Chapter 17
Markets with
Asymmetric
Information
Chapter 17 Slide 2
Topics to be Discussed
? Quality Uncertainty and the Market for
Lemons
? Market Signaling
? Moral Hazard
? The Principal-Agent Problem
Chapter 17 Slide 3
Topics to be Discussed
? Managerial Incentives in an
Integrated Firm
? Asymmetric Information in Labor
Markets,Efficiency Wage Theory
Chapter 17 Slide 4
Introduction
? We will study how imperfect
information influences resource
allocation and the price system,
Chapter 17 Slide 5
Quality Uncertainty
and the Market for Lemons
? The lack of complete information
when purchasing a used car
increases the risk of the purchase and
lowers the value of the car,
Chapter 17 Slide 6
? The Market for Used Cars
? Assume
?Buyers and sellers can distinguish
between high and low quality cars
?There will be two markets
Quality Uncertainty
and the Market for Lemons
The Lemons Problem
PH PL
QH QL
SH
SL
DH
DL
5,000
50,000 50,000
The market for high and low
quality cars when buyers and sellers
can identify each car
10,000
DL
DM
DM
75,000 25,000
With asymmetric information buyers will
find it difficult to determine quality,They lower
their expectations of the average quality of
used cars,Demand for low and high quality
used cars shifts to DM,
DLM
DLM
The increase in QL
reduces expectations and
demand to DLM,The adjustment process
continues until demand = DL,
Chapter 17 Slide 8
? The Market for Used Cars
? With asymmetric information,
? Low quality goods drive high quality goods
out of the market,
? The market has failed to produce mutually
beneficial trade,
? Too many low and too few high quality cars
are on the market,
? Adverse selection occurs; the only cars on
the market will be low quality cars,
Quality Uncertainty
and the Market for Lemons
Chapter 17 Slide 9
Implications of Asymmetric Information
? Medical Insurance
? Question
?Is it possible for insurance companies to
separate high and low risk policy holders?
? If not,only high risk people will purchase
insurance,
? Adverse selection would make medical
insurance unprofitable,
The Market for Insurance
Chapter 17 Slide 10
Implications of Asymmetric Information
? Automobile Insurance
? Questions
? What impact does asymmetric information
and adverse selection have on insurance
rates and the delivery of automobile accident
insurance?
? How can the government reduce the impact
of adverse selection in the insurance
industry?
The Market for Insurance
Chapter 17 Slide 11
Implications of Asymmetric Information
? The Market for Credit
? Asymmetric information creates the
potential that only high risk borrowers
will seek loans,
? Question
?How can credit histories help make
this market more efficient and reduce
the cost of credit?
Chapter 17 Slide 12
Implications of Asymmetric Information
? The Importance of Reputation and
Standardization
? Asymmetric Information and Daily
Market Decisions
?Retail sales
?Antiques,art,rare coins
?Home repairs
?Restaurants
Chapter 17 Slide 13
Implications of Asymmetric Information
? Question
? How can these producers provide high-
quality goods when asymmetric
information will drive out high-quality
goods through adverse selection,
? Answer
?Reputation
Chapter 17 Slide 14
Implications of Asymmetric Information
? Question
? Why do you look forward to a Big Mac
when traveling even though you would
never consider buying one at home,
? Holiday Inn once advertised,No
Surprises” to address the issue of
adverse selection,
Chapter 17 Slide 15
Lemons in Major League Baseball
? Asymmetric information and the
market for free agents
? If a lemons market exists,free agents
should be less reliable (disabled) than
renewed contracts,
Chapter 17 Slide 16
Player Disability
All Players 4.73 12.55 165.4
Renewed players 4.76 9.68 103.4
Free agents 4.67 17.23 268.9
Days Spent on Disabled List per Season
Precontract Postcontract Percentage Change
Chapter 17 Slide 17
? Findings
? Days on the disabled list increase for
both free agents and renewed players,
? Free agents have a significantly higher
disability rate than renewed players,
? This indicates a lemons market,
Lemons in Major League Baseball
Chapter 17 Slide 18
? Question
? If you are a team owner,what steps
would you take to reduce the
asymmetric information for free agents?
