You are on page 1of 24

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, surplusgenerating trades may not occur Akerlof’s paper shows how a market can unravel completely because of adverse selection Remedies Lemons x2 Cows Credit scoring
BPUB 203 1

Examples
  

Wharton

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 Differential between milking and dry cows is smaller when there’s a drought in seller’s village

Prices are influenced

Wharton

BPUB 203

2

Remedies for Adverse Selection  Market-based  Government Wharton BPUB 203 3 .

are you going to seek long-term value or shortterm profits? As a sharecropper. we call this “adverse selection” (last time)    How good a driver are you? How likely are you to stay healthy? How smart or hard-working are you?  Hidden actions following contracting.Two Types of Asymmetric Information  Hidden fixed characteristics at the time of contracting. are you going to work hard and contribute complementary inputs?  Wharton Where do bureaucrats’ interests align? BPUB 203 4 . we call this “moral hazard” (today’s session)   As CEO.

Asymmetric Information – Moral Hazard  Economic concepts   Adverse selection pertains to hidden characteristics. Hidden actions by the agent–or at least non-contractible actions– can prevent the action under the contract from being efficient. Often the inefficiency arises because the principal wants to give the agent incentives to perform.”    A conflict is present between the interests of the principal and the interests of the agent. while moral hazard pertains to hidden actions In a “principal-agent problem. while the agent wants to be insured against losses  Examples    CEO compensation Bailouts Bureaucrats BPUB 203 5 Wharton .

Examples of Moral Hazard  i. principals and their respective agents Wharton BPUB 203 6 ..e.

Output equals 0 with probability 1 if effort is 0 Output equals y 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 but not on effort P chooses w(y) and w(0) to maximize expected output minus expected wages BPUB 203 7 Wharton . or A can drop out and receive u0. a Principal P and an Agent A       A can contribute effort e or effort 0.A Canonical Model of Moral Hazard  Two people.

cont.Canonical Model.  P’s profit:   If effort = e: If effort = 0:  A’s utility   π = qy − (1 − q )w(0 ) − qw( y ) π = 0 − w(0 ) If effort = e: U = (1 − q )u (w(0 )) + qu (w( y )) − c If effort = 0: U = u (w(0 ))   “Incentive compatibility”: wages have to suffice to motivate effort (incentives) “Individual rationality”: wages have to suffice to motivate participation (insurance) BPUB 203 8 Wharton .

cont.  IC: (1 − q )u (w(0)) + qu (w( y )) − c ≥ u (w(0)) q[u (w( y )) − u (w(0 ))] ≥ c    P never wants to implement 0 effort. too BPUB 203 9 . so ignore IR0. IC will always hold with equality IRe: (1 − q )u (w(0 )) + qu (w( y )) − c ≥ u0 u (w(0 )) ≥ u0 u (w(0 )) + q[u (w( y )) − u (w(0 ))] − c ≥ u0  Wharton IRe will always hold with equality.Canonical Model.

P would pay a flat wage w to induce effort e. IR would be u (w) − c ≥ u0 π = qy − u (u0 + c ) −1 w = u −1 (u0 + c )  Wharton If u is concave.  Substituting in. so wages higher and profits lower under MH BPUB 203 10 . w(0 ) = u −1 (u0 ) π = qy − qu −1 (c / q + u0 ) − (1 − q )u −1 (u0 )  w( y ) = u −1 (c / q + u0 ) If effort were contractible. cont. there would be no IC constraint. its inverse is convex.Canonical Model.

or u is very strongly concave? Wharton BPUB 203 11 .Market failure?  What if y is small.

continuous outcome possibilities Many tasks Repeated interactions (“career concerns”) Reliance on others (“teams”) Many ways to provide compensation Other preferences Incentive problems for P.Canonical Model Comments         Wharton A dramatic oversimplification Continuous effort choices. too BPUB 203 12 .

Delegates. Monitors Accountable to Corporation’s Managers Maximize personal benefits BPUB 203 13 Wharton .Executive Compensation Shareholders/Owners Maximize Economic Performance Votes Accountable to Board of Directors Monitor Managers Selects.

Views of pay  Optimal contracting Managerial power  Wharton BPUB 203 14 .

Facts  ExecuComp 7.89% of profits  Wharton BPUB 203 15 .

Facts  ExecuComp 7.89% of profits  Wharton BPUB 203 16 .

000)   Perks Reappointments.626 (Enron: $380. often on executive-drafted slates Wharton BPUB 203 17 .Facts  Average director compensation:   $152.

Determinants of pay  Considerations (as discussed by Bebchuk and Fried) Wharton BPUB 203 18 .

Principal-Agent Problems and Government  Prendergast. “The Motivation and Bias of Bureaucrats” What if bureaucrats care about their jobs?  Wharton BPUB 203 19 .

Three main results  Bureaucrats should be biased Depending on the case. the optimal bias can go in either direction Self-selection to bureaucracies is likely to be bifurcated   Wharton BPUB 203 20 .

and who is the agent? What is the desired solution?   Wharton BPUB 203 21 .Bailouts  What does it mean to be “too big to fail”? Who is the principal.

The wild cheering on the floor of the New York Stock Exchange and around the financial district last week did not spread much beyond Wall Street.’” -. Across the U. there is still deepening gloom about the economy.S.Limits to insurance “American companies are now failing at the rate of 500 a week. This year their ranks are being trimmed by bankruptcy faster than at any time since the Depression….Chairman of Eastern Air Lines Frank Borman. But it's hard to see any good news in this. 10/18/1982 Wharton BPUB 203 22 . ‘I've long said that capitalism without bankruptcy is like Christianity without hell. and no single group is more painfully aware of it than the beleaguered owners of American businesses.

NYTimes. ”– Henry Paulson. 2/16/2010 Wharton BPUB 203 23 . the outcome is liquidation. which is not well-suited for such complex firms in the midst of a financial crisis.. the government needs broad-based authority to liquidate any failing financial institution without going through the bankruptcy process. “To address the moral hazard issue. we cannot leave any hope that we would inject taxpayer dollars to preserve the failing firm in its present form.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. We must send a clear signal to market participants that whenever this process is put in motion..

while the agent wants to be insured against losses  Examples    CEO compensation Bureaucrats Bailouts BPUB 203 24 Wharton . while moral hazard pertains to hidden actions In a “principal-agent problem.Summary  Economic concepts   Adverse selection pertains to hidden characteristics. Hidden actions by the agent–or at least non-contractible actions– can prevent the action under the contract from being efficient.”    A conflict is present between the interests of the principal and the interests of the agent. Often the inefficiency arises because the principal wants to give the agent incentives to perform.