longer have an
incentive to run the program, therefore the probability of
loss becomes .01.
$500 premium will lead to a loss to the insurance firm
because the expected loss is now $1,000 (.01 x $100,000)
31
Introduction-cont.
Example: Costs for For-profit Hospitals vs Nonprofit Hospitals

In a study of 725 hospitals, from 14 major
hospital chains,
After adjusting for services performed, the average cost of a

patient day in nonprofit hospitals was 8 percent higher than in
for-profit hospitals.
Without the competitive forces faced by for-profit hospitals,
nonprofit hospitals may be less cost-conscious and therefore
less likely to serve appropriately for the society.
32
Challenge: How would you solve this morally-hazardous

behaviors?
Insurance
Deductibles, co-payment etc
Non-profit hospitals
Introduce private sector schemes
After all, it is all about adding designing the right incentive

scheme.
It should be in the best interest of the informed side only to take the
desirable action..
33
Outline
Introduction
Adverse Selection
Introduction
Other Signals
Moral Hazard
Introduction
34
PRINCIPAL-AGENT (P-A) PROBLEM

A firm often can be understood as a relation between
principal and agents
principal Individual who employs one or more agents to achieve an
objective.
agent Individual employed by a principal to achieve the principals
objective
principalagent problem Problem arising when agents
(e.g., a firms managers) pursue their own goals rather than the
goals of principals (e.g., the firms owners).
35
Principal-Agent Model in Corporate

The traditional corporate governance structure is straightforward.
Shareholders own the firms assets and assume the risks of doing
business.
Shareholders hire managers (agents) to perform the duties of running the
business.
Principals determine rules that assign agents compensation as a function of
principals observation of the firm performance. But there is asymmetric
information here: agents (managers) have more information about the action
relative to the principal. This asymmetric information consists of two basic
problems:
The agents action is not directly observable by the principal

The outcome of the action is not completely determined by the agents
actions
And then the result may be:
There is a possibility for the agent to pursue their own goals, even at an
expense of owners: Moral Hazard Problem (Or Hidden Action Problem)
36
Principal-Agent Model in Corporate

The most common hidden
action problem in the
corporate world is
determining the effort of
agents.
Effort has a disutility to the
agent, but a value to the
principal because it increases
the probability of a favorable
outcome (higher profit).
Principal however cannot
observe agents efforts.
37
A P-A model
Revenue is determined jointly by agents effort and market states.
Agents effort Low (EL) or High (EH)
Three possible market states with 1/3 each
Principal cannot directly observe agents effort.

State 1 (s1) State 2 (s2) State 3 (s3)
EL = low effort
5,000
10,000
EH = high effort
10,000
30,000
15,000
50,000
Expected Revenue
10,000
30,000
Effort Cost to the Agent

The cost of effort = $0
$4,000
.
if low effort
if high effort
38
Assume both principals and agents are all risk-neutral.

Then the situation can be depicted through the following game:
P
Offers a Contract (Wage Scheme)

A
EL
(L,EIL)
EH
(,EIH)
E = expected profit for the principal

EI = expected income for the agent
39
Compensation Contract 1: A Straight Wage

Wage (W) = $9,000 (straight wage regardless of revenue outcome)
EL = low effort
5,000
10,000
EH = high effort
10,000
30,000
15,000
50,000
Expected Revenue
10,000
30,000
Agent Expected Income

EIL = 9,000 0 = 9,000
EIH = 9,000 - 4,000 = 5,000
Principals Expected Profit
EL = 10,000 9,000 = 1,000
EH = 30,000 9,000 = 21,000
P-A problem then can be viewed as below:

40
Compensation Contract 1: A Straight Wage cont.
Wi = 9,000 ; i = L, H
A
EL
EH
()
()
In equilibrium:
Agent would exert low effort and the principal gets a lower payoff.
We would have to design an incentive scheme to induce the agent to

exert high effort.
41
Compensation Contract 2: A Bonus Plan

If Revenue < 30,000, then W = $8,000.
If Revenue 30,000 , then W = $8,000 plus a bonus of $6,500.
EL = low effort
5,000
10,000
EH = high effort
10,000
30,000
15,000
50,000
Expected Revenue
10,000
30,000
Agents Expected Income

EIL = 8,000 0 = 8,000.
EIH = [8,000 4,000](1/3) + [8,000 + 6,500 4,000](1/3)
+ [8,000 + 6,500 4,000](1/3) = 8,333.33
EL = (5,000-8,000)(1/3) + (10,000-8,000)(1/3) + (15,000-8,000)(1/3)
= 2,000
EH = (10,000-8,000)(1/3) + (30,000 8,000 6,500)(1/3)
+ (50,000 8,000 6,500)(1/3) = 17,666.67
42
Compensation Contract 2: A Bonus Plan- cont.
EL
(2,000 ; 8,000)
W = 8,000, if Revenue < 30,000