Lemons in Major League Baseball
Chapter 17 Slide 19
Market Signaling
? The process of sellers using signals
to convey information to buyers about
the product’s quality helps buyers and
sellers deal with asymmetric
information,
Chapter 17 Slide 20
Market Signaling
? Strong Signal
? To be effective,a signal must be easier
for high quality sellers to give than low
quality sellers,
? Example
?Highly productive workers signal with
educational attainment level,
Chapter 17 Slide 21
Market Signaling
? A Simple Model of Job Market
Signaling
? Assume
?Two groups of workers
?Group I,Low productivity--AP & MP = 1
?Group II,High productivity--AP & MP = 2
?The workers are equally divided between
Group I and Group II--AP for all workers
= 1.5
Chapter 17 Slide 22
Market Signaling
? A Simple Model of Job Market Signaling
? Assume
? Competitive Product Market
? P = $10,000
? Employees average 10 years of employment
? Group I Revenue = $100,000 (10,000/yr,x 10)
? Group II Revenue = $200,000 (20,000/yr,X 10)
Chapter 17 Slide 23
Market Signaling
? With Complete Information
? w = MRP
? Group I wage = $10,000/yr,
? Group II wage = $20,000/yr,
? With Asymmetric Information
? w = average productivity
? Group I & II wage = $15,000
Chapter 17 Slide 24
Market Signaling
? Signaling With Education to Reduce
Asymmetric Information
? y = education index (years of higher
education)
? C = cost of attaining educational level y
? Group I--CI(y) = $40,000y
? Group II--CII(y) = $20,000y
Chapter 17 Slide 25
Market Signaling
? Signaling With Education to Reduce
Asymmetric Information
? Assume education does not increase
productivity
? Decision Rule,
?y* signals GII and wage = $20,000
?Below y* signals GI and wage =
$10,000
Signaling
Years of
College
Value of
College
Educ,
0
$100K
Value of
College
Educ,
Years of
College
1 2 3 4 5 6 0 1 2 3 4 5 6
$200K
$100K
$200K
Group I Group II
CI(y) = $40,000y
Optimal choice of
y for Group I
How much education
should a person obtain?
The education decision
is based on benefits/cost
comparison,
B(y) B(y)
y* y*
B(y) = increase in
wage associated with
each level of education
CII(y) = $20,000y
Optimal choice of
y for Group I
Signaling
Years of
College
Value of
College
Educ,
0
$100K
Value of
College
Educ,
Years of
College
1 2 3 4 5 6 0 1 2 3 4 5 6
$200K
$100K
$200K C
I(y) = $40,000y
Optimal choice of
y for Group I
B(y) B(y)
y* y*
?Benefits = $100,000
?Cost
?CI(y) = 40,000y
?$100,000<$40,000y*
?y* > 2.5
?Choose no education
CII(y) = $20,000y
Optimal choice of
y for Group I
?Benefits = $100,000
?Cost
?CII(yO)= 20,000y
?$100,000<$20,000y*
?y* < 5
?Choose y*
Chapter 17 Slide 28
Signaling
? Cost/Benefit Comparison
? Decision rule works if y* is between 2.5
and 5
? If y* = 4
?Group I would choose no school
?Group II would choose y*
?Rule discriminates correctly
Chapter 17 Slide 29
Signaling
? Education does increase productivity
and provides a useful signal about
individual work habits,
Chapter 17 Slide 30
Working into the Night
? Question
?How can you signal to your employer
you are more productive?
Chapter 17 Slide 31
Market Signaling
? Guarantees and Warranties
? Signaling to identify high quality and
dependability
? Effective decision tool because the cost
of warranties to low-quality producers is
too high
Chapter 17 Slide 32
Moral Hazard
? Moral hazard occurs when the
insured party whose actions are
unobserved can affect the probability
or magnitude of a payment
associated with an event,
Chapter 17 Slide 33
Moral Hazard
? Determining the Premium for Fire
Insurance
? Warehouse worth $100,000
? Probability of a fire,
?.005 with a $50 fire prevention
program
?.01 without the program
Chapter 17 Slide 34
Moral Hazard
? Determining the Premium for Fire Insurance
? With the program the premium is,
?,005 x $100,000 = $500
? Once insured owners purchase the insurance,the
owners no longer have an incentive to run the
program,therefore the probability of loss is,01
? $500 premium will lead to a loss because the
expected loss is not $1,000 (.01 x $100,000)
Chapter 17 Slide 35
The Effects of Moral Hazard
Miles per Week 0
$0.50
50 100 140
Cost
per
Mile
$1.00
$1.50
$2.00
D = MB
MC’
With moral hazard
insurance companies cannot
measure mileage,MC to $1.00 and
miles driven increases to 140
miles/week--inefficient allocation,
MC
MC is the marginal cost
of driving,With no moral hazard
and assuming insurance
companies can measure miles
driven MC = MB at $1.50 and
100 miles/week--efficient allocation,
Chapter 17 Slide 36
Reducing Moral Hazard
--Warranties of Animal Health
? Scenario
? Livestock buyers want disease free animals,
? Asymmetric information exists
? Many states require warranties
? Buyers and sellers no longer have an incentive
to reduce disease (moral hazard),
? Question
? How can this moral hazard be reduced?
