APPLIED ECONOMICS

-: Chapter :-

MARKETS WITH ASYMMETRIC INFORMATION

Assignment submitted to

Prof. Dhaval Pandya

-: Prepared by:-1. Roshan Christian2. Pinkesh Mehta3. Jigar Purohit4. Ragnesh Rathod5. Chetan Master

Semester-1, MHRD (Evening)Department of Research Methodology & Interdisciplinary Studies in Social Science

VEER NARMAD SOUTH GUJARAT UNIVERSITY

CONTENTS1. Introduction : Asymmetric Information

2. Quality uncertainty and Market for ‘LEMONS’ Example : Market of used cars

3. Implication of Asymmetric Information

4. Adverse Selection The market for insurance The market for Credit

5. Importance of Reputation and Standardization

6. Market Signaling Example : Labor Market

7. Guarantees and Warranties

8. Moral Hazard

9. The Principal – Agent Problem Principal-Agent problem in Private Enterprises Principal-Agent problem in Public Enterprises

10. Managerial Incentives in an Integrated Firm

11. Asymmetric information in Labor Markets : Efficiency Wage Theory

Asymmetric Information :

Asymmetric information means, “Some parties know more than others.”

This sentence is quite common.

As we usually see in the market, The seller knows more than the buyer. The employees know their own efficiency more than the employer. The Managers know more about organization’s investment opportunities,

productivity and competitive position more than the owner.

That is perhaps the main reason why - The automobile companies give warranty on the cars,- The employees sign contracts with more incentives and rewards.

Quality uncertainty and Market for ‘LEMONS’ :

Suppose, you bought a new brand car for Rs. 2,00,000/-. You drove it for

only 100 kms. The car performed beautifully. There is nothing wrong with it.

Still you simply feel that you can just do as better without it and it would be

better to save money for other things by selling the car. Then you decide to sell

the car. What price do you expect to get for the car ? Certainly, not more than

Rs. 1,60,00/-. Why ???

Only because the owner of the car thinks of the buyer’s mind :

BUYER’S MIND

Why is the owner selling a

car if it is reliable ?

Why to sell a new brand car at low price ?

Is there anything

wrong with the car ?

Is the car ‘LEMON’ ?

The buyer can hire a mechanic to check the condition of the car. But the

buyer is always afraid whether the product (car) he is going to buy could be

‘LEMON’. Therefore, used cars are generally sold at much lesser price than

new cars because of asymmetric information.

Factor of asymmetric information makes certain effect on some other

markets also like Insurance, Financial credit, Employment etc.

EXAMPLE :

MARKET OF USED CARS

HIGH QUALITY LOW QUALITY

Here, we have assumed that buyer and seller, both can tell the type of a

particular car. That means both of them have proper information about the cars.

Figure-1 Figure-2

Price S H

Rs. 1,00,000 D H

Rs. 75,000 D M

Rs. 50,000 D LM

D L

25,000 50,000 75,000

( High-Quality Cars ) .

Price

Rs. 1,00,000 S L

D L

Rs. 75,000 D LM

Rs. 50,000 D L

25,000 50,000 75,000

( Low-Quality Cars ) .

As shown in Figure-1, SH is the supply curve of High-Quality cars. DL is

the demand curve for the High-Quality cars. Similarly, in Figure-2, SL is the

supply curve of the Low-Quality cars and DL is the demand curve for the Low-

Quality cars.

For any given price, SH always tends to lie to the left of SL as owners of

High-Quality cars are more reluctant to part with them and must receive a

higher price to do so. Similarly, DH is higher than DL because buyers are willing

to pay more to get a High-Quality car.

As the figure shows,

Here, The market price for High quality car is Rs. 1,00,000/-

The market price for Low quality car is Rs. 50,000/-

50,000 cars of each type are sold in the market.

In reality, the seller of a used car knows much more about its quality than

the buyer. Initially, buyer thinks that there is 50-50 % chance to get a high

quality. Why? Both have the knowledge of the quality. 50,000 cars of each

type are sold. When purchasing, the buyer views all cars as “MEDIUM

QUALITY” in the sense that there is an equal chance of getting a high-quality

or low-quality car. (The buyer knows the fact only after purchasing.)

