Chapter 17(f) Lemons

8/17/2019 Chapter 17(f) Lemons

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CHAPTER 17

Markets with Asymmetric Information

Information Asymmetry

Adverse Selection Moral Hazard Principal Agent Problem

Signalling/Guarantee Warranty Monitoring managerial/worer incentive

!eputation/branding/"ig"er cosrs

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Quality Uncertainty an the Market for !emons

• Asymmetric information

"ituation in which a #uyer an a seller $ossess ifferentinformation a#out a transaction

• AI leas to a%erse selection& market inefficiency an failure since

'oos are not $rice accorin' to their (uality an #a 'oo ri%e

out the 'oo ones

• Adverse selection – Different qlty products same price –branding,

signaling, incentives can overcome defects of AI and AS

• Bad goods drive out ‘good’ goods

)orm of market failure resultin' from asymmetric information*

"i'nallin'& +uarantees an ,arrantees can #e a 'oo si'nal of (uality * they can o%ercome A"

Moral Ha-ar

• .ue to Moral Ha-ar social costs/#enefits Pri%ateCosts

/#enefits

• Moral ha-ar ,hen an insure $arty whose actions are

uno#ser%e can affect the $ro#a#ility or ma'nitue of a $ayment

associate with an e%ent

• Moral ha-ar not only alters #eha%ior0 it also creates economic

inefficiency The inefficiency arises #ecause the insure ini%iual

$ercei%es either the cost or the #enefit of the acti%ity ifferently

from the true social cost or #enefit

• Moral ha-ar alters the a#ility of markets to allocate resources

efficiently . 'i%es the eman for automatic ri%in' ,ith no

moral ha-ar& the mar'inal cost of trans$ortation MC is 2134 $ermile0 the ri%er ri%es 144 miles& which is the efficient amount

,ith moral ha-ar& the ri%er $ercei%es the cost $er mile to #e

MC5 6 2144 an ri%es 14 miles

• Use cars sell for much less than new cars #ecause there is

asymmetric information a#out their (uality* The seller of a use

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car knows much more a#out the car than the $ros$ecti%e #uyer

oes The #uyer can hire a mechanic to check the car& #ut the

seller has ha e8$erience with it an will know more a#out it

)urthermore& they %ery fact that the car is for sale inicates that it

may #e a 9lemon:;why sell a relia#le car< As a result& the

$ros$ecti%e #uyer of a use car will always sus$icious of its

(uality;an with 'oo reason

• Akerlof5s analysis 'oes far #eyon the market for use cars The

markets for insurance& financial creit& an e%en em$loyment are

also characteri-e #y asymmetric (uality information Tounerstan the im$lications of asymmetric information& we will

start with the market for sue cars an then see how the same

$rinci$les a$$ly to other markets

• =ther E8am$les > Restaurants/retail stores >seller knows #etter

than #uyer

Lemons roblem

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• !"ampleof Lemons and #ems – $%y t%e former drives

a$ay t%e latter Let us t%in& of a seconds mar&et for 'oyota (amrys) Some

cars are better t%an average and if consumers &ne$ t%at t%ey$ere buying one of t%ese gems t%ey $ould be $illing to pay

*+, for it) -t%er are lemons and if consumers &ne$ t%ey$ere buying a lemon, t%ey $ould be $illing to offer only

*.) '%e problem is t%at consumers do not &no$ $%ic% car is a

lemon and $%ic% is a gem) So at first blus% t%ey are $illing to pay a price of */.

reflecting average quality) Sellers do,of course &no$ t%equality of $%at t%ey are selling

At a price of */.& o$ners of gems t%at really are $ort% *+, $ould

not sell for */.

& o$ners of lemons t%at are $ort% *. $ould be%appy to sell for */.

