Managerial economics strategy by m perloff and brander chapter 15 asymmetric information

Chapter 15
Asymmetric
Information


Table of Contents
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15.1 Adverse Selection

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15.2 Reducing Adverse Selection

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15.3 Moral Hazard

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15.4 Using Contracts to Reduce Moral Hazard

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15.5 Using Monitoring to Reduce Moral Hazard

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Introduction
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Managerial Problem

– During the mortgage market meltdown that started in 2007, record
numbers of mortgage holders defaulted on their loans.
– Why did executives at these banks take risks that resulted in so much lost
shareholder value? How can a firm compensate its corporate executives so
as to prevent them from undertaking irresponsible and potentially
devastating actions?
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Solution Approach

– We need to examine how a manager’s incentives can lead to excessive
risk taking.
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Empirical Methods

– A party in a transaction may know less than the other party (asymmetric
information) because of hidden characteristics or hidden actions.
– A more-informed party may exploit the less-informed party, engaging in
opportunistic behavior and creating two problems: adverse selection and
moral hazard.

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15.1 Adverse Selection
• The Problems of Adverse Selection
– If consumers lack relevant information, they may not engage in
transactions to avoid being exploited by better informed sellers (adverse
selection).
– As a result, not all desirable transactions occur and potential consumer
and producer surplus is lost.
– In extreme cases, adverse selection may prevent a market from operating
at all.

• Adverse Selection Cases
– Two important examples of adverse selection problems are insurance and
products of varying quality.

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15.1 Adverse Selection
• Adverse Selection in Insurance Markets
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How would people react to a fair insurance rate (a rate for insurance equal to the

average cost of health care for the entire population)?
Unhealthy people—people who expect to incur health care costs that are higher than
average—would view this insurance as a good deal and many would buy it.
Healthy people, in contrast, would not buy it because the premiums would exceed
their expected health care costs (unless they are extremely risk averse).
So a disproportionately large share of unhealthy people will buy the insurance
(adverse selection).
The insurance company’s average cost of medical care for covered people exceeds
the population average. The company makes a loss.

• Consequences of Adverse Selection in Insurance Markets
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Adverse selection results in an inefficient market outcome: few healthy people are
insured and insurer’s cost is high. The sum of CS and PS is not maximized.
This outcome could be changed with perfect information: healthy people would buy
insurance at a lower premium, but the insurer must first verify they are healthy.

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15.1 Adverse Selection
• Products of Unknown Quality
– Adverse selection often arises because sellers of a product have better
information about the product’s quality than the buyer.
– In a transaction of a used car, the seller knows whether his car is a lemon,
but the buyer cannot know it (hidden characteristic).

• Consequences of Unknown Quality
– If sellers have more information than buyers, adverse selection may drive
high-quality products out of the market (Akerlof, 1970). Why?
– Car buyers worry that a used car might be a lemon. They would be willing
to pay only relatively low prices that reflect the possibility of getting a
lemon.
– However, sellers of excellent used cars do not want to sell their cars at
such low prices. They do not enter the market.
– Adverse selection has driven the high-quality cars out of the market,
leaving only lemons.

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15.1 Adverse Selection
• Lemons Example
– 1,000 sellers cannot alter the quality of their used cars; 1,000 buyers are
willing to pay $4,000 for a lemon and $8,000 for a good used car.
– The demand curve for lemons, DL, is horizontal at $4,000 in panel a of Figure
15.1, and the demand curve for good cars, DG, is horizontal at $8,000 in panel
b.
– The reservation price of lemon owners is $3,000, so the supply curve for
lemons, SL in panel a, is horizontal at $3,000 up to 1,000 cars, where it
becomes vertical (no more cars are for sale at any price).
– The reservation price of owners of high-quality used cars is v, which is less
than $8,000. Panel b shows two possible values of v. If v = $5,000, the supply
curve for good cars, S1, is horizontal at $5,000 up to 1,000 cars and then

becomes vertical. If v = $7,000, the supply curve is S2.

• Equilibrium with Full & Symmetric Information
– In panel a of Figure 15.1, the equilibrium in the lemons market (DL=SL) is at e
and 1,000 lemons sell for $4,000 each. In panel b, the equilibrium in the goodcar market is at E and 1,000 good cars sell for $8,000 each.
– This market is efficient: the goods go to the people who value them the most.

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15.1 Adverse Selection
Figure 15.1 Markets for Lemons and Good Cars

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15.1 Adverse Selection
• Equilibrium with Incomplete & Symmetric Information
– If information is symmetric and buyers and sellers are equally ignorant
about the quality of cars, EV = 0.5 x 8000 + 0.5 x 4000 = $6,000. A riskneutral buyer and a seller would transact at $6,000.
– This market is efficient: the goods go to the people who value them the
most.

