Ch17 Pindyck Myslides

Chapter 17
Markets with Asymmetric

Information
Topics to be Discussed
Quality Uncertainty and the Market for
Lemons
Market Signaling
Moral Hazard
The Principal-Agent Problem
Managerial Incentives in an Integrated
Firm
Asymmetric Information in Labor
Markets: Efficiency Wage Theory
©2005 Pearson Education, Inc. Chapter 17 2

Introduction
When one party has more information
about relevant variables than the other,
we have asymmetric information
Asymmetric information is all around us
 Sellers usually know more about the quality
of their product than buyers
 Workers know more about their own skills
and abilities than employers
 Managers know more about investment
opportunities than shareholders

The Market for Lemons
Ex: The market for used cars
 Two types of used cars – high quality and
low quality
 First, assume that buyers and sellers can
distinguish between the cars
There will be two markets – one for high quality
cars and one for low quality cars

SH is higher than SL because owners of

high quality cars generally require a high
price to sell them
Similarly, DH is higher than DL because
consumers are generally willing to pay
more for higher quality cars

Price for high quality cars is $10,000.
PH PL
SH
$10,000
Price for low quality cars is $5000.

DH
SL
$5,000
50,000 of each type are sold. DL
50,000 50,000
QH QL

 Now assume sellers can distinguish between
the cars but buyers cannot
 This will allow us to see the role of asymmetric
information
 Since, under complete information, the same
number of high- and low-quality cars are sold,
under asymmetric information buyers may think
the odds that a car is high quality are 50/50
 Since buyers can’t distinguish, they will view all cars
as medium quality (with demand DM)
 Keep in mind that no car is actually of medium
quality

HQ cars are perceived as MQ and LQ cars are perceived as MQ and
sell for $7500. sell for $7500.
PH PL
SH
SL
10,000
DH
7,500 7,500
DH
5,000 DM
DM
DL
25,000 HQ cars end up being sold.
DL 75,000 LQ cars end up being sold.
25,000 50,000 50,000 75,000

©2005 Pearson Education, Inc. QH 8 QL
Since only 25,000 HQ cars are sold while
75,000 LQ cars are sold, a buyer will
change her subjective probability that the
car is high quality to 25/75 from 50/50
 Buyers will now view all cars as “low-medium”
quality (with demand DLM)

Price will drop below $7500.
PH PL
SH
10,000 SL
7,500 7,500
DH
DM
5,000
DM
DLM
Subjective probabilityDof
LMbuying a HQ car will drop below 25/75. DL
DL
25,000 50,000 50,000 75,000

©2005 Pearson Education, Inc. QH 10 QL
You get the picture: as price drops, a
buyer’s subjective probability of the
proportion of HQ cars decreases, and
this in turn causes price to drop even
further
This vicious cycle will continue until the
price drops to PL and all cars offered for
sale are LQ.
 In well-functioning markets, this cycle takes a
very short time to complete

With asymmetric information:
 Low quality goods can drive high quality
goods out of the market - the lemons
problem
 The market can fail (in the above example,
mutually beneficial trade for HQ cars does
not occur)
 Adverse selection occurs; in equilibrium,
trade takes place mainly for lower quality
goods

Market for Health Insurance
 Ex: Health Insurance
 Older individuals have difficulty purchasing health
insurance at almost any price – Why?
 They know more about their own health than the
insurance company does
 Unhealthy people are more likely to want insurance
than healthy people; therefore the proportion of
unhealthy people in the pool of those insured rises
 As the pool tilts toward unhealthy, prices rise; in turn
the pool tilts even more toward unhealthy
 Eventually, the only people left are the most
unhealthy, and the price of insurance becomes
extremely high
Market for Auto Insurance
Ex: Auto insurance
 Insurance companies know that some drivers
have a low probability of being in an accident
and some have a high probability
 If they can’t distinguish among drivers, they
will base premiums on the average
experience
 Safe drivers will... (you complete the rest)

Market for Insurance
How do we solve the problem of
asymmetric information?
A possible solution is to pool risks
 The government can take on this role, as
with Medicare
Problem of adverse selection is eliminated

Market for Credit
Ex: Credit cards
 Asymmetric information regarding the ability
to repay debt
 Potential for lemons problem
 To solve this, banks and credit agencies use

credit histories, and even share credit
histories, to gauge credit-worthyness

Importance of Reputation and
Standardization
Asymmetric information is everywhere
 Antiques, art, rare coins – real or counterfeit?
 Restaurants – check the kitchen?
 Home repair – climb up to see job?