Chapter 17 Slide 37
Crisis in the Savings and Loan Industry
? Question
? How many people know the financial
strength of their bank?
? Why not?
? Deposit insurance,moral hazard,and
failures in the S&L industry
Chapter 17 Slide 38
? Cost of the S&L Bailout
? 1,000+ failed institutions
? $200 billion (1990)
? Texas alone--$42 billion (1990)
? Agency expenditures--$100 million (1990)
? Question
? How can this moral hazard be reduced?
Crisis in the Savings and Loan Industry
Chapter 17 Slide 39
The Principal--Agent Problem
? Agency Relationship
? One person’s welfare depends on what
another person does
? Agent
? Person who acts
? Principal
? Person whom the action effects
Chapter 17 Slide 40
The Principal--Agent Problem
? Company owners are principals,
? Workers and managers are agents,
? Owners do not have complete
knowledge,
? Employees may pursue their own
goals and reduce profits,
Chapter 17 Slide 41
The Principal--Agent Problem
? The Principal--Agent Problem in
Private Enterprises
? Only 16 of 100 largest corporations have
individual family or financial institution
ownership exceeding 10%,
? Most large firms are controlled by
management,
? Monitoring management is costly
(asymmetric information),
Chapter 17 Slide 42
The Principal--Agent Problem
? The Principal--Agent Problem in
Private Enterprises
? Managers may pursue their own
objectives,
?Growth
?Utility from job
Chapter 17 Slide 43
The Principal--Agent Problem
? The Principal--Agent Problem in
Private Enterprises
? Limitations to managers’ ability to
deviate from objective of owners
?Stockholders can oust managers
?Takeover attempts
?Market for managers who maximize
profits
Chapter 17 Slide 44
The Principal--Agent Problem
? The Principal--Agent Problem in
Public Enterprises
? Observations
?Managers’ goals may deviate from the
agencies goal (size)
?Oversight is difficult (asymmetric
information)
?Market forces are lacking
Chapter 17 Slide 45
The Principal--Agent Problem
? The Principal--Agent Problem in Public
Enterprises
? Limitations to Management Power
? Managers choose a public service position
? Managerial job market
? Legislative and agency oversight (GAO &
OMB)
? Competition among agencies
Chapter 17 Slide 46
The Managers of
Nonprofit Hospitals as Agents
? Are non profit organizations more or
less efficient that for-profit firms?
? 725 hospitals from 14 hospital chains
? Return on investment (ROI) and average
cost (AC) measured
Chapter 17 Slide 47
For-Profit 11.6% 12.7%
Nonprofit 8.8% 7.4%
Return On Investment
1977 1981
The Managers of
Nonprofit Hospitals as Agents
Chapter 17 Slide 48
? After adjusting for differences in
services,
? AC/patient day in nonprofits is 8%
greater than profits
? Conclusion
?Profit incentive impacts performance
? Cost and benefits of subsidizing
nonprofits must be considered,
The Managers of
Nonprofit Hospitals as Agents
Chapter 17 Slide 49
? Incentives in the Principal-Agent Framework
? Designing a reward system to align the principal and
agent’s goals--an example
? Watch manufacturer
? Uses labor and machinery
? Owners goal is to maximize profit
? Machine repairperson can influence reliability of
machines and profits
The Managers of
Nonprofit Hospitals as Agents
Chapter 17 Slide 50
The Principal--Agent Problem
? Incentives in the Principal-Agent
Framework
? Designing a reward system to align the
principal and agent’s goals--an example
?Revenue also depends,in part,on the
quality of parts and the reliability of labor,
?High monitoring cost makes it difficult to
assess the repair-person’s work
Chapter 17 Slide 51
The Revenue from Making Watches
Low effort (a = 0) $10,000 $20,000
High effort (a = 1) $20,000 $40,000
Poor Luck Good Luck
Chapter 17 Slide 52
The Principal--Agent Problem
? Incentives in the Principal-Agent Framework
? Designing a reward system to align the principal and
agent’s goals--an example
? Repairperson can work with either high or low
effort
? Revenues depend on effort relative to the other
events (poor or good luck)
? Owners cannot determine a high or low effort
when revenue = $20,000
Chapter 17 Slide 53
The Principal--Agent Problem
? Incentives in the Principal-Agent Framework