• Equilibrium with Asymmetric Information
– When sellers know the quality but buyers do not, there are two possible
equilibria.

– If sellers value good cars at v = $5,000 and buyers consider EV = $6,000,
all cars are sold at $6,000. The equilibrium points are f and F in Figure
15.1. In this case asymmetric information does not cause an efficiency
problem, but it does have equity implications.
– If sellers value good cars at v = $7,000, they will not sell them at $6,000.
Buyers realize good cars cannot be found for less than $7,000. Then, the
lemons drive good cars out of the market, only lemons are sold at $4,000
leading to an inefficient equilibrium.
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15.1 Adverse Selection
• Summary of the Lemons Problem
– If buyers have less information about product quality than sellers do, the
result might be a lemons problem in which high-quality cars do not sell
even though potential buyers value the cars more than their current
owners do.
– The lemons problem does not occur if the information is symmetric. If
buyers and sellers of used cars know the quality of the cars, each car sells
for its true value in a perfectly competitive market. If, as with new cars,
neither buyers nor sellers can identify lemons, all cars sell at a price equal
to the EV.

• Varying Quality Under Asymmetric Information
– If consumers cannot identify high-quality goods before purchase, they pay
the same for all goods regardless of quality.
– Firms do not produce top-quality goods if p is the same for High and Low
quality.

– The outcome is inefficient, assuming consumers are willing to pay more
for top-quality goods.
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15.2 Reducing Adverse Selection
• Restricting Opportunistic Behavior
– One method for solving adverse selection problems is to restrict the ability
of the informed party to take advantage of hidden information.
– Which type of restriction works best depends on the nature of the adverse
selection problem, as we see below.

• Mandating Universal Coverage
– Health insurance markets have adverse selection because low-risk
consumers do not buy insurance at prices that reflect the average risk.
– Such adverse selection can be eliminated by providing insurance to
everyone or by mandating that everyone buy insurance.

• Laws to Prevent Opportunism
– Product quality and product safety are known characteristics to sellers but
not observed by buyers.
– Product liability laws protect consumers from being stuck with
nonfunctional or dangerous products.

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15.2 Reducing Adverse Selection
• Equalizing Information
– Another method for solving adverse selection problems is to provide
information to all parties.
– There are three methods for reducing information asymmetries: screening,
signaling, and third party.

• Screening Reduces Adverse Selection
– Insurance companies screen potential customers based on their health
records or medical exams. They collect information until marginal benefit
and marginal cost from the extra information are equal.
– Buyers of used cars test or drive the cars, bring a trusted mechanic, or
buy only from sellers with good reputation. Reputation is not easy to get in
markets where buyers or sellers trade only once, like in tourist areas.

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15.2 Reducing Adverse Selection
• Signaling Reduces Adverse Selection
– An informed party may signal the uninformed party to eliminate adverse
selection. However, signals work only when the recipients view them as
credible.
– Examples: A firm may distribute a favorable report on its product quality
by an independent testing agency; a candidate for life insurance may
present a health report signed by a doctor approved by the insurer;
education is also a signal.

• Third Party Information Reduces Adverse Selection
– If the information on quality provided by consumer groups, nonprofit
organizations, and government agencies is credible, it can reduce adverse
selection.
– These groups and organizations also provide standards and certification. If
these programs inexpensively and completely inform consumers and do
not restrict the goods available, the programs are socially desirable.

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15.3 Moral Hazard
• Moral Hazard and Adverse Selection
– Moral hazard problems come from hidden actions. For instance, renters
driving rental cars off-road, workers loafing when the boss is not watching,
and lawyers acting in their own interests instead of those of their clients.
– We will focus on the insurance market and the principal-agent relationship.

• Moral Hazard in Insurance Markets
– Many types of insurance are highly vulnerable to hidden actions by
insured parties that result in moral hazard problems.
– Example: A business insures merchandise in a warehouse against hazards
such as fire and theft. If merchandise is not selling, the owner faces a
significant financial loss. He may burn down the warehouse and make an
insurance claim.
– Example: If doctor’s visits are free and unlimited with health insurance,
the insured may make ‘excessive’ visits.

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15.3 Moral Hazard
• Moral Hazard in Principal-Agent Relationships
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Principal-Agent problem or agent problem: when responsibilities are delegated, a
principal contracts with an agent to take an action that benefits the principal. If the
agent’s actions are hidden, moral hazard may result.
Example: A business owner (principal) hires an employee (agent) to work at a
remote site and cannot observe whether the employee is working hard. The
employee may shirk by not providing all the services they’re paid to provide.