The Demand curve for cars recognized as medium-quality cars is DM, is

below DH but above DL. As per the figure, medium-quality cars will sell for

about Rs. 75,000/- each.

However, fewer High-Quality cars (i.e. 25000) and more Low-

Quality cars (i.e.75000) will be sold.

Now consumers realize that most cars sold (about three fourth) are of

low-quality. Now the new demand curve shifts to DLM. It means that, on an

average, most of the cars are of Low-medium quality. The mix of the cars shifts

down heavily now. This shifting continues till low-quality cars are sold. At

that point, the market price would be too low for high-quality cars for sale, so

consumers correctly assume that any car they buy will be of low-quality. As a

result, the new relevant demand curve will be DL.

The market may come into equilibrium at a price that brings out at least

some high-quality cars. But the fraction of high-quality cars will be smaller

than it would be if consumers could identify quality before making the

purchase. That is why you should expect to sell your brand new car, which you

think to be in a perfect condition, at a very low price than you paid for it.

Because of asymmetric information, low-quality goods drive high-

quality goods out of the market. That is called ‘LEMONS PROBLEM’, which is

an important source of market failure.

Implication of Asymmetric Information:

The example of used cars shows how it results in Market

Failure. In an ideal world of fully functioning markets, consumers

would be able to choose between low-quality and high-quality cars.

Some buyers choose low-quality cars because of low cost.

Unfortunately, consumers cannot easily determine the quality of a

used car until they purchase it. As a result, price of used cars falls,

and high-quality cars are driven out of the market.

Market Failure arises, therefore, because there are owners of

high-quality cars who value their cars less than potential buyers of

high-quality cars. Both parties could enjoy the gains from trade, but,

unfortunately, buyers’ lack of information prevents this mutually

beneficial trade from occurring.

Adverse Selection :

It is a form of Market Failure resulting when products of different qualities

are sold at a same price because of asymmetric information, so that too much of

the low-quality and too little of high-quality products are sold.

Examples :

1). The market for insurance :

The people over age 65 have difficulties to buy a medical insurance as they

have higher risk of serious illness. Why doesn’t the prices of insurance rise to reflect

this risk? Only because of asymmetric information. People who wish to buy a

medical insurance know their physical condition more than the insurance company.

The company can even insist on a medical examination. As a result, adverse selection

arises. As unhealthy people are more likely to buy medical insurance, the proportion

of unhealthy people amongst insured people will increase. This forces the price of

insurance to rise. So healthy people elect not to be insured. This further increases the

proportion of unhealthy people amongst the insured people. The process continues

until most people who wish to buy insurance are unhealthy. At this point, insurance

becomes very expensive - in the extreme, the companies may stop selling insurance.

Solution of this problem is to pool risks. For example, in U.S., there is

Medicare program in which all people over age 65 are covered with insurance. Thus,

chances of occurring adverse selection decrease a lot.

2). The market for Credit:

By using a credit-card, most of the people borrow money without any collateral. Most of the credit-cards allow the customers to run a debt of several thousand rupees for specific period. Credit-card companies earn by charging interest on the debt balance. But how can a Credit-card company or Bank recognize high-quality borrowers who pay their debts in time and low-quality borrowers who don’t. In this case, borrowers have more information about their nature. Again LEMONS PROBLEM arises.

Low-quality borrowers are more likely to ask for credit than the high-quality borrowers. This forces the interest rate to rise. Ultimately high-quality borrowers elect not to have a credit-card. The proportion of low-quality credit-card holders rise and the interest rate rises further, and so on.

Of course, the banks and financial firms keep history of the customers to be secured from such asymmetric information.

Importance of Reputation and Standardization:

Asymmetric information is also present in many other markets.

Here are some examples.

RETAIL STORES: Will the store allow you to return a defective product? The stores know more about such policies.

RESTAURANTS : How often do you visit the kitchen of a restaurant? Do they obey the laws of the health department?

ROOFERS, PLUMBERS, ELECTRICIAN: Do we check whether the work is done in a proper manner or not?