? Designing a reward system to align the principal and
agent’s goals--an example
?Repairperson’s goal is to maximize wage net of
cost
? Cost = 0 for low effort
? Cost = $10,000 for high effort
? w(R) = repairperson wage based only on output
Chapter 17 Slide 54
The Principal--Agent Problem
? Incentives in the Principal-Agent
Framework
? Choosing a Wage
?w = 0; a = 0; R = $15,000
?R = $10,000 or $20,000,w = 0
?R = $40,000; w = $24,000
?R = $30,000; Profit = $18,000
?Net wage = $2,000
Chapter 17 Slide 55
The Principal--Agent Problem
? Incentives in the Principal-Agent
Framework
? Choosing a Wage
?w = R - $18,000
?Net wage = $2,000
?High effort
Chapter 17 Slide 56
The Principal--Agent Problem
? Conclusion
? Incentive structure that rewards the
outcome of high levels of effort can
induce agents to aim for the goals set by
the principals,
Chapter 17 Slide 57
The Principal--Agent Problem
? Asymmetric Information and Incentive
Design in the Integrated Firm
? In integrated firms,division managers have
better (asymmetric) information about
production than central management
Chapter 17 Slide 58
The Principal--Agent Problem
? Asymmetric Information and Incentive
Design in the Integrated Firm
? Two Issues
?How can central management illicit
accurate information
?How can central management achieve
efficient divisional production
Chapter 17 Slide 59
The Principal--Agent Problem
? Possible Incentive Plans
? Bonus based on output or profit
?Will this plan provide an incentive for
accurate information?
Chapter 17 Slide 60
The Principal--Agent Problem
? Possible Incentive Plans
? Bonus based on how close the managers get to
their forecasts of output and profits
? Qf = estimate of feasible production level
? B = bonus in dollars
? Q = actual output
? B = 10,000 -,5(Qf - Q)
? Incentive to underestimate Qf
Chapter 17 Slide 61
The Principal--Agent Problem
? Possible Incentive Plans
? Bonus still tied to accuracy of forecast
?If Q > Qf ;B =,3Qf +,2(Q - Qf)
?If Q < Qf ;B =,3Qf -,5(Qf - Q)
Chapter 17 Slide 62
Incentive Design in an Integrated Firm
Output
(units per year)
2,000
4,000
6,000
10,000
0 10,000 20,000 30,000 40,000
Bonus
($ per
year)
8,000
If Qf = 30,000,
bonus is $6,000,
the maximum
amount possible,
Qf = 30,000
Qf = 10,000
If Qf = 10,000,
bonus is $5,000
Qf = 20,000
If Qf = 20,000,
bonus is $4,000
Chapter 17 Slide 63
Asymmetric Information in Labor
Markets,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,
Chapter 17 Slide 64
? 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,
Asymmetric Information in Labor
Markets,Efficiency Wage Theory
Chapter 17 Slide 65
? 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,
Asymmetric Information in Labor
Markets,Efficiency Wage Theory
Chapter 17 Slide 66
Without shirking,the market wage
is w*,and full-employment exists at L*
Demand for
Labor
w*
L*
SL
Unemployment in a Shirking Model
Quantity of
Labor
Wage
No-Shirking
Constraint
The no-shirking
constraint gives
the wage necessary
to keep workers
from shirking,
we
Le
At the equilibrium wage,We the
firm hires Le workers
creating unemployment of L* - Le,
Chapter 17 Slide 67
Efficiency Wages at Ford Motor Company
? Labor turnover at Ford
?1913,380%
?1914,1000%
?Average pay = $2 - $3
?Ford increased pay to $5
Chapter 17 Slide 68
Efficiency Wages at Ford Motor Company
? Results
?Productivity increased 51%
?Absenteeism had been halved
?Profitability rose from $30 million in 1914
to $60 million in 1916,
Chapter 17 Slide 69
Summary
? Asymmetric information creates a market
failure in which bad products tend to drive
good products out of the market,
? Insurance markets frequently involve
asymmetric information because the
insuring party has better information about
the risk involved than the insurance
company,
Chapter 17 Slide 70
Summary
? Asymmetric information may make it
costly for the owners of firms to
monitor accurately the behavior of the
firm’s manager,
? Asymmetric information can explain
why labor markets have substantial
unemployment when some workers
are actively seeking work,
End of Chapter 17
Markets with
Asymmetric
Information
Markets with
Asymmetric
Information
Chapter 17 Slide 2
Topics to be Discussed