& '%us only lemons are sold)

& 0o$ supposing consumers &no$ t%at only lemons arebeing sold t%en t%ey $ill only offer *.) '%is is o& for lemon o$ners, t%at means more of t%em $ill besold)

& '%us Bad good1lemon2 drives a$ay t%e good one1gems2

& If consumers cannot tell the (uality of a $rouct an are willin' to

$ay only an a%era'e $rice for it& then this $rice is more attracti%e

for sellers who ha%e #a $roucts than to sellers who ha%e 'oo$roucts ?hence the term a%erse selection@

& Conse(uently& more #a $roucts ?ie& lemons@ will #e offere

than 'oo $roucts ow& if consumers are rational& they shoul

antici$ate this a%erse selection an e8$ect that at any 'i%en $rice&

a ranomly chosen $rouct is more likely to #e a lemon than a 'oo

$rouct

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B =f course& these e8$ectations im$ly a lower willin'ness to $ay for

$roucts an so the $ro$ortion of 'oo $roucts that is actually

offere falls further E%entually& this $rocess may lea to a com$lete

#reak own of the market

B This lemons iea is also im$ortant for cor$orate finance* if

in%estors cannot o#ser%e the %alue of firms #efore they #uy them

then they woul #e willin' to $ay only an a%era'e $rice for the

e(uity of firms

& +i%en that the $rice is a%era'e& sellin' e(uity on the marketis much more attracti%e to owners of #a firms than to owners of

'oo firms so the a%era'e %alue of firms that are actually offere on

the market shoul #e #elow a%era'e

B This im$lies that in%estors shoul #e sus$icious that if they are

offere e(uity then it must mean that the firm5s %alue is more likely

to #e #elow the a%era'e Hence& in%estors will no lon'er #e willin'to $ay an a%era'e $rice for the e(uity of firms once they ha%e

offere to #uy this e(uity

Insurance Com$anies

Reason for insurance com$anies to char'e ifferent $remiums

e$enin' on risk le%els > #anks hi'her interest rates to ri%e away

hi'h risk #orrowers

If insurance com$anies must char'e a sin'le $remium #ecause they

cannot istin'uish #etween hi'hBrisk an lowBrisk ini%iuals&

more hi'hBrisk ini%iuals will insure& makin' it un$rofita#le to sell

insurance

Peo$le who #uy insurance know much more a#out their 'eneral

health than any insurance com$any can ho$e to know& e%en if it

insists on a meical e8amination As a result& a%erse selection

arises& much as it oes in the market for use cars ecauseunhealthy $eo$le are more likely to want insurance& the $ro$ortion

of unhealthy $eo$le in the $ool of insure $eo$le increases This

forces the $rice of insurance to rise& so that more healthy $eo$le&

aware of their low risks& elect not to #e insure This further

increases the $ro$ortion of unhealthy $eo$le amon' the insure&

which forces the $rice of insurance u$ more This $rocess continues

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until nearly all $eo$le who want to #uy insurance are unhealthy At

that $oint& sellin' insurance #ecomes un$rofita#le

A%erse "election in e ayIn D444 Ro#ert an Teri !a Plant $ai 2 D34 for a 11 carat

mar(uise cot iamon on e ay Power user Mr ,atch was the seller

,hen they notice a %isi#le chi$ on the iamon they returne it Al

a'on who oes #usiness as Mr ,atch refuse to refun the money

alle'in' that the Plants ha chi$$e it to a%oi $ayin' Mr a'on note

that an a$$raisal accom$anie the iamon when it was shi$$e The

!a Plants countere #y sayin' that the a$$raisal was 1F months ol an

that they ha%e collecte the 2D44 insurance $olicy that eAy offers for

all its $urchases E ay refuses to sus$en Mr ,atch from the site

notin' that he ha 1F44 $ositi%e an only F ne'ati%e res$onses Pro#lems like this arise #ecause e ay sellers ha%e #etter info a#out the

