Firms & Markets (Fall 2011)
LJW Class Notes Nov 8
Asymmetric information applied
An example of hidden information:
- Suppose that there are two kinds of strawberries: “OK” strawberries, which will cost and sell for
$2/quart in a competitive market; and “really wonderful” strawberries, which will cost and sell for
$4/quart (in a competitive market)
-- With complete information, buyers who want and are willing to pay for high quality
strawberries do so; buyers who want and are willing to pay for low quality strawberries do so; both
kinds of strawberries are sold
-- But what happens if buyers are unable to discern which are the high quality strawberries?
Suppose that all strawberries look alike, and buyers can only figure out which is a high quality
strawberry when they get home from the store (when it’s too late to do anything about it)
--- In this circumstance, in the absence of any corrective actions, the high quality
strawberries will disappear from the market; only low-quality strawberries will be able to survive;
competition will drive the price down to $2
- In general, if buyers cannot discern quality differences among sellers, then costly quality
differences cannot survive in the market; equivalently, if buyers have no appreciation for quality
differences, then they will view the items as commodities and only the low-cost low quality
products can survive in a competitive process where unlimited numbers of low quality items can be
produced (e.g., only low-quality cars will survive)
-- Though some buyers may be subject initially to fraud (i.e., low quality sellers who
masquerade as high quality sellers and charge high prices), the competitive process will drive down
the price of the items to the price that is appropriate to the low quality items, and buyers are likely
eventually to learn that only low quality products should be expected
-- The absence of high quality items, even though some buyers want them and are willing to
pay for them (if only the buyers could discern which they really are), represents a market
inefficiency; this is the “lemons” problem (or, equivalently, a problem of adverse selection): The
potential buyers of high-quality items are adversely selected against (and they must either buy low
quality items or not buy at all); it also represents a market opportunity/challenge to the potential
sellers of high quality items (and to the buyers who want them)
- A similar problem arises in insurance: Sellers (insurers) may not be able to discern differences
among buyers (see AN EXAMPLE OF THE ADVERSE SELECTION PROBLEM IN
INSURANCE)
-- If there are individuals that represent different levels of risk to the insurer (e.g., different
frequency of accidents), then insurers want to identify which individuals represent which risks and
charge the appropriate prices (insurance premiums) to each category; with complete information
they will do so
-- But if insurers cannot discern who represents which levels of risk (or the insurers may not
even be able to discern that there are different levels), then they only observe average risk
frequencies and set their prices accordingly; but this average price is too high for the low-risk
individuals, who may well drop out of the insurance market and self-insure (and it is a bargain for
the high-risk individuals, who will want to buy as much as they can); the result is that only high-risk
individuals are left in the pool of insured individuals, and a high premium (appropriate to their risk)
is charged to them
-- Again, this is the problem of adverse selection: The insurers have been adversely selected
against (since the low-risk individuals drop out of the market)
-- Since (from the perspective of the insurers) the low-risk individuals are high quality, the
adverse selection problem is the same whether it is buyers or sellers suffer from asymmetric
information: The high quality end of the market disappears
- Lenders face the same problem: trying to identify who (among loan applicants) are the ones who
are likely to repay the loan
-- A lender has to worry, “Are the loan applicants who are knocking on my door the ones
that other lenders have already rejected?”
- Employers face the same problem: trying to identify who is a “high productivity” employee and
who is a “low productivity” employee
-- An employer has to worry, “Are the job applicants who are applying for the position that I
have advertised the ones who other employers have already rejected?”
-- If an employer cannot identify the “high productivity” employees, then the employer will
be “adversely selected against” and will end up hiring only “low productivity” employees
Hidden action problems:
- Often in service markets, sellers have expertise that buyers do not have; it is difficult for buyers to
discern whether the actions that the sellers are taking, and the fees that they are charging, are
appropriate to the task/problem at hand
-- This is the agent-principal (or moral-hazard) problem; at the limit, the service provider
will wholly exploit the ill-informed buyer: do very little and charge extremely high fees (more
generally, moral hazard or agent-principal problems refer to the changed behavior by an individual
or firm in response to the incentives of an arrangement that is clouded in asymmetric information)
Firms & Markets Class Notes Nov 8 Page 2
-- As buyers learn about their exploitation, they will refrain from buying; buy much less; or
sometimes “vertically integrate” and attempt to do the activity themselves
-- Again, the full-blown problem represents a market inefficiency, and a challenge to (but
also an opportunity for) market participants
- Insurers face a similar problem: once they have provided insurance, insured parties have less
reason to be careful, since the insurance will cover their losses from accidents
-- In insurance, this is described as the moral hazard problem: the frequency of accidents
increase subsequent to the granting of insurance
-- The consequence is that insurance policies become more costly (insurers charge higher
prices) than if the insureds took more care
- Lenders face a similar problem: once they have made a loan, how do they ensure that it will be
repaid? How do they prevent the borrower from “taking the money and running”?