? Quality Uncertainty and the Market for
Lemons
? Market Signaling
? Moral Hazard
? The Principal-Agent Problem
Chapter 17 Slide 3
Topics to be Discussed
? Managerial Incentives in an
Integrated Firm
? Asymmetric Information in Labor
Markets,Efficiency Wage Theory
Chapter 17 Slide 4
Introduction
? We will study how imperfect
information influences resource
allocation and the price system,
Chapter 17 Slide 5
Quality Uncertainty
and the Market for Lemons
? The lack of complete information
when purchasing a used car
increases the risk of the purchase and
lowers the value of the car,
Chapter 17 Slide 6
? The Market for Used Cars
? Assume
?Buyers and sellers can distinguish
between high and low quality cars
?There will be two markets
Quality Uncertainty
and the Market for Lemons
The Lemons Problem
PH PL
QH QL
SH
SL
DH
DL
5,000
50,000 50,000
The market for high and low
quality cars when buyers and sellers
can identify each car
10,000
DL
DM
DM
75,000 25,000
With asymmetric information buyers will
find it difficult to determine quality,They lower
their expectations of the average quality of
used cars,Demand for low and high quality
used cars shifts to DM,
DLM
DLM
The increase in QL
reduces expectations and
demand to DLM,The adjustment process
continues until demand = DL,
Chapter 17 Slide 8
? The Market for Used Cars
? With asymmetric information,
? Low quality goods drive high quality goods
out of the market,
? The market has failed to produce mutually
beneficial trade,
? Too many low and too few high quality cars
are on the market,
? Adverse selection occurs; the only cars on
the market will be low quality cars,
Quality Uncertainty
and the Market for Lemons
Chapter 17 Slide 9
Implications of Asymmetric Information
? Medical Insurance
? Question
?Is it possible for insurance companies to
separate high and low risk policy holders?
? If not,only high risk people will purchase
insurance,
? Adverse selection would make medical
insurance unprofitable,
The Market for Insurance
Chapter 17 Slide 10
Implications of Asymmetric Information
? Automobile Insurance
? Questions
? What impact does asymmetric information
and adverse selection have on insurance
rates and the delivery of automobile accident
insurance?
? How can the government reduce the impact
of adverse selection in the insurance
industry?
The Market for Insurance
Chapter 17 Slide 11
Implications of Asymmetric Information
? The Market for Credit
? Asymmetric information creates the
potential that only high risk borrowers
will seek loans,
? Question
?How can credit histories help make
this market more efficient and reduce
the cost of credit?
Chapter 17 Slide 12
Implications of Asymmetric Information
? The Importance of Reputation and
Standardization
? Asymmetric Information and Daily
Market Decisions
?Retail sales
?Antiques,art,rare coins
?Home repairs
?Restaurants
Chapter 17 Slide 13
Implications of Asymmetric Information
? Question
? How can these producers provide high-
quality goods when asymmetric
information will drive out high-quality
goods through adverse selection,
? Answer
?Reputation
Chapter 17 Slide 14
Implications of Asymmetric Information
? Question
? Why do you look forward to a Big Mac
when traveling even though you would
never consider buying one at home,
? Holiday Inn once advertised,No
Surprises” to address the issue of
adverse selection,
Chapter 17 Slide 15
Lemons in Major League Baseball
? Asymmetric information and the
market for free agents
? If a lemons market exists,free agents
should be less reliable (disabled) than
renewed contracts,
Chapter 17 Slide 16
Player Disability
All Players 4.73 12.55 165.4
Renewed players 4.76 9.68 103.4
Free agents 4.67 17.23 268.9
Days Spent on Disabled List per Season
Precontract Postcontract Percentage Change
Chapter 17 Slide 17
? Findings
? Days on the disabled list increase for
both free agents and renewed players,
? Free agents have a significantly higher
disability rate than renewed players,
? This indicates a lemons market,
Lemons in Major League Baseball
Chapter 17 Slide 18
? Question
? If you are a team owner,what steps
would you take to reduce the
asymmetric information for free agents?
