04 - Asymmetric Information - Moral Hazard

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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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    Wharton BPUB 203 5

    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)

    ( ) ( ) ( )( )00

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    w

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    =

    ( ) ( )( ) ( )( )( )( )0

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    wuU

    cywquwuqU

    =

    +=

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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

    ( ) ( )( ) ( )( ) ( )( )( )( ) ( )( )[ ] cwuywuq

    wucywquwuq

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    0

    001

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    ( ) ( )( ) ( )( )

    ( )( ) ( )( ) ( )( )[ ]

    ( )( )0

    0

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    0

    00

    01

    uwu

    ucwuywuqwu

    ucywquwuq

    +

    +

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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

    ( ) ( ) ( )0

    1

    0

    11/ uuquqcquqy

    +=

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    ( ) ( )

    ( ) ( )0

    1

    0

    1

    /

    0

    uqcuyw

    uuw

    +=

    =

    ( )

    ( )cuuw

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    0

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    ( )cuuqy += 0

    1

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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