DEALER OF RARE STAMPS, COINS AND PAINTINGS: The dealer knows more than the buyer whether the stamp, coin or painting is fake or counterfeit.

In all these cases, the seller knows more than the buyer about the quality of

the product. Unless the seller provides the buyer information about the quality

of the product, low-quality goods and services drive out high-quality products

and services and there will be Market Failure. Sellers of high-quality products

have to convince the customers that the quality of their product is indeed high.

In the above cases, this task is performed largely by reputation. Particular

restaurants have good reputation. You have never come to know that someone

became sick after taking a meal there, so you go there often. Some plumbers

have good reputation of their work.

Sometimes, it is impossible for business to develop reputation. For example,

customers of highway diners go to a particular dhaba or restaurant. How can

they deal with LEMONS PROBLEM ? Only solution is standardization.

McDonalds is a good example of that. McDonald will attract you more on the

highways because you know about the standards of food served there.

Market Signaling :

Market Signaling is a process by which the sellers send signals to buyers conveying information about the product quality.

We know how asymmetric information can lead to a lemons problem. Sellers know more about product’s quality than the buyers. Buyers assume the product quality to be low, causing the prices to fall and only low-quality products remain to be sold. High quality products get driven out of the market. Government intervention and developing a reputation can alleviate the problem of asymmetric information.

Example : Labor Market

Suppose, a firm is thinking about hiring some new people. The new workers are sellers (of labor) and firm is a buyer. The new workers know more about their efficiency, responsibility, skill and knowledge than the buyer. The firm can learn this only after hiring them.

What happens if the firm simply hires new people, tries them, fires the workers with low productivity? It proves to be too costly for the firm. Moreover, in many jobs, period upto 3 or 6 months is considered to be ‘Training Period’. A person becomes effective only after working for this period. Thus, the firm might not learn how good the workers are till 3 or 6 months. It is better for the firm to know the workers with potential before hiring them.

What characteristics can be kept in mind by the firm to get potential workers ?

Can potential employees convey information about their productivity? Dressing well for the interview might convey some information but even unproductive people can dress well. Dressing, thus, is a weak signal.

Education is a strong signal in labor markets. A person’s education level can be measured easily. Degrees, Person’s grade or class, Reputation of the university etc. indicate person’s education. And education can directly or indirectly improve productivity of a person. Thus, the firms are correct in considering education as a signal of productivity.

A simple model of Job Market Signaling :

Let’s assume that there are two groups of workers.

Group-1 consists of low-quality workers and Group-2 consists of high-quality workers.

Marginal Productivity of each worker of Group-1 is 1. Marginal Productivity of each worker of Group-2 is 2.

Workers will be empowered by competitive firms whose products sell for Rs. 1,00,000/- and who expect an average 10 years’ work from each worker.

We also assume that half of the workers belong to Group-1 and the rest belong to Group-2. Thus, average productivity of all workers is 1.5.

Revenue expected to be generated from Group-1 workers is Rs.1,00,000 x 10 yrs. = Rs. 10,00,000/-from Group-2 workers is Rs. 2,00,000 x 10 yrs. = Rs. 20,00,000/-

If the firm identifies workers from their productivity, the wages to be paid to Group-1 will be Rs. 1,00,000/-the wages to be paid to Group-2 will be Rs. 2,00,000/-

But as asymmetric information is there, and workers know their productivity more than the firm, the workers will be assumed to be of medium-quality. Thus, Group-1 will earn Rs.150000/- , that means Rs. 50000 more than they deserve and Group-2 will earn Rs.150000/- which means Rs. 50000 less than they deserve.