Lemons in Major League Baseball
Chapter 17 Slide 19
Market Signaling
? The process of sellers using signals
to convey information to buyers about
the product’s quality helps buyers and
sellers deal with asymmetric
information,
Chapter 17 Slide 20
Market Signaling
? Strong Signal
? To be effective,a signal must be easier
for high quality sellers to give than low
quality sellers,
? Example
?Highly productive workers signal with
educational attainment level,
Chapter 17 Slide 21
Market Signaling
? A Simple Model of Job Market
Signaling
? Assume
?Two groups of workers
?Group I,Low productivity--AP & MP = 1
?Group II,High productivity--AP & MP = 2
?The workers are equally divided between
Group I and Group II--AP for all workers
= 1.5
Chapter 17 Slide 22
Market Signaling
? A Simple Model of Job Market Signaling
? Assume
? Competitive Product Market
? P = $10,000
? Employees average 10 years of employment
? Group I Revenue = $100,000 (10,000/yr,x 10)
? Group II Revenue = $200,000 (20,000/yr,X 10)
Chapter 17 Slide 23
Market Signaling
? With Complete Information
? w = MRP
? Group I wage = $10,000/yr,
? Group II wage = $20,000/yr,
? With Asymmetric Information
? w = average productivity
? Group I & II wage = $15,000
Chapter 17 Slide 24
Market Signaling
? Signaling With Education to Reduce
Asymmetric Information
? y = education index (years of higher
education)
? C = cost of attaining educational level y
? Group I--CI(y) = $40,000y
? Group II--CII(y) = $20,000y
Chapter 17 Slide 25
Market Signaling
? Signaling With Education to Reduce
Asymmetric Information
? Assume education does not increase
productivity
? Decision Rule,
?y* signals GII and wage = $20,000
?Below y* signals GI and wage =
$10,000
Signaling
Years of
College
Value of
College
Educ,
0
$100K
Value of
College
Educ,
Years of
College
1 2 3 4 5 6 0 1 2 3 4 5 6
$200K
$100K
$200K
Group I Group II
CI(y) = $40,000y
Optimal choice of
y for Group I
How much education
should a person obtain?
The education decision
is based on benefits/cost
comparison,
B(y) B(y)
y* y*
B(y) = increase in
wage associated with
each level of education
CII(y) = $20,000y
Optimal choice of
y for Group I
Signaling
Years of
College
Value of
College
Educ,
0
$100K
Value of
College
Educ,
Years of
College
1 2 3 4 5 6 0 1 2 3 4 5 6
$200K
$100K
$200K C
I(y) = $40,000y
Optimal choice of
y for Group I
B(y) B(y)
y* y*
?Benefits = $100,000
?Cost
?CI(y) = 40,000y
?$100,000<$40,000y*
?y* > 2.5
?Choose no education
CII(y) = $20,000y
Optimal choice of
y for Group I
?Benefits = $100,000
?Cost
?CII(yO)= 20,000y
?$100,000<$20,000y*
?y* < 5
?Choose y*
Chapter 17 Slide 28
Signaling
? Cost/Benefit Comparison
? Decision rule works if y* is between 2.5
and 5
? If y* = 4
?Group I would choose no school
?Group II would choose y*
?Rule discriminates correctly
Chapter 17 Slide 29
Signaling
? Education does increase productivity
and provides a useful signal about
individual work habits,
Chapter 17 Slide 30
Working into the Night
? Question
?How can you signal to your employer
you are more productive?
Chapter 17 Slide 31
Market Signaling
? Guarantees and Warranties
? Signaling to identify high quality and
dependability
? Effective decision tool because the cost
of warranties to low-quality producers is
too high
Chapter 17 Slide 32
Moral Hazard
? Moral hazard occurs when the
insured party whose actions are
unobserved can affect the probability
or magnitude of a payment
associated with an event,
Chapter 17 Slide 33
Moral Hazard
? Determining the Premium for Fire
Insurance
? Warehouse worth $100,000
? Probability of a fire,
?.005 with a $50 fire prevention
program
?.01 without the program
Chapter 17 Slide 34
Moral Hazard
? Determining the Premium for Fire Insurance
? With the program the premium is,
?,005 x $100,000 = $500
? Once insured owners purchase the insurance,the
owners no longer have an incentive to run the
program,therefore the probability of loss is,01
? $500 premium will lead to a loss because the
expected loss is not $1,000 (.01 x $100,000)
Chapter 17 Slide 35
The Effects of Moral Hazard
Miles per Week 0
$0.50
50 100 140
Cost
per
Mile
$1.00
$1.50
$2.00
D = MB
MC’
With moral hazard
insurance companies cannot
measure mileage,MC to $1.00 and
miles driven increases to 140
miles/week--inefficient allocation,
MC
MC is the marginal cost
of driving,With no moral hazard
and assuming insurance
companies can measure miles
driven MC = MB at $1.50 and
100 miles/week--efficient allocation,
Chapter 17 Slide 36
Reducing Moral Hazard
--Warranties of Animal Health
? Scenario
? Livestock buyers want disease free animals,
? Asymmetric information exists
? Many states require warranties
? Buyers and sellers no longer have an incentive
to reduce disease (moral hazard),
? Question
? How can this moral hazard be reduced?