• Reducing Moral Hazard using Efficient Contracts
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The principal and agent can agree to an efficient contract: an agreement in which
neither party can be made better off without harming the other party.
If the parties to the contract are risk neutral, efficiency requires that the combined

profit of the principal and agent be maximized.
If one party is more risk averse than the other, efficiency requires that the less riskaverse party bear more of the risk.
In the previous example, efficiency occurs if the agent works extra hard so total
profit is maximized, and if the agent (risk averse party) bears none of the risk.

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15.3 Moral Hazard
• Moral Hazard & Efficient Contracts: Ice Cream Shop
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Paul (principal) owns many ice cream parlors across North America. He contracts
with Amy (agent) to manage his Miami shop. Her duties include supervising workers,
purchasing supplies, and performing other necessary actions.
The shop’s daily earnings depend on the local demand conditions and on how hard
Amy works (Table 15.1). Demand can be high or low depending on weather
conditions (50%) and Amy can put in normal or extra effort (valued $40 per day).
Paul is risk neutral because he can pull earnings from the many stores he owns.
Amy, like most people, is risk averse.
We know an efficient contract requires Amy to bear no risk, but the outcome
depends on symmetric and asymmetric information.

• Ice Cream Shop Efficient Contract & Symmetric Information
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Moral hazard is not a problem if Paul can directly supervise Amy and agree that:
Amy earns $200 per day if she works extra hard, but loses her job if she doesn’t.
Amy’s zero risk: She gets $200 independently of weather.
Amy’s incentive to work hard: She nets $160 (200-40), better than being fired.
Paul bears all risk: EV = $200; σ2 = 10,000 (perfect monitoring row in Table 15.2)
Efficient contract: Profit maximized, risk averse agent bears no risk.

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15.3 Moral Hazard
Table 15.1 Ice Cream Shop Profits

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15.3 Moral Hazard
Table 15.2 Ice Cream Shop Outcomes

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15.3 Moral Hazard
• Ice Cream Shop Inefficient Contract & Asymmetric Information
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Moral hazard is a problem if Paul cannot observe Amy’s effort. Both agree on a fixedfee contract: Amy earns $100 per day.
Amy’s zero risk: She gets $100 independently of weather.
Amy’s incentive to work normally: If she works normally, she gets $100. But, if she
works hard, she only nets $60 (100-40).
Paul bears all risk: EV = $100; σ2 = 10,000 (fixed wage row in Table 15.2)
Inefficient contract: Profit is not maximized, although risk averse agent bears no
risk.

• Moral Hazard and Selfish Doctors Study Case in China
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Patients (principals) rely on doctors (agents) for good medical advice with respect to
drug prescriptions. Do doctors act only in their patient’s best interests?
Lu (2011) found in China that doctors prescribed similarly whether or not a patient

had insurance if the doctors received no compensation for prescriptions. However, if
doctors were compensated, they prescribed drugs that cost 43% more on average
for insured patients than for uninsured patients.
Thus, many of these doctors appeared to be motivated largely by self-interest.

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15.4 Using Contracts to Reduce
Moral Hazard
• Contracts and Correct Incentives
– A skillfully designed contract that provides strong incentives for the agent
to act so that the outcome is always efficient may solve moral hazard
problems.
– We will focus on fixed-fee and contingent contracts.

• Fixed-Fee Contracts
– Amy could pay Paul a fixed license fee to operate Paul’s shop. Paul bears
no risk as he receives a fixed fee, Amy bears all the risk and gets the
residual profit.
– Paul makes $200 with certainty.
– Amy’s incentive to work hard: She earns all the increase in expected profit
from her extra effort. EVHARD = $160 > -$100 = EVNORMAL, σ2 = 10,000
– Efficient contract: Licensing fee profit > fixed wage profit in Table 15.2
(360 > 200). However, it does not provide efficient risk bearing.
– If Amy is nearly risk-neutral, she picks the license fee. If she’s highly riskaverse, she picks the fixed wage.

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15.4 Using Contracts to Reduce
Moral Hazard
• Contingent Contracts
– Many contracts specify that the parties receive payoffs that are contingent on
some other variable.
– If monitoring is possible, contingency may be the action taken by the agent.
– If monitoring is not possible, payoff may be contingent to the state of nature,
profit sharing, bonuses & options, piece rates and commissions.

