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Fernando & Yvonn Quijano

Prepared by:

Markets withAsymmetric

Information

17

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Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e.

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Chapter17:MarketswithAsymmetricInformation

2 of 28Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e.

CHAPTER 17 OUTLINE

17.1 Quality Uncertainty and the Market for Lemons

17.2 Market Signaling

17.3 Moral Hazard

17.4 The PrincipalAgent Problem

17.5 Managerial Incentives in an Integrated Firm

17.6 Asymmetric Information in Labor Markets:

Efficiency Wage Theory

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QUALITY UNCERTAINTY AND THE MARKETFOR LEMONS

17.1

asymmetric information Situation in which a buyer and

a seller possess different information about a transaction.

The Market for Used Cars


Figure 17.1

When sellers of productshave better informationabout product quality thanbuyers, a lemons problem

may arise in which low-quality goods drive out highquality goods.

In (a) the demand curve for

high-quality cars is DH.

However, as buyers lowertheir expectations about theaverage quality of cars onthe market, their perceiveddemand shifts to DM.

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17.1



(continued)

Figure 17.1

Likewise, in (b) theperceived demand curvefor low-quality cars shiftsfrom DL to DM.

As a result, the quantity ofhigh-quality cars sold fallsfrom 50,000 to 25,000,

and the quantity of low-quality cars sold increasesfrom 50,000 to 75,000.

Eventually, only low qualitycars are sold.

asymmetric information Situation in which a buyer and

a seller possess different information about a transaction.

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17.1


The lemons problem: With asymmetric information,low-quality goods can drive high-quality goods outof the market.

Implications of Asymmetric Information

Adverse Selection

adverse selection Form of market failureresulting when products of different qualities aresold at a single price because of asymmetricinformation, so that too much of the low-qualityproduct and too little of the high-quality productare sold.

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17.1

Implications of Asymmetric Information

The Market for Insurance

The Market for Credit

People who buy insurance know much more abouttheir general health than any insurance company canhope to know, even if it insists on a medicalexamination.

As a result, adverse selection arises, much as itdoes in the market for used cars.

Credit card companies and banks can, to some

extent, use computerized credit histories, which theyoften share with one another, to distinguish low-quality from high-quality borrowers.

Many people, however, think that computerizedcredit histories invade their privacy.

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17.1

The Importance of Reputation and Standardization

Asymmetric information is also present in many other markets.Here are just a few examples:

Retail stores: Will the store repair or allow you to return adefective product?

Dealers of rare stamps, coins, books, and paintings:

Are the items real or counterfeit?

Roofers, plumbers, and electricians: When a rooferrepairs or renovates the roof of your house, do you climb

up to check the quality of the work?

Restaurants: How often do you go into the kitchen tocheck if the chef is using fresh ingredients and obeyinghealth laws?

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17.1

Asymmetric information isprominent in the free-agentmarket. One potential purchaser,the players original team, has

better information about the

players abilities than other teamshave.

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MARKET SIGNALING17.2

market signaling Process by whichsellers send signals to buyersconveying information about productquality.

To be strong, 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.

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A Simple Model of Job Market Signaling

Equilibrium

Signaling

Figure 17.2

Education can be a usefulsignal of the highproductivity of a group ofworkers if education iseasier to obtain for thisgroup than for a low-productivity group.

In (a), the low-productivitygroup will choose an

education level ofy= 0because the cost ofeducation is greater thanthe increased earningsresulting from education.

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Equilibrium

Signaling

Figure 17.2

Education can be a usefulsignal of the highproductivity of a group ofworkers if education iseasier to obtain for thisgroup than for a low-productivity group.

However, in (b), the high-productivity group will

choose an education levelofy* = 4 because the gainin earnings is greater thanthe cost.

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CostBenefit Comparison

In deciding how much education to obtain, people compare thebenefit of education with the cost.

People in each group make the following cost-benefit calculation:Obtain the education levely* if the benefit (i.e., the increase inearnings) is at least as large as the cost of this education.

Guarantees and Warranties

Firms that produce a higher-quality, more dependable productmust 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 qualitybecause an extensive warranty is more costly for the producer ofa low-quality item than for the producer of a high-quality item.

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Job market signaling does notend when one is hired. This isespecially true for workers inknowledge-based fields such asengineering, computer

programming, finance, law,management, and consulting.

Given this asymmetric information, what policy shouldemployers use to determine promotions and salaryincreases? Workers can often signal talent and productivityby working harder and longer hours.

Employers rely increasingly on the signaling value of longhours as rapid technological change makes it harder forthem to find other ways of assessing workers skills and

productivity. The worker will know more about his abilitiesthan the employer.

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MORAL HAZARD17.3

moral hazard When a party whose actions are

unobserved can affect the probability or magnitude of apayment associated with an event.

The Effects of Moral Hazard

Figure 17.3

Moral hazard alters the ability ofmarkets to allocate resources efficiently.D gives the demand for automobiledriving.

With no moral hazard, the marginal costof transportation MC is $1.50 per mile;the driver drives 100 miles, which is theefficient amount.

With moral hazard, the driver perceivesthe cost per mile to be MC = $1.00 anddrives 140 miles.

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MORAL HAZARD17.3

For buyers of livestock,information about the animals

health is very important.

Because of asymmetric

information in the livestockmarket, most states requirewarranties on the sale of livestock.

Although warranties solve the problem of the seller havingbetter information than the buyer, they also create a form

of moral hazard.In response to the moral hazard problem, many stateshave modified their animal warranty laws by requiringsellers to tell buyers whether livestock are diseased at thetime of sale.

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THE PRINCIPALAGENT PROBLEM17.4

principalagent problem Problem arisingwhen agents (e.g., a firms managers) pursue

their own goals rather than the goals ofprincipals (e.g., the firms owners).

agent Individual employed by a principal to

achieve the principals objective.

principal Individual who employs one ormore agents to achieve an objective.