(ualityof 'oos sol #ein' offere for saleuyers offer less an sellers

are willin' to sell less of hi'h (uality 'oos

E ay tries to sol%e the $ro#lem of a%erse selection #y usin'

authentication 'rain' an escrow ser%ices an insurance a'ainst

frau "ellers can als4 #uil 'oo re$utations as custoners rate each

transaction with the seller "ellers who ha%e 'oo re$utation comman

hi'her $rices on e ay for the same items An increase in a seller5s

ratin' #y 14G leas to a 1G hi'her e8$ecte $rice&rise

A%erse "election in )inancial Markets* Enron&"atyam an

"ar#anes =8ley

.urin' the late 14s many in%estors in U" #ecame less

cautious an more willin' to in%est in firms a#out which they

ha little information They focuse on stock $rices an hence

$ressure increase for firms to re$ort that they ha earne

$rofits at least as hi'h as in%estment analysts were forecastin'they woul )irms re$ortin' $rofits that were lower than what

analysts ha forecast e8$erience a shar$ ecline in their stock

$rices The situation of cookin' the #ooks #ecame the orer

leain' to scanals

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)inancial statements when cooke lea in%estment analysts to

e%aluate ifferently than what is the true situation Creates

moral ha-ar $ro#lems for in%estors The mana'ement of the

firm knows more a#out the firm5s finances than any outsie

in%estor knows "atyam in Inia i this Enron mana'e tokee$ much of its e#ts from #ein' inclue on its #alance

sheet E%entually eclarin' its #ankcru$tcy

Citi'rou$ Inc also is state to ha%e misle in%estors #y not

$ro$erly isclosin' the amount of trou#le mort'a'e assets it

hel as the market #e'an to im$loe in D447 The result is that

in%estors increasin'ly #ecame istrustful of firm5s own

estimates an re'ulators ?"EC@ #e'an e8aminin' measurementmethos an isclosures

In the U" a s$ate of false financial statements le to loss of

faith of in%estors in the relia#ility of financial statements

leain' to a wa%e of sellin' that hit the U" stock markets in the

summer of D44D which le the Con'ress to $ass the "ar#anesB

=a8ley Act of D44D to stren'then U" security laws The ill

authori-es the "EC to set u$ a 'o%t #oar to o%ersee auitin'of financial statements

*bama+s ,inancial !egulation -ill is also designed to avoid AssInf and Adverse Selection

Arsene ,en'er Ca$itali-es on Assymmetric Info in Player5s

Transfer Market for Arsenal

Inter&.lub ransfer marets in Soccer are c"aracterized byAsymmetric Information w"ere t"e club selling/transferring a

player nows more about t"e wort" of t"e transferred player0Arsene Wenger1 Manager1 Arsenal for some years now1 is a trainedeconomist w"o also can 2udge a player+s 3peaing+ before ot"ers0Sold 4mmanuel Petit for 5#60( million1 "ierry Henry for 5%6

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million in $667 to -arcelona 8boug"t from 9uventis at Pd #6million in #:::; and Patric


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• ut CCI" oes not allow thisB in fact it su#sii-es $remium rates

A umerical in%ol%in' Automo#ile Insurance

Good drivers pay low premiumC bad ones "ig"C -ut insurancecompanies are not able to mae out w"o is good and w"o is badD*t"erwise "e could "ave "ad differential premium0Eet us assume t"at eac" policy "older "as a wealt" level of 5 #$(1

but a loss can reduce t"e wealt" to $( ie loss of #66 in t"e event of an accident0 ,or t"e "ig" ris category t"e prob of an accident is607( w"ile t"e same is 60$( for low ris drivers0A competitive premium will be c"arged based on e?pected loss ie7( and $( respy for "ig" ris and low ris drivers;0Given Ftility function t"at reflects ris aversion

Ftility 8wealt";60(

,or t"e $ categories t"e situations are as followsCEow !is Ftility wit" insurance 8#$( $(; 60( #6Ftility wit"out insurance 8607(;8#$(; 60( > 860$(;8$(; 60( :0)%(

for t"e "ig" ris groupFtility wit" insurance 8#$( 7(; 60( 7067#Ftility wit"out insurance 860$(;8#$(; 60( > 8607(;8$(; 60( )0('(