Now there is a signaling of education. Suppose all the attributes of education can be summarized by a single index – y that represents years of higher education. All education involves tuition, books, opportunity cost of foregone wages, and the psychic cost of having to work hard to obtain high grades. What is important is that the cost of education is greater for the low-productivity group than for the high-productivity group. We might expect this to be the case for two reasons. First, low-productivity workers may be less studious. Secondly, they may progress more slowly. In particular, suppose that for Group-1 people, the cost of attaining educational level y is given by

C1 (y) = Rs. 4,00,000 y

And that for Group-2 people, it is

C2 (y) = Rs. 2,00,000 y

Equilibrium :

Consider the following possible equilibrium. Suppose firms use this decision

Rule : Anyone with an education level of y* or more is a Group-2 worker and is

offered a wage Rs. 2,00,000, while anyone with an education level below y* is a

Group-1 person and is offered a wage of Rs. 1,00,000. The particular level y*

that the firms choose is arbitrary, but for this decision rule to be part of an

equilibrium, firms must have identified people correctly. Otherwise, the firms

will want to change the rule. Is this going to work ???

Group-1 Group-2

To answer this question, we must determine how much education the people in

each group will obtain, given that firms are using this decision rule. To do this,

remember that education allows one to get a better-paying job. The benefit of

education B(y) is the increase in the wage associated with each level of

education, as shown in figure. Observe that B(y) is 0 initially, which represents

the Rs. 1,00,000/- base 10-year earnings that are earned without any college

education. For an education level less than y*, B(y) remains 0, because 10-year

earnings remain at the Rs. 1,00,000 base level. But when the education level

reaches y* or greater, 10-year earnings increase to Rs. 2,00,000/-, increasing

B(y) to Rs. 1,00,000/-,

Value of college education

Rs. 2,00,000

C1 (y) = Rs. 4,00,000 y

/

Rs. 1,00,000 B(y)

0 1 2 3 4 5 6 y* years of

Optimal choice of y for group-1 college .

Value of college education

Rs. 2,00,000

C1 (y) = Rs. 2,00,000 y

/

Rs. 1,00,000 B(y)

0 1 2 3 4 5 6 y* years of

Optimal choice of y for group-2 college

How much education should a person obtain ? Clearly the choice is

between no education ( i.e., y=0) and an education level of y*. Similarly, there

is no benefit from obtaining an educational level above y* because y* is

sufficient to allow one to enjoy the higher total earning of Rs. 2,00,000/-.

These results give us an equilibrium as long as y* is between 2.5 and 5.

Suppose, for example, that y* is 4.0 as in the figure. In that case, people in

Group-1 will find that education does not pay and will not obtain any, whereas

people in Group-2 will find that education does pay and will obtain the level

y=4.0. Now, when a firm interviews job candidates who have no college

education, it correctly assumes they have low productivity and offers them a

wage of Rs. 100000. Similarly, when the firm interviews people who have four

years of college, it correctly assumes their productivity is high, warranting a

wage of Rs. 200000. We therefore have equilibrium. High-productivity people

will obtain a college education to signal their productivity; firms will read this

signal and offer them a high wage.

Guarantees and Warranties :

We saw the signaling in the labor markets. It can also play an important role in

the markets (with asymmetric information) of television, refrigerators, cameras,

stereos etc. Many firms produce these equipments but some brands are more

dependable than others. If consumer couldn’t tell which brand is more

dependable, the dependable brand could not be sold for higher prices. Firms

that produce high-quality products have to make the consumers aware of the

fact that their products are of higher-quality.

As they are costly for the producer, Guarantees and Warranties effectively

signal product quality. The low-quality product requires servicing under the

warranty, for which the producer pays. In their own self-interest, therefore,

producers of low-quality products will not offer Guarantees and Warranties.

Thus, the consumer can identify the high-quality product.

Moral Hazard :

When a party is fully insured and cannot be accurately monitored by insurance

company having limited information, the insured party may take an action that

increases the probability of accident or injury to him. For example, if my home

is fully insured against theft, I may choose to install alarm system. The

possibility that a person’s behavior may change because he has insurance is an

example of a problem known as Moral Hazard.

Example :

As per the figure, D is the demand curve for vehicle driving in kms. per week.

The demand curve measures the marginal benefits of driving, is downward

sloping because some people switch to alternative transportation as the cost of

driving increases. Suppose that initially, the cost of driving includes the

insurance cost and that insurance company can accurately measure miles driven.

In this case, there is no moral hazard and the marginal cost of driving is given

by MC. Drivers know that more driving will increase their insurance premiums

and so increase their total cost of driving.