Implications of Asymmetric
Information
 How can these producers provide high-quality
goods when asymmetric information will drive
out high-quality goods through adverse
selection?
 Reputation
 You hear about restaurants or stores that have good
or bad service and quality
 Standardization
 Chains that keep production the same everywhere
 You look forward to a Big Mac when traveling, even if you
would not typically buy one at home, because you know
what to expect

Market Signaling
Another way to alleviate the problem of
asymmetric information is through
market signaling
 Market signaling is the process by which
sellers send information to buyers about
product quality
For example, a potential worker (selling
labor) will usually submit a resume to the
potential employer (buying labor),
thereby signaling his/her ability and skills

Market Signaling
Not all signals are the same
 Dressing well for the interview is a weak
signal
Weak because even unproductive employees
can dress well
 Having an advanced degree from a reputable
university is a strong signal
To be effective, a signal must be difficult for
sellers of LQ products to imitate
 Degree in Financial Engineering from Polytechnic

Model of Job Market Signaling
 Simple model of signaling
 Two groups of workers
 Group I: Low productivity
 Marginal (and average) product of labor = 1 unit per
year
 Group II: High productivity
 Marginal (and average) product of labor = 2 units per
year
 There is an equal number of Group I and Group II
workers
 Average product of labor for all workers = 1.5 units
per year

Assume competitive markets (no profit)
 Price = $10,000/unit
 Employees average 10 years of employment
 Revenue from Group I worker = $100,000

(1 x $10,000 x 10 years)
 Revenue from Group II worker = $200,000
(2 x $10,000 X 10 years)

With Complete Information
 Wage = revenue from worker
Group I wage = $10,000/yr.
Group II wage = $20,000/yr.
With Asymmetric Information

 Wage = average revenue from all workers
Group I & II wage = $15,000/yr.
Group I workers essentially gain at the expense
of group II workers

Consider a potential signal:
 y = education index (e.g., years of education,
reputation of university, GPA, etc.)
 C(y) = cost of attaining educational level y
Direct costs
 tuition
 textbooks
Indirect costs
 opportunity cost of doing something else
 suffering through FE 601

Assume education is more costly for
Group I for any level of y
 Why?
Low productivity workers may simply be less
studious
Low productivity workers progress slower
through degree programs
 Group I  CI(y) = $40,000y
 Group II  CII(y) = $20,000y

 Assume education is only valuable as a potential
signal
 Does not improve your skills
 Can we find an equilibrium where Group I
workers choose less education and Group II
workers choose more education?
 We have an equilibrium if we can identify a level
y* such that Group I optimally chooses < y* and
Group II chooses ≥ y*
 Employers will be able to tell workers apart based on
level of education

 Some observations:
 Since y* is the only threshold and education is costly,
no one will choose y > y* and no one will choose
y* > y > 0
 y > y* sends the same signal as y = y*
 y* > y > 0 sends the same signal as y = 0
 Ed level of y* signals GII and wage = $20,000/yr
 Ed level of 0 signals GI and wage = $10,000/yr
 Note that there is no 1 right solution to the level
of y*, but for education to be an effective signal,
firms must identify a correct solution
How much education will individuals
obtain given that firms use this decision
rule?
Benefit of education B(y) is the increase
in wage associated with each level of
education
B(y) is initially 0, which corresponds to
the $100,000 base 10-year earnings
 B(y) continues to be zero until ed reaches y*

 How much education to choose is a cost-benefit
comparison
 Obtain education level y* if the benefit, B(y), is at least as
large as the cost, C(y).
 Group I:
 No education if $100,000 < $40,000y*
 ⇒ no education if y* > 2.5
 Group II:
 No education if $100,000 < $20,000y*
 ⇒ no education if y* > 5
 Therefore, any level of y* between 2.5 and 5 will work in
distinguishing Group I workers from Group II workers
 Make sure you understand this

Suppose y* = 4
 People in Group I will find education is not
worthwhile, since $100,000 < $40,000×4
Benefit lower than cost
 People in Group II will find education is
worthwhile, since $100,000 > $20,000×4
Benefit higher than cost
Therefore, y* = 4 is an effective
separating equilibrium