-- This includes the problem of bond-holders vis-à-vis equity holders
- Managers face the same problem in trying to figure out which employees are working to their full
potential and which employees are slacking off
-- This is a general problem for owners (shareholders) of a company vis-à-vis the CEO and
senior management; senior management vis-à-vis junior management, etc.
Solutions to the adverse selection (lemons) problem for goods:
- Sellers and buyers both are generally aware that they face an asymmetric information problem;
they are usually not passive but try to use various means and mechanisms to pierce the “fog” of
asymmetric information: sellers of high-quality goods/services want to establish credibly that their
goods/services are high quality (buyers of high quality goods/services want to assure themselves of
the same); among the mechanisms
-- Establish a distinctive brand, so that buyers can identify your goods/services; use the
brand as a means of establishing a reputation (buyers will seek out branded items)
-- Advertise; provide information (point-of-sale, etc.) (buyers will gather information)
-- Obtain certification, endorsements (buyers will seek certified items, etc.)
-- Offer samples, often at reduced prices (buyers will seek samples)
-- Offer warranties/guarantees; warranties may be too costly for low-quality sellers to offer
(buyers will seek warranties)
Firms & Markets Class Notes Nov 8 Page 3
--- In these circumstances, warranties constitute a “signal”: an action or mechanism
that is too costly for low-quality sellers to employ and therefore something that buyers can reliably
use to identify high-quality items
--- “Signals” and “screens” are similar: Mechanisms that allow the market to
distinguish quality because it is too costly for the low quality party to send the signal (or pass
through the screen); signals are “sent” by the party that is trying to distinguish itself; screens are
created by the other side of the market (but if buyers say, “I will only believe that a product is high
quality if it carries a warranty,” and then sellers respond with warranties, is this a case of a screen or
a signal?)
--- The offeror of a warranty has to make the offer credible to customers (“How do I
know that they warranty will be honored?”)
--- The offeror must worry about abuse of the warranty by customers (which is a
separate problem of asymmetric information: in essence, the offeror of a warranty is providing an
insurance policy to its customers…)
--- A warranty is worthwhile for the seller to offer to buyers only if its benefits to the
seller exceed its costs
-- Promote the firm's reputation (buyers will seek firms with good reputations)
Solutions to the adverse selection problem in insurance, lending, employment
- Insurance companies' efforts to deal with adverse selection:
-- Primarily, they try to gather extensive information about their insureds that will be linked
to the likelihood that they are high or low risk (i.e., the extent to which they are accident-prone)
--- The accident experience of the insured may well be important
-- Use deductibles and co-pay (loss sharing)
--- May use deductibles and co-pay in coordination with policy price and other
features of the policy to induce high risk and low risk individuals to self-select to appropriate
policies
-- Set limits on coverage
-- “Just say no”
-- Note that it is harder for low-risk (high quality) individuals to break through the
asymmetric information “fog”, since they do not have branding and advertising and reputation and
sampling to rely on (although their experience as an accident-free customer with an insurance
company is usually a valuable piece of information that is used by the insurance company)
Firms & Markets Class Notes Nov 8 Page 4
- Banks' efforts to deal with adverse selection (the basic problem: banks have to protect themselves
against lending to borrowers who won't repay):
-- Collect information
--- Personal loan: personal finances, tax returns, credit history
--- Business loan: business finances, balance sheet, P&L statement, tax returns,
business plans, credit history
--- “Credit scoring” is the automated version of this collection of information
-- Ask for collateral as “security” for the loan
--- Collateral may be a “signal”: high-risk borrowers may be reluctant to “post”
collateral, since their default on the loan will cause them to lose their collateral
-- Ask for a co-signer
--- Again, this may be a signal (a cosigner may be reluctant to do so for a high-risk
borrower)
-- Require a downpayment (e.g., 20% downpayment on a home); equivalently, have a
maximum loan-to-value (LTV) ratio (e.g., maximum of 80%)
--- In the event of a loan default, the bank has a “cushion” to protect itself against a
reduction in the value of the collateral
--- This is similar in effect to a deductible in an insurance policy
--- Again, it may serve as a signal
-- Set limits on the size of loans
-- “Just say no”
-- Again, it is harder for low-risk (high quality) individuals to break through the asymmetric
information “fog”, since they do not have branding and advertising and reputation and sampling to
rely on to demonstrate their high quality (high creditworthiness); but having a good credit history
helps, etc.