Chapter 17 Slide 37
Crisis in the Savings and Loan Industry
? Question
? How many people know the financial
strength of their bank?
? Why not?
? Deposit insurance,moral hazard,and
failures in the S&L industry
Chapter 17 Slide 38
? Cost of the S&L Bailout
? 1,000+ failed institutions
? $200 billion (1990)
? Texas alone--$42 billion (1990)
? Agency expenditures--$100 million (1990)
? Question
? How can this moral hazard be reduced?
Crisis in the Savings and Loan Industry
Chapter 17 Slide 39
The Principal--Agent Problem
? Agency Relationship
? One person’s welfare depends on what
another person does
? Agent
? Person who acts
? Principal
? Person whom the action effects
Chapter 17 Slide 40
The Principal--Agent Problem
? Company owners are principals,
? Workers and managers are agents,
? Owners do not have complete
knowledge,
? Employees may pursue their own
goals and reduce profits,
Chapter 17 Slide 41
The Principal--Agent Problem
? The Principal--Agent Problem in
Private Enterprises
? Only 16 of 100 largest corporations have
individual family or financial institution
ownership exceeding 10%,
? Most large firms are controlled by
management,
? Monitoring management is costly
(asymmetric information),
Chapter 17 Slide 42
The Principal--Agent Problem
? The Principal--Agent Problem in
Private Enterprises
? Managers may pursue their own
objectives,
?Growth
?Utility from job
Chapter 17 Slide 43
The Principal--Agent Problem
? The Principal--Agent Problem in
Private Enterprises
? Limitations to managers’ ability to
deviate from objective of owners
?Stockholders can oust managers
?Takeover attempts
?Market for managers who maximize
profits
Chapter 17 Slide 44
The Principal--Agent Problem
? The Principal--Agent Problem in
Public Enterprises
? Observations
?Managers’ goals may deviate from the
agencies goal (size)
?Oversight is difficult (asymmetric
information)
?Market forces are lacking
Chapter 17 Slide 45
The Principal--Agent Problem
? The Principal--Agent Problem in Public
Enterprises
? Limitations to Management Power
? Managers choose a public service position
? Managerial job market
? Legislative and agency oversight (GAO &
OMB)
? Competition among agencies
Chapter 17 Slide 46
The Managers of
Nonprofit Hospitals as Agents
? Are non profit organizations more or
less efficient that for-profit firms?
? 725 hospitals from 14 hospital chains
? Return on investment (ROI) and average
cost (AC) measured
Chapter 17 Slide 47
For-Profit 11.6% 12.7%
Nonprofit 8.8% 7.4%
Return On Investment
1977 1981
The Managers of
Nonprofit Hospitals as Agents
Chapter 17 Slide 48
? After adjusting for differences in
services,
? AC/patient day in nonprofits is 8%
greater than profits
? Conclusion
?Profit incentive impacts performance
? Cost and benefits of subsidizing
nonprofits must be considered,
The Managers of
Nonprofit Hospitals as Agents
Chapter 17 Slide 49
? Incentives in the Principal-Agent Framework
? Designing a reward system to align the principal and
agent’s goals--an example
? Watch manufacturer
? Uses labor and machinery
? Owners goal is to maximize profit
? Machine repairperson can influence reliability of
machines and profits
The Managers of
Nonprofit Hospitals as Agents
Chapter 17 Slide 50
The Principal--Agent Problem
? Incentives in the Principal-Agent
Framework
? Designing a reward system to align the
principal and agent’s goals--an example
?Revenue also depends,in part,on the
quality of parts and the reliability of labor,
?High monitoring cost makes it difficult to
assess the repair-person’s work
Chapter 17 Slide 51
The Revenue from Making Watches
Low effort (a = 0) $10,000 $20,000
High effort (a = 1) $20,000 $40,000
Poor Luck Good Luck
Chapter 17 Slide 52
The Principal--Agent Problem
? Incentives in the Principal-Agent Framework
? Designing a reward system to align the principal and
agent’s goals--an example
? Repairperson can work with either high or low
effort
? Revenues depend on effort relative to the other
events (poor or good luck)
? Owners cannot determine a high or low effort
when revenue = $20,000
Chapter 17 Slide 53
The Principal--Agent Problem