Value of Group I Value of Group II
College College
Educ. Educ.
$200K $200K
CI(y) = $40,000y CII(y) = $20,000y
$100K $100K
B(y)
B(y)
0 1 2 3 4 5 6 Education 0 1 2 3 4 5 6 Education
y* level y* level
©2005 Pearson Education, Inc. 31
Conclusion
 Education is valuable as a signal, even in the
absence of other benefits
In reality, of course, education makes you more
productive

Market Signaling
Another example of market signaling:
Guarantees and warranties
 Sellers of HQ products signal quality and the
cost to LQ producers of offering guarantees
and warranties is too high

Moral Hazard
 Moral hazard occurs when a party whose
actions are unobserved can affect the
probability or magnitude of an adverse event
 If your home is insured, you might be less likely to
lock doors or install a security system
 If you have a flat salary, you might decide to work less
hard
 Here we have hidden action rather than hidden
information

Moral Hazard
Ex: Determining the Premium for Fire
Insurance
 Warehouse worth $100,000
 Probability of a fire:
.005 if conduct a $50 fire-prevention program
.01 if don’t conduct the program
 If the insurance company cannot monitor the
company’s decision whether to conduct the
fire-prevention program, how does it set the
premium?

Moral Hazard
With the program the premium is:
 0.005 x $100,000 = $500
However, once insurance is purchased,
the owners no longer have an incentive
to run the program
 Probability of fire increases to 0.01
 Premium increases to (0.01 x $100,000) =
$1000

The Principal-Agent Problem
This leads us to a discussion of agency
Typically, owners (principals) do not
continuously monitor managers (agents),
so the managers can potentially take
actions which are detrimental to the
owners
This creates a principal-agent problem
which arises when agents pursue their
own goals, rather than the goals of the
principal
Some examples of principals and agents
 Company owner (principal) wants to
maximize profits, managers and employees
(agents) want to take it easy
 U.S. residents (principals), politicians
(agents)
 Parents of a baby (principals), babysitter
(agent)

A Principal-Agent Problem in the Private
Sector: Management vs. Shareholders
 Ownership of most U.S. firms is not highly
concentrated
 It is costly to monitor managers, and when
ownership is diffuse the benefits don’t justify
the costs for any 1 shareholder

Managers may pursue their own
objectives
 Increase company size and market share,
which ultimately will lead to more respect and
power
 Increase own salary and bonuses
 Increase own job security

Limitations to managers’ ability to deviate
from owners’ objectives
 Stockholders can oust managers with help
from board of directors
 Another firm may attempt a takeover
 Compensation can be structured to better

align managers’ and owners’ incentives

The problem of limited stockholder
control shows up in executive
compensation
 In 2002, Business Week reported that, on
average, CEOs of large corporations earn
$13.1 million per year, and that the annual
growth rate in executive compensation has
been in double-digits

CEOs vs. All Workers: Salaries
All Workers Top 100 CEOs
1970 $32,522 $1.3 Mil.
1999 $35,864 $37.5 Mil.
CEO compensation has gone from 40

times the pay of average worker to over
1000 times*
*Based on 1/18/2003 NYT article

Incentives in the Principal-Agent
Framework
When a principal-agent problem arises,
the best solution is to design a reward
system for the agent such that his/her
incentives are aligned with the principal’s
goals
 This usually involves tying the reward to
some observable variable

Framework
Ex: Watch manufacturer
 Uses labor and machinery
 Manufacturer’s goal is to maximize profit
 Machine repairperson can work with low effort

or high effort
Low effort increases the probability that machines
will break down, thereby reducing profits
High effort reduces the probability that machines
will break down, thereby increasing profits
Effort is not observed (monitoring too costly)

Framework
Some other assumptions:
 Revenue also depends on other factors
besides repairperson’s effort
 Effort cannot be deduced from revenue level
This means that effort is not ex-post verifiable

The Revenue from Making
Watches
Revenue
Poor Luck Good Luck
Low Effort
$10,000 $20,000
(a = 0) ia
bl
e
not erif
o rt st v
f
ef -po
High Effort ex
$20,000 $40,000
(a = 1)