For example, the cost of driving is Rs. 2.50 per km. and drivers will go 100

kms. per week. A moral hazard problem arises when insurance companies

can’t monitor individual driving habits, so that insurance premiums do not

depend on kms. driven. In that case, drivers assume that any additional accident

costs that they incur will be spread over a large group, with only a negligible

portion accruing to each of them individually. Because their insurance

premiums do not vary with the number of kms. that they drive, an additional

km. of transportation will cost Rs. 1.50, as shown by the marginal cost curve

MC’, rather than Rs. 2.50. the number of kms. driven will increase from 100 to

the socially inefficient level of 140.

Figure

Moral hazard creates economic inefficiency. In the driving example, the

efficient level of driving is given by the intersection of the marginal benefit

(MB) and marginal cost (MC) curves. With moral hazard, the individual’s

perceived marginal cost (MC) is less than actual cost, and the number of kms.

driven per week (140) is higher than the efficient level at which marginal

benefit is equal to marginal cost (100).

Cost perKm.

Rs. 3.00

Rs. 2.50 MC Rs. 2.00 MC’ Rs. 1.50 D=MB

0 50 100 140 Kilometres per week

The Principal – Agent Problem :

Principal : Individual who employs one or more agents to achieve an objective.

Agent : Individual employed by a principal to achieve the principal’s objective.

Principal-Agent Problem : The problem arising when agents (e.g. managers of the firm) pursue their own goals rather than the goals of the principals (e.g. owners of firm).

The owners of business always wish to monitor and ensure the productivity of the managers and workers. But it is costly and not possible as well to monitor whether they are working effectively or not. Employees have better information about their efficiency than the employers. This asymmetric information creates Principal-Agent Problem.

The agent acts and that affects the Principal. In this problem, the agents pursue their own goals rather than the goals of the principal. In our example, workers and managers are agents and the owners of the firm are the Principal. In Principal-Agent problem, the managers may pursue their individual goals even at the cost of lower profits for the owners.

Principal-Agent problem in Private Enterprises :

In India, most of the stocks of major companies are hold by small investors and the management of the company is in the hands of the Managers. The managers’ act and that affects the share-holders.

It is impossible to monitor the managers and that is too costly. Thus the managers pursue their individual objectives rather than the principal’s. Sometimes they prefer growth instead of profits.

Principal-Agent problem in Public Enterprises :

In the public organization, the managers may be interested in power and perks, both of which can be obtained by expanding their organization beyond the “efficient” level. As it is costly to monitor the effectiveness of such managers, there are no guarantee that they will produce effective output. Legislative checks are not likely to be there in public enterprises.

Managers of public enterprises care about more than just the size of their agency. Many choose lower paying public jobs as they are concerned about

public interest. Public managers who pursue improper objectives, their ability to earn high salaries in future gets damaged.

Solution : Incentives in the Principal-Agent Framework :

The managers’ and owners’ objectives are likely to differ within the Principal-Agent framework. Therefore, the owners can design reward systems so that managers and workers come as close as possible to meeting owners’ goals.

Managerial Incentives in an Integrated Firm :

The managers and owners of the firm have asymmetric information about demand, cost and other variables. The owners can create reward systems to encourage the managers to achieve the principal’s objectives.

Now, Let’s see the Integrated firms. Some may be horizontally integrated and some may be vertically integrated.

Here, each firm has several departments and each department has got a separate manager. Upstream divisions produce materials, parts and components that downstream divisions use to produce final products.

Integration creates organizational problems. Asymmetric Information and Incentive Design in the Integrated Firm

The managers have better information about their different operating costs and production potential than central management has.

This asymmetric information causes two problems.

1) How can central management obtain accurate information about divisional operation costs and production potential from divisional managers ? This is important information because the inputs into some divisions may be the outputs of the other divisions, because deliveries must be scheduled to customers, and because prices cannot be set without knowing overall production capacity and costs.

2) What reward structure should central management use to encourage divisional managers to produce as efficiently as possible? Should they be given bonuses based on how much they produce? If so, how should they be structured?