? Incentives in the Principal-Agent Framework
? Designing a reward system to align the principal and
agent’s goals--an example
?Repairperson’s goal is to maximize wage net of
cost
? Cost = 0 for low effort
? Cost = $10,000 for high effort
? w(R) = repairperson wage based only on output
Chapter 17 Slide 54
The Principal--Agent Problem
? Incentives in the Principal-Agent
Framework
? Choosing a Wage
?w = 0; a = 0; R = $15,000
?R = $10,000 or $20,000,w = 0
?R = $40,000; w = $24,000
?R = $30,000; Profit = $18,000
?Net wage = $2,000
Chapter 17 Slide 55
The Principal--Agent Problem
? Incentives in the Principal-Agent
Framework
? Choosing a Wage
?w = R - $18,000
?Net wage = $2,000
?High effort
Chapter 17 Slide 56
The Principal--Agent Problem
? Conclusion
? Incentive structure that rewards the
outcome of high levels of effort can
induce agents to aim for the goals set by
the principals,
Chapter 17 Slide 57
The Principal--Agent Problem
? Asymmetric Information and Incentive
Design in the Integrated Firm
? In integrated firms,division managers have
better (asymmetric) information about
production than central management
Chapter 17 Slide 58
The Principal--Agent Problem
? Asymmetric Information and Incentive
Design in the Integrated Firm
? Two Issues
?How can central management illicit
accurate information
?How can central management achieve
efficient divisional production
Chapter 17 Slide 59
The Principal--Agent Problem
? Possible Incentive Plans
? Bonus based on output or profit
?Will this plan provide an incentive for
accurate information?
Chapter 17 Slide 60
The Principal--Agent Problem
? Possible Incentive Plans
? Bonus based on how close the managers get to
their forecasts of output and profits
? Qf = estimate of feasible production level
? B = bonus in dollars
? Q = actual output
? B = 10,000 -,5(Qf - Q)
? Incentive to underestimate Qf
Chapter 17 Slide 61
The Principal--Agent Problem
? Possible Incentive Plans
? Bonus still tied to accuracy of forecast
?If Q > Qf ;B =,3Qf +,2(Q - Qf)
?If Q < Qf ;B =,3Qf -,5(Qf - Q)
Chapter 17 Slide 62
Incentive Design in an Integrated Firm
Output
(units per year)
2,000
4,000
6,000
10,000
0 10,000 20,000 30,000 40,000
Bonus
($ per
year)
8,000
If Qf = 30,000,
bonus is $6,000,
the maximum
amount possible,
Qf = 30,000
Qf = 10,000
If Qf = 10,000,
bonus is $5,000
Qf = 20,000
If Qf = 20,000,
bonus is $4,000
Chapter 17 Slide 63
Asymmetric Information in Labor
Markets,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,
Chapter 17 Slide 64
? 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,
Asymmetric Information in Labor
Markets,Efficiency Wage Theory
Chapter 17 Slide 65
? 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,
Asymmetric Information in Labor
Markets,Efficiency Wage Theory
Chapter 17 Slide 66
Without shirking,the market wage
is w*,and full-employment exists at L*
Demand for
Labor
w*
L*
SL
Unemployment in a Shirking Model
Quantity of
Labor
Wage
No-Shirking
Constraint
The no-shirking
constraint gives
the wage necessary
to keep workers
from shirking,
we
Le
At the equilibrium wage,We the
firm hires Le workers
creating unemployment of L* - Le,
Chapter 17 Slide 67
Efficiency Wages at Ford Motor Company
? Labor turnover at Ford
?1913,380%
?1914,1000%
?Average pay = $2 - $3
?Ford increased pay to $5
Chapter 17 Slide 68
Efficiency Wages at Ford Motor Company
? Results
?Productivity increased 51%
?Absenteeism had been halved
?Profitability rose from $30 million in 1914
to $60 million in 1916,
Chapter 17 Slide 69
Summary
? Asymmetric information creates a market
failure in which bad products tend to drive
good products out of the market,
? Insurance markets frequently involve
asymmetric information because the
insuring party has better information about
the risk involved than the insurance
company,
Chapter 17 Slide 70
Summary
? Asymmetric information may make it
costly for the owners of firms to
monitor accurately the behavior of the
firm’s manager,
? Asymmetric information can explain
why labor markets have substantial
unemployment when some workers
are actively seeking work,
End of Chapter 17
Markets with
Asymmetric
Information