Framework
 Repairperson’s (agent’s) goal
 Maximize wage less the cost of effort
 Assume cost = 0 for low effort, cost = $10,000 for
high effort
 Note that this goal implies that the repairperson is
risk-neutral
 Owner’s (principal’s) goal
 Maximize revenue less repairperson’s wage
 Choose a payment scheme that will maximize profits
 Since effort is not observable, the wage can only be
set as a function of revenue, not effort
 w(R) = repairperson’s wage as a function of revenue

Framework
 Lets compare two payment schemes:
 Scheme1: Fixed wage
w = 0 (why zero? How much does the wage need to be if cost is 0?)
 Then, effort = low, wL – cost(effortL) = 0
 E[profit] = E[revenue] – E[wL] = $15,000 - $0 = $15,000

 Scheme2: Bonus arrangement
w = 0 if r = $10,000 or $20,000
 w = $24,000 if r = $40,000
 Then, repairperson will choose effort = high, since E[wH]
– cost(effortH) is $12,000 - $10,000 = $2000 but E[wL]
– cost(effortL) is $0 - $0 = $0
 Incentivize the repairperson to choose effort = high
 E[profit] = E[revenue] – E[wH] = $30,000 - $12,000 = $18,000
 Thus, both are better
©2005 Pearson Education, Inc.
off under the bonus arrangement
Chapter 17 49
Framework
Suppose there are many repairpersons,
so there is a lot of competition for the job
If you are the watch manufacturer what
payment scheme would you choose?
 Clearly, a fixed wage is not a good idea
 The bonus from previous slide is a better idea
 But even better:
w = 0 if revenue = $10,000 or $20,000
w = $20,001 if revenue = $40,000
This scheme allows you to extract maximum
rents; E[profit] = $19,999.50
Framework
Conclusion
 A clever incentive structure can induce the
agent to aim for the goals set by the principal

Managerial Incentives in an
Integrated Firm
o p
t
In integrated firms, division managers
have better (asymmetric) information
S re
about production than central
management
Two Issues
e
 How can central management elicit accurate
h
information?
 How can central management achieve
efficient divisional production?

Integrated Firm
We will focus on firms that are integrated
Horizontally integrated
 Several plants produce the same or related
products
Vertically integrated
 Firm contains several divisions, with some
producing parts and components that others
use to produce finished products

Integrated Firm
 Possible Incentive Plans
2. Give plant managers bonuses based on
either total output or operating profit
 Would encourage managers to maximize
output
 Would penalize managers whose plants
have higher costs and lower capacity
 No incentive to obtain and reveal accurate
cost and capacity information

Integrated Firm
1. Ask managers about their costs and

capacities and then base bonuses on
how well they do relative to their
answers
 Qf = estimate of feasible production level
 B = bonus in dollars
 Q = actual output
 B = 10,000 - .5(Qf - Q)
 Incentive to underestimate Qf

Integrated Firm
If manager estimates capacity to be
18,000 rather than 20,000, and if the
plant only produces 16,000, her bonus
increases from $8000 to $9000
 Don’t get accurate information about capacity
and don’t insure efficiency
Bonus still tied to accuracy of forecast

Integrated Firm
Modify scheme by asking managers how
much their plants can feasibly produce
and tie bonuses to it
Bonuses based on more complicated
formula to give incentive to reveal true
feasible production and actual output
 If Q > Qf ,B = .3Qf + .2(Q - Qf)
 If Q ≤ Qf ,B = .3Qf - .5(Qf - Q)

Integrated Firm
Assume true production limit is Q* =
20,000
 Line for 20,000 is continued for outputs
beyond 20,000 to illustrate the bonus
scheme but dashed to signify the infeasibility
of such production
 Bonus is maximized when firm produces at
its limit of 20,000; the bonus is then $6000

Incentive Design in an
Integrated Firm
Bonus
($ per If Qf = 10,000,
Qf = 30,000
year) bonus is $5,000.
Qf = 20,000
10,000
If Qf = Q* = 20,000, Qf = 10,000
bonus is $6,000.
8,000
6,000
If Qf = 30,000,
4,000 bonus is $4,000,
the maximum
amount possible.
2,000
Output
0 10,000 20,000 30,000 40,000 (units per year)
Efficiency Wage Theory
In a competitive labor market, all who
wish to work will find jobs for a wage
equal to their marginal product
 However, most countries’ economies
experience unemployment