= 8,000 + 6,500, otherwise
EH
(17,666.67 ; 8,333.33)
In equilibrium:
Agent would exert high effort.
Moral hazard problem
disappears!
43
Compensation Contract 3: Revenue Sharing

If Revenue > 14,500, then W= 0.95(gross revenues 14,500)
Otherwise, then W = 0
EL = low effort
5,000
10,000
EH = high effort
10,000
30,000
15,000
50,000
Expected Revenue
10,000
30,000
Agents Expected Income

EIL = (0)(1/3) + (0)(1/3) + 0.95[15,000 14,500](1/3) = 158.33
EIH = [0 4,000](1/3) + {0.95*[30,000 14,500] - 4,000}(1/3)
+ {0.95*[50,000 14,500] 4,000}(1/3) = 12,150
EL = 5,000 (1/3) + 10,000(1/3) + {15,000 0.95[15,000 14,500]}(1/3) = 9,841.67
EH = 10,000(1/3) + {30,000 0.95[30,000 14,500]} (1/3)
+ {50,000 0.95[50,000 14,500]} (1/3) = 13,850

44
Compensation Contract 3: Revenue Sharing - cont.
EL
(9,841.67 ; 158.33)
W = 0.95(R 14,500) if Revenue >14,500

=0
Otherwise
EH
(13,850 ; 12,150)
In equilibrium:
Again, agent would exert high effort.
Moral hazard problem

disappears, again!
45
An episode.
Where is all food gone? from the reading
46
Thank you!
47
Some Information on the Final Exam
Closed book exam, but one A4-size cheat sheet is allowed.
Two hour exam and four questions altogether.

two from Prof Yang (Q1 and Q2)
two from me (Q3 and Q4)
No MCQs this time.
Questions will be about both concepts and quantitative work.

When answering, read the instructions carefully. Some
questions require explanations and some dont.
You can use a calculator during the exam.

48

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Semester II, AY2013-2014

NUS Business School

asymmetric information Situation in which a buyer and a seller

How much would you pay?

Two types of information asymmetry

Hidden Information (or Hidden Characteristics)

A bum at Orchard offering a golf jewelry for sale

The potential inefficiency problem caused is called Adverse Selection.

Driving less carefully once insured

The potential inefficiency problem caused is called Moral Hazard.

Adverse selection refers to a situation where a selection process

Recall the Orchard bum who was eager to sell you

Now, suppose there was a bum who had a windfall of

Adverse selection refers to a situation where a selection process under

The Market for Lemons (Case of Used Cars)

George Akerlof, The market for Lemons: Quality Uncertainty

The Market for Credit

The Market for Health Insurance

At that point, insurance becomes very expensive, orin the extremeinsurance

One solution to the problem of adverse selection is to pool risks.

Likewise, insurance companies offer group health insurance policies at places of

Think from the Reading (More Sex is Safer Sex)

Two types of patrons in a club:

Signaling and Screening

Job Market Signaling

SIGNALING AND SCREENING

Signaling and screening usually not necessarily coexist.

Signaling and Screening cont.

Screening: Case of Auto Insurance

Job Market Signaling

Guarantees and Warranties

Signaling in Job Markets

Job Market Signaling cont.

Job Market Signaling cont.

If candidates types are identifiable,

Job Market Signaling cont.

High quality candidates: $20,000 per higher school year

Low quality candidates: $40,000 per higher school year

Job Market Signaling cont.

(a) Incentive Compatibility (IC) for Low Quality Candidates

Low-quality candidates should not have incentive to send the signal.

Then, N should be: N > 2.5

Job Market Signaling cont.

(b) Individual Rationality (IR) Condition for High Quality Candidates:

High-quality candidates should have an incentive to send the signal.

Then, N should be: N < 5

Job Market Signaling cont.

Separating Equilibrium (Candidates types are revealed.)

Guarantees and Warranties

Guarantees and Warranties

Guarantees and warranties effectively signal product quality because an

Thus consumers can correctly view extensive warranties as signals of high

More sex is safer sex from the reading

What is moral hazard problem?

Example: Fire Insurance

0.005 with a fire prevention program

With the program the actuarially fair premium is:

Example: Costs for For-profit Hospitals vs Nonprofit Hospitals

After adjusting for services performed, the average cost of a

Challenge: How would you solve this morally-hazardous

After all, it is all about adding designing the right incentive

PRINCIPAL-AGENT (P-A) PROBLEM

Principal-Agent Model in Corporate