Suggested Methods :

1) Give plant managers bonuses based on the total output of their plant. This would encourage the managers to maximize the output. The managers, whose plants are with higher costs and lower capacity would be penalize. Plant managers would also have no incentive to obtain and reveal accurate information about cost and capacity.

2) Ask managers about their cost and capacity and then base bonuses on how well they do relative to their answers.

Example :

Bonus(Rs.per year)

Qf = 30,000 10,000 ---

Qf = 20,000

8,000 --- Qf = 10,000

6,000 ---

4,000 ---

2,000 ---

10000 20000 30000 40000

Output (Units per year)

12. Asymmetric information in Labor Markets :Efficiency Wage Theory

When the market is competitive, all who wish to work find jobs for wages equal

to their marginal products.

Yet there is substantial unemployment in many countries, many are

aggressively seeking job, many unemployed would presumably work for even

lower wage rate than that being received by employed people. Why don’t we

see cutting wage rates, increasing employment level, and thereby increasing

profit?

Here, efficiency wage theory shows the presence of unemployment and wage

discrimination. We have thus determined labor productivity according to

workers’ abilities and firms’ investment in capital. Efficiency wage models

recognize that labor productivity also depends on the wage rate. There are

various explanations for this relationship. Economists have suggested that the

productivity of workers in developing countries depends on the wage rate for

nutritional reasons : Better-paid workers can afford to buy more and better food

and therefore healthier and can work more productively.

Countries like U.S. can be explained and found in Shirking model. Because

monitoring workers is costly or impossible. Firms have asymmetric

information about the productivity of workers and there is Principal-Agent

Problem. In its simplest form, this model assumes perfectly competitive

market in which all workers are equally productive and earn the same wage.

Once hired, workers can either work productively or shirk. But because

information about their performance is limited, workers may not get fired for

shirking.

The model works as follows :

If a firm pays its workers the market-clearing wage (w*), they have an incentive

to shirk. Even if they get caught and are fired, they can immediately get hired

somewhere else for the same wage. Because the treat of being fired does not

impose a cost on workers, they have no incentives to be productive. As an

incentive not to shirk, a firm must offer workers a higher wage. At this higher

wage, workers who are fired for shirking will face a decrease in wages when

hired by another firm at w*. If the difference in wages is large enough, workers

will be induced to be productive, and the employer will not have a problem with

shirking. The wage at which no shirking occurs is the efficiency wage.

Up to this point, we have looked at only one firm. But all firms face the

problem of shirking. All firms, therefore, will offer wages greater than the

market-clearing wage w* - say we (efficiency wage). Does this remove the

incentive for workers not to shirk because they will be hired, at the higher wage

by other firms if they get fired? No, because all firms are offering wages

greater than w*, the demand for labor is less than the market-clearing quantity,

and there is unemployment. Consequently, workers fired for shirking will face

spells of unemployment before earning we at another firm.

The figure below shows shirking in the labor market. The demand for labor DL

is downward sloping for the traditional reasons. If there were no shirking, the

intersection of DL with the supply of labor (SL) would set the market wage at

w*, and full employment would result (L*). With shirking, however, individual

firms are unwilling to pay w*. Rather, for every level of unemployment in the

labor market, firms must pay some wage greater than w* to induce workers to

be productive. This wage is shown as the no-shirking constraints (NSC) curve.

This curve shows the minimum wage, for each level of unemployment, that

workers must earn in order not to shirk. Note that the greater the level of

unemployment, the smaller the difference between the efficiency wage and w*.

Why is this so? Because with high levels of unemployment, people who shirk

risk long periods of unemployment and therefore don’t need much inducement

to be productive.

In figure, equilibrium wage will be at the intersection of the NSC curve and DL

curves, with Le workers earning we. This equilibrium occurs because the NSC

curve gives the lowest wage that firms can pay and still discourage shirking.

Firms need not pay more than this wage to get the number of workers they need,

and they will not pay less because a lower wage will encourage shirking. Note

that the NSC curve never crosses the labor supply curve. That means there will

always be some unemployment in the equilibrium.

WageNon-Shirking Constraint (NSC)

Demand curve for labor

we

W* DL

Le L*Quantity of labor

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