The efficiency wage theory can explain
the presence of unemployment and wage
discrimination
 In developing countries, productivity depends
on the wage rate for nutritional reasons

The shirking model can be better used to
explain unemployment and wage
discrimination in the United States
 Assumes perfectly competitive markets
 However, workers can work or shirk
 Since performance information is limited,

workers may not get fired

If workers are paid market clearing wage
w*, they have incentive to shirk
If they get caught and fired, they can
immediately get a job elsewhere for
same wage
Firms have to pay a higher wage to
make loss higher from shirking
Wage at which no shirking occurs is the
efficiency wage

All firms will offer more than market
clearing wage, w*, say we (efficiency
wage)
In this case, workers fired for shirking
face unemployment because demand for
labor is less than market clearing
quantity

Unemployment in a Shirking
Model
Demand for
Wage Labor
No-Shirking Without shirking, the market wage
Constraint is w*, and full-employment exists at L*
SL
The no-shirking
constraint gives
the wage necessary
to keep workers
from shirking.
At the equilibrium wage, We the

we firm hires Le workers
creating unemployment of L* - Le.
w*
Quantity of
Le L* Labor

Efficiency Wages at Ford Motor
Company
Labor turnover at Ford
 1913: 380%
 1914: 1000%
Average pay = $2 - $3
Ford increased pay to $5

Efficiency Wages at Ford Motor
Company
Results
 Productivity increased 51%
 Absenteeism was halved
 Profitability rose from $30 million in 1914 to

$60 million in 1916

Important concepts
 Asymmetric information
 Lemons problem
 Adverse selection
 Pooling risks
 Market signaling
 Separating equilibrium
 Moral hazard
 Principal
 Agent
 Principal-agent problem

Homework
Questions for review: 4
Exercises: 5,8,9,10
Due in 2 weeks
Next week: final exam


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Chapter 17

Markets with Asymmetric

©2005 Pearson Education, Inc. Chapter 17 2

©2005 Pearson Education, Inc. Chapter 17 3

©2005 Pearson Education, Inc. Chapter 17 4

SH is higher than SL because owners of

©2005 Pearson Education, Inc. Chapter 17 5

Price for low quality cars is $5000.

50,000 of each type are sold. DL

©2005 Pearson Education, Inc. Chapter 17 6

©2005 Pearson Education, Inc. Chapter 17 7

DL 75,000 LQ cars end up being sold.

25,000 50,000 50,000 75,000

©2005 Pearson Education, Inc. Chapter 17 9

25,000 50,000 50,000 75,000

©2005 Pearson Education, Inc. Chapter 17 11

©2005 Pearson Education, Inc. Chapter 17 12

©2005 Pearson Education, Inc. Chapter 17 14

©2005 Pearson Education, Inc. Chapter 17 15

 To solve this, banks and credit agencies use

©2005 Pearson Education, Inc. Chapter 17 16

 Home repair – climb up to see job?

©2005 Pearson Education, Inc. Chapter 17 17

©2005 Pearson Education, Inc. Chapter 17 18

©2005 Pearson Education, Inc. Chapter 17 19

©2005 Pearson Education, Inc. Chapter 17 20

©2005 Pearson Education, Inc. Chapter 17 21

 Revenue from Group I worker = $100,000

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With Asymmetric Information

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 Increase own job security

©2005 Pearson Education, Inc. Chapter 17 40

 Compensation can be structured to better

©2005 Pearson Education, Inc. Chapter 17 41

©2005 Pearson Education, Inc. Chapter 17 42

All Workers Top 100 CEOs

1970 $32,522 $1.3 Mil.

1999 $35,864 $37.5 Mil.

CEO compensation has gone from 40

©2005 Pearson Education, Inc. Chapter 17 43

©2005 Pearson Education, Inc. Chapter 17 44

 Machine repairperson can work with low effort

©2005 Pearson Education, Inc. Chapter 17 45

©2005 Pearson Education, Inc. Chapter 17 46

©2005 Pearson Education, Inc. Chapter 17 47

©2005 Pearson Education, Inc. Chapter 17 48

 E[profit] = E[revenue] – E[wL] = $15,000 - $0 = $15,000

©2005 Pearson Education, Inc. Chapter 17 51

©2005 Pearson Education, Inc. Chapter 17 52