• State Contingent Contracts
– In a state-contingent contract, one party’s payoff is contingent on only the
state of nature (weather conditions determine low and high demand).
– Contract: Amy pays a license fee of $100 if demand is low and $300 if
demand is high, and keeps all extra earnings (state-contingent row in Table
15.2)
– Amy’s incentive to work hard: Working normal she nets zero. She must work
hard.
– Amy bears no risk: EVHARD = $160 = EVNORMAL, σ2 =0.
– Paul bears all risk: EV = $200, σ2 =10,000.
– Efficient outcome: Profit is maximized, risk averse agent bears no risk.

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15.4 Using Contracts to Reduce
Moral Hazard

• Profit Sharing
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A profit-sharing contract: the payoff to each party is a fraction of the observable
total profit (profit sharing row in Table 15.2).
Contract: Paul and Amy agree to split the earnings of the ice cream shop equally.
Amy’s incentive to work hard and risk: EVHARD = $160 > $100 = EVNORMAL, and σ2 =
2,500 for both efforts. She prefers to work hard.
Paul earnings: EV = $200, and he is risk neutral.
Efficient outcome: Profit is maximized but risk averse agent bears risk. Paul prefers
this contract to a fixed-fee contract. Amy works hard if her profit share > 20%.

• Bonuses
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A principal offers the agent a bonus: extra payment if a performance target is hit.
Contract: Paul offers Amy a base wage of $100 and a bonus of $200 if the shop’s
earnings (before paying Amy) exceed $300 (wage and bonus rows in Table 15.2)
Amy’s incentive to work hard: Working normal she nets $100. Working hard, EVHARD

= $160 and σ2 =10,000. Her choice depends on her risk-averse level.
If Amy is nearly risk neutral, she works hard (before last row in Table 15.2).
If Amy is highly risk-averse, she works normal (last row in Table 15.2).
Efficient outcome: Profit is maximized only if Amy is risk neutral.

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15.4 Using Contracts to Reduce
Moral Hazard
• Options
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An option gives the holder the right to buy up to a certain number of shares of the
company at a given price (the exercise price) during a specified time interval.
An option provides a benefit to the executive (agent) if the firm’s stock price
exceeds the exercise price and is therefore a bonus based on the stock price.

• Piece Rates and Commissions
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Piece rate contract: agent receives a payment per unit of output produced.
Contract: Amy is paid for every serving of ice cream she sells. It gives her an

incentive to work hard, but she bears the risk from fluctuations in demand.
Revenue-sharing contract or commissions: agent receives some share of revenues
earned
Contract: Amy gets a 5% commission for every serving she sells. It gives her an
incentive to work hard, but she bears the risk from fluctuations in demand.
Efficiency: Commissions provide an incentive for agents to work harder than they
would with a fixed-rate contract. But, this incentive is not necessarily strong enough
to offset the agent’s cost of extra effort and the agent bears some risk.

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15.5 Using Monitoring to Reduce
Moral Hazard
• Problem and Monitoring Solution
– Moral Hazard Problem: employees who are paid a fixed salary have little
incentive to work hard if the employer cannot observe shirking. And if paid
by the hour but employer but cannot observe how many hours they work,
employees may inflate the number of hours they report working.
– It pays to prevent shirking by carefully monitoring and firing employees
who do not work hard if the cost of monitoring workers is low enough.

• Low Cost Monitoring Practices
– Most common types of surveillance: tallying phone numbers called and
recording the duration of the calls (37%), videotaping employees’ work
(16%), storing and reviewing e-mail (15%), storing and reviewing
computer files (14%), and taping and reviewing phone conversations
(10%).
– Nearly 75% of employers monitor and surveillance employees (81% in the
financial sector). Firms usually monitor selected workers using spot

checks.
– A quarter of firms that monitor employees do not tell them.
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15.5 Using Monitoring to Reduce
Moral Hazard
• Monitoring May be Counterproductive
– For some jobs, however, monitoring is counterproductive or not cost
effective. Monitoring may lower employees’ morale, which in turn reduces
productivity.
– Example: Northwest Airlines took the doors off bathroom stalls to prevent
workers from staying too long in the stalls. When new management
eliminated this policy, productivity increased.

• Monitoring Difficulties
– As telecommuting increases in the work place, monitoring workers may
become increasingly difficult.
– A firm’s board of directors is supposed to represent shareholders
(principals) by monitoring senior executives (agents). Are they good in
monitoring?
– No. In a study of firms in which senior executives engaged in illegal pricefixing, exposing the firm to significant legal liability, it was found that
these executives were more inclined to recruit directors who were likely to
be inattentive monitors.
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