If t"e insurance company can+t distinguis" between "ig" ris andlow ris drivers1 t"ey will c"arge a uniform average premium rateof 8$(>7(; (6,or t"is premium t"e "ig" ris driver will go for policy since "er

utility wit" insurance is "ig"er t"an wit"outFtility wit" insurance 8#$( (6; 60( B0))6Ftility wit"out insurance 860$(;8#$(; 60( > 8607(;8$(; 60( )0('("e low ris driver will not go for t"is since utility wit" insuranceis lower t"an wit"outFtility wit" insurance 8#$( (6; 60( B0))6

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Ftility wit"out insurance 8607(;8#$(; 60( > 860$(;8$(; 60( :0)%(

So t"e low ris drivers will not buy t"e policy w"ile t"e "ig" ris ones will crowd in0 "is is not good for t"e insurance companies0

Pre%entin' A%erse "election * .ri%ers5 Case A'ain.ompetition amongst insurers may "elp reduce t"e problem of AS in $ways0&.ompetition induces insurers to see and compile information about losse?pectations t"at enables t"em to use premium structures t"at discriminate

among ris groups0 In a competitive maret AS is reduced to t"e level t"atreflects t"e cost of information& *ffering a c"oice to eac" driver 8"ig" ris and low ris; of $ policies0 "isis self&selection w"ic" will mae t"e company "ave an idea of t"e ris typeto w"ic" a person belongs0 *ne policy "as a "ig" premium and offers fullinsurance & t"e ot"er policy "as a lower premium but a big deductible w"ic"means t"at t"e insurer does not pay t"e full loss but pays loss minus some

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fi?ed amount0for a bad driver t"e deductible is a big deterrent so s"e goesJfor policy #0 "e good driver goes for low premium1 but deductible one0

Market "i'nalin'

Eucation is a stron' si'nal in la#or markets A $erson5seucational le%el can #e measure #y se%eral thin's;the num#er

of years of schoolin'& e'rees o#taine& the re$utation of the

uni%ersity or colle'e that 'rante the e'rees& the $erson5s 'rae

$oint a%era'e& an so on

=f course& eucation can irectly an inirectly im$ro%e a

$erson5s $roucti%ity #y $ro%iin' information& skills& an

'eneral knowle'e that are hel$ful in work

ut e%en if eucation i not im$ro%e $roucti%ity& it woul still

#e a useful si'nal of $roucti%ity #ecause more $roucti%e $eo$le

fin it easier to attain hi'h le%els of eucation

ot sur$risin'ly& $roucti%e $eo$le ten to #e more intelli'ent&

more moti%ate& more isci$line& an more ener'etic an harB

workin';characteristics that are also hel$ful in school More

$roucti%e $eo$le are therefore more likely to attain hi'h le%els of

eucation in orer to si'nal their $roucti%ity to firms an

there#y o#tain #etterB$ayin' o#s Thus firms are correct inconsierin' eucation a si'nal of $roucti%ity

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"i'nalin'

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+uarantees an ,arrantees an Moral Ha-ar

,e ha%e stresse the role of si'nalin' in la#or markets& #ut it can also

$ay an im$ortant role in many other markets in which there is

asymmetric information Consier the markets for such ura#le 'oos

as tele%isions& stereos& cameras& an refri'erators Many firms $rouce

these items& #ut some #rans are more e$ena#le than others If

consumers coul not #e more e$ena#le& the #etter #rans coul not

#e sol for hi'her $rices )irms that $rouce a hi'herB(uality& more

e$ena#le $rouct must therefore make consumers aware of this

ifference ut how can they o it in a con%incin' way< The answer is

'uarantees an warranties

+uarantees an warranties effecti%ely si'nal $rouct (uality #ecause an

e8tensi%e warranty is more costly for the $roucer of a lowB(uality item

than for the $roucer of a hi'hB(uality item The lowB(uality item is

more likely to re(uire ser%in' uner the warranty& which the $roucer

will ha%e to $ay for As a result& in their own selfBinterest& $roucers of

lowB(uality items will not offer e8tensi%e warranties Thus consumers

can correctly %iew an e8tensi%e warranty as a si'nal of hi'h (uality& anthey will $ay more for $roucts that offer one