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The PrincipalAgent Problem in Private Enterprises

Most large firms are controlled by management.

Managers of private enterprises can thus pursue their ownobjectives.

However, there are limitations to managers ability to deviatefrom the objectives of owners.

First, stockholders can complain loudly when they feel thatmanagers are behaving improperly.

Second, a vigorous market for corporate control can develop.

Third, there can be a highly developed market for managers.

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CEO compensation has increased sharply over time.

For years, many economists believed that executivecompensation reflected an appropriate reward for talent.

Recent evidence, however, suggests that managers have

been able to increase their power over boards of directorsand have used that power to extract compensationpackages that are out of line with their economiccontributions.

First, most boards of directors do not have the necessary

information or independence to negotiate effectively withmanagers.

Second, managers have introduced forms of compensationthat camouflage the extraction of rents from shareholders.

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The PrincipalAgent Problem in Public Enterprises

The principalagent framework can also help us understandthe behavior of the managers of public organizations.

Although the public sector lacks some of the market forces thatkeep private managers in line, government agencies can still

be effectively monitored.First, managers of government agencies care about more thanjust the size of their agencies.

Second, much like private managers, public managers aresubject to the rigors of the managerial job market.

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Do the managers of nonprofitorganizations have the same goalsas those of for-profit organizations?

In a study of 725 hospitals, from 14

major hospital chains, researcherscompared the return on investment

and average costs of nonprofit and for-profit hospitals todetermine if they performed differently.

The study found that after adjusting for services performed,

the average cost of a patient day in nonprofit hospitals was8 percent higher than in for-profit hospitals.

Without the competitive forces faced by for-profit hospitals,nonprofit hospitals may be less cost-conscious andtherefore less likely to serve appropriately as agents fortheir principalsnamely, society at large.

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Incentives in the PrincipalAgent Framework

Suppose, for example, that the owners offer the repairperson thefollowing payment scheme:

Under this system, the repairperson will choose to make a high levelof effort.

(17.1)

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This is not the only payment scheme that will work for the owners,however.

Suppose they contract to have the worker participate in the followingrevenue-sharing arrangement. When revenues are greater than$18,000,

(Otherwise, the wage is zero.)

In this case, if the repairperson makes a low effort, he receives an

expected payment of $1000. But if he makes a high level of effort, hisexpected payment is $12,000

Incentives in the PrincipalAgent Framework

(17.2)

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MANAGERIAL INCENTIVES IN ANINTEGRATED FIRM

*17.5

horizontal integration Organizational form inwhich several plants produce the same or relatedproducts for a firm.

vertical integration Organizational form inwhich a firm contains several divisions, withsome producing parts and components thatothers use to produce finished products.

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*17.5

In an integrated firm, division managers are likely to have betterinformation about their different operating costs and productionpotential than central management has. This asymmetricinformation causes two problems.

1. How can central management elicit accurate information aboutdivisional operating costs and production potential fromdivisional managers?

2. What reward or incentive structure should central managementuse to encourage divisional managers to produce as efficiently

as possible?

Asymmetric Information and Incentive Design in the

Integrated Firm

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For example, if the managers estimate of the feasible production level

is Qf, the annual bonus in dollars, B, might be

where Qis the plants actual output, 10,000 is the bonus when outputis at capacity, and .5 is a factor chosen to reduce the bonus ifQ isbelow Qf.

We will use a slightly more complicated formula than the one in (17.3)to calculate the bonus:

The parameters (.3, .2, and .5) have been chosen so that eachmanager has the incentive to reveal the true feasible production levelandto make Q, the actual output of the plant, as large as possible.


Integrated Firm

(17.3)

(17.4)


*17.5

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Incentive Design in an Integrated Firm

Figure 17.4

A bonus scheme can be designed

that gives a manager the incentive toestimate accurately the size of theplant.

If the manager reports a feasiblecapacity of 20,000 units per year,equal to the actual capacity, then thebonus will be maximized (at $6000).


Integrated Firm


*17.5

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Applications

Companies are learning that bonus schemes provide betterresults.

The salesperson can be given an array of numbers showing

the bonus as a function of both the sales target chosen bythe salesperson and the actual level of sales.

Salespeople will quickly figure out that they do best byreporting feasible sales targets and then working as hard aspossible to meet them.


*17.5

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ASYMMETRIC INFORMATION IN LABORMARKETS: EFFICIENCY WAGE THEORY

17.6

efficiency wage theory Explanation forthe presence of unemployment and wagediscrimination which recognizes that laborproductivity may be affected by the wagerate.

shirking model Principle that workers stillhave an incentive to shirk if a firm pays them amarket-clearing wage, because fired workerscan be hired somewhere else for the same

wage.

efficiency wage Wage that a firm will pay toan employee as an incentive not to shirk.

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17.6

Unemployment in a Shirking Model

Figure 17.5

Unemployment can arise inotherwise competitive labormarkets when employers cannot

accurately monitor workers.

Here, the no shirking constraint

(NSC) gives the wage necessary tokeep workers from shirking.

The firm hires Le workers (at ahigher than competitive efficiency

wage we), creating L* Le ofunemployment.

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17.6

One of the early examples of thepayment of efficiency wages canbe found in the history of FordMotor Company.

Ford needed to maintain a stableworkforce, and Henry Ford (andhis business partner JamesCouzens) provided it.

In 1914, when the going wage for a days work in industry

averaged between $2 and $3, Ford introduced a pay policy of

$5 a day. The policy was prompted by improved laborefficiency, not generosity.

Although Henry Ford was attacked for it, his policysucceeded. His workforce did become more stable, and thepublicity helped Fords sales.

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