- Employers’ efforts to deal with adverse selection:
-- Collect information
Firms & Markets Class Notes Nov 8 Page 5
--- Hold interviews
--- Inspect resumes
--- Check references
-- Probationary employment (“sampling”)
-- Testing; certification
-- Require educational degree
--- Is this because the degree indicates the acquisition of knowledge? Or because the
degree is a “signal” (screen) for high productivity workers
--- If it is too costly (e.g., personal costs) for a low productivity person to persist
through an educational degree, then a degree may be (correctly) positively associated with high
productivity, but the reason will be related to this signaling/screening rather than to any underlying
“education” associated with the degree
- Overall, these mechanisms for dealing with adverse selection aren’t perfect; but they are used,
because the parties on both sides of these kinds of transactions understand the adverse
selection/lemons problem and actively try to deal with it
- Efforts to identify the better customers (lower cost, lower risk, more profitable, etc.) or better
employees or better products, etc., that are embedded in a larger population is sometimes described
as “cherry picking”
Solutions to the agent-principal/moral hazard problem:
- Sellers and buyers are not passive in the face of these problems; sellers want to try to reassure
buyers that the latter will not be exploited (buyers want to be reassured)
- Solutions in goods and services markets:
-- Branding, the establishment of reputation (buyers will seek out sellers with reputations for
trustworthiness)
-- Advertising (buyers will gather information about sellers)
-- Recommendations/referrals
-- Direct monitoring
-- Sampling
Firms & Markets Class Notes Nov 8 Page 6
-- Certification or endorsements
-- Warranties and guaranties
-- Incentive pricing
--- Staged payments for work completed
--- Bonuses for early completion of projects; penalties for delays
--- Contingency fee arrangements
- Insurance companies address their problems of moral hazard behavior on the part of their insureds
by:
-- Incentive pricing: deductibles and co-payment arrangements
-- Historical experience pricing: rewarding good risks (low accident claims) with lower
prices (lower premiums); penalizing poor risks (high accident claims) with higher prices
-- Setting rules and cancelling policies (or not paying off) if an insured party has violated the
rules
-- Direct monitoring
-- Again, it is harder for individuals to convince insurers that they (the insureds) will not
“exploit” the insurance company by taking less care; but personal experience may matter
- Banks address their problems of moral hazard behavior on the part of borrowers (banks have to
assure themselves that borrowers, after receiving the loan, won't behave in ways that reduce the
probability of repayment) by:
-- Direct monitoring of the borrower
-- Covenants/lending agreements
--- Restrictions on borrowers’ behavior; monitoring
-- Requiring periodic repayments (e.g., mortgage loan, car loan)
-- Threatening delinquent borrowers with loss of credit rating
- Managers address their principal-agent (moral hazard) problems by:
-- Direct monitoring
Firms & Markets Class Notes Nov 8 Page 7
-- Incentive payments
--- Sales commissions
--- Piecework compensation
--- Bonuses
--- But incentive payments require monitoring and a belief by the relevant parties
that the system is fair, transparent, etc.
-- Pay systems (e.g., a mixture of salary and commissions) that induce self-selection among
employees into positions that are commensurate with the employees' abilities and proclivities
toward risk-taking, etc.
-- Creating a company culture that discourages slacking and encourages on-the-job effort
- Overall, these mechanisms for addressing agent-principal/moral hazard problems are not perfect;
but they're used because the various parties recognize that the agent-principal/moral hazard
problems are present
- These asymmetric information problems generally can also be seen to be important as causes why
large companies are harder to manage (diseconomies of scale, diseconomies of vertical integration)
but also why some companies may chose to undertake some vertically related processes on an in-
house basis rather than to outsource them
Firms & Markets Class Notes Nov 8 Page 8
AN EXAMPLE OF THE ADVERSE SELECTION PROBLEM IN INSURANCE
Assumptions:
- Competitive insurance industry that sells “collision” automobile insurance -- i.e., insurance
that protects the driver’s own car in the event of a crash
- The cost of an auto crash is $1,000/crash; this includes repairs, administrative costs, and
a normal profit for insurers
- There are two types of drivers: “low-risk” drivers, who experience a crash (on average)
once every five years; and “high-risk” drivers who experience a crash (on average) once each year
- Each driver knows whether he/she is a low-risk or a high-risk driver
- Buying insurance is voluntary; drivers are generally risk-averse, and will buy insurance
that is “reasonably priced”: i.e., the annual premium (i.e., the price of insurance) is not too far away
from what the driver knows to be his/her expected annual costs from crashes; but if insurance is
“too expensive”, drivers will forgo insurance and “self-insure”
- There are 5 million low-risk drivers and 5 million high-risk drivers in the general
population
Outcomes:
A. Complete information:
- Suppose that the insurance industry has complete information as to who is a low-risk and
who is a high-risk driver
- What will the (approximate) price of insurance be? Why?
B. Imperfect information:
- Suppose that the insurance industry doesn’t know that there are different types of drivers;
the only thing that the insurance industry can observe is the annual rate of crashes among the overall
population of drivers (or the insurance industry may know that there are different types of drivers
but can’t identify who they are; again, all that the industry can observe is the annual rate of crashes
among the overall population of drivers)
- What will the (approximate) price of insurance be? Why?
- Is this last outcome stable? If not, what happens next? Why? What is the end result?
How does this result compare with the complete information result?
Firms & Markets Class Notes Nov 8 Page 9