"hort "ellers as "i'nallers

S"ort& selling brings information into t"e maretplace t"at is incrediblyuseful and valuable0 It signals t"e performance or e?pected performance of companies0 o restrict s&s 1 as w"at t"e FS S4. wants to do is to put bumpson descent of stocs during volatile times0

Principal Agent Problem• PA problem arises from Information Assymetry

• Per en2oying manager loos to "ig" growt" and large

maret s"are at t"e cost of Profit 8 in FS after t"eonset of t"e economic crisis1 loss maing concerns

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giving "uge compensation8bonuses; to its e?ecutives"as been a big issue;

• PSFs can grow into big empires wit"out regard to

efficiency because it is costly to monitor performanceof managers

• o avoid IA set an Incentive wage and monitor results

• 4fficiency wage t"eory non s"ir wages & set it &

fewer employment ascending wage & forced to beefficient& maret clearing wage gives incentive tos"ir

•

Managerial incentive in suc" a manner t"at youdeclare correct capacities and t"us performaut"entically

.reditors as PrincipalsC W"y t"ey do not "ave t"e will to*versee

• In t"e wae of t"e recent global economic crisis1 many

mismanaged companies in FS were propped up 2ust because t"ey were too big to be allowed to fail& 2obmarets impacts1 economic credibility etc were t"eissues at stae0 Satyam "as been t"e outstanding casein India w"ere Govt "ad to step in to save t"ecompany

• However derivatives in t"e FSA caused many

company stae"olders not to care to eep and c"ect"e companies t"ey "ad invested in0

• A credit default swap is a derivative t"at insures a

creditor from credit default by its customer company0

• Here comes t"e problem 0 A creditor w"o buys t"e

swap does not care w"et"er t"e company remains in business or not0 "is undermines creditor watc" over

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client companies and undermines corporategovernance and debt governance mec"anism0

• Goldman Sac"s "ad "edged its e?posure to AIG by

purc"asing credit default swaps on AIG t"usweaening its resolve to watc" AIG

• ,rom t"e Kerivatives industry perspective1 it

encounters moral "azard from its clients w"o getcareless due to t"e "edge

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How "i%a Jyothi5s ?"J@ e8tra information hel$e

+olman "achs

Sep ## $66#& immediately after t"e planes cras"ed

into W.1 Mr S91 t"en Head1 Proprietaryrading at GS in Eondon at t"e rading floor1looed up t"e weat"er at @ew Lor 0 ,ound it a

pleasant morning1 realized t"at it was not acras" but an act of terror0 "is was an "our and"alf before t"e world realized it was a terrorattac0 S9 closed out on all trading positions of"is division w"ic" was liely to be affected bya terror attac and moved swiftly to buying calloptions on Government -onds at a set price infuture0

Wit"in $' "ours of "is doing t"is ot"er investors werecrowding to t"e safe "aven of Govt bonds

driving up prices0 S9 boug"t a big bonanza forGS t"roug" t"e .all *ption0& aided by t"esuperior info "e possessed mostly self&generated and aided by "is s"arp intuition

,ranc"isingGrowt" of franc"ising in India in recent years is

a solution to t"e P&A incentive conflict0 "e principal of t"e parent company t"at owns a popular brand0lie ,.0 As t"e company growsit "as a c"oice it can open up company owned

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stores or it can let franc"isees open and runstores0 "e franc"isees t"en pay t"e company afee for t"e rig"t to use t"e parent company+

brand0 In t"is case w"at matters is w"et"erfranc"ize organizational form is more profitableto t"e parent company or not0 In a companyowned structure managers do not wor as "ardas t"ey can if t"ey owned t"e restaurant 8 moralHazard; and t"e salaried managers may attract

lazy managers0 8adverse selection;0 "e agencycost disappear once a franc"isee owns t"e firm

because t"e agent and t"e principal become oneand t"e same0 !unning a franc"ised store can bet"oug"t of a strong form of incentivecompensation you turn a manager into a owner

8franc"isee; w"en you give "im t"e profit fromrunning t"e store0

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Chapter 17(f) Lemons