C17 - Asymmetric Information Part 1

Because the car is for sale it indicates it is a

"Lemon" and will always be suspicious of its quality to the buyter.

Principal-agent problem is a

(agency problem) where the manager does not want to follow the goals of the owner because the employees are better informed about them than the owner.

The Consequences of Asymmetric Information

1. Adverse Selection and the lemon problem 2: Moral Hazard

Solutions to Moral Hazard

1. Changing Incentives 2. Improve information

The solution for Principal-agent problem: Information and incentives too!

1. Information such as reviews and reputation. 2. Incentives: compensation tied to results (bonuses), performance evaluations, give stocks of a company to CEOs (stock ownership)

Other Markets with Adverse Selection

1. Retail stores 2. Restaurants 3. Roofers, plumbers, and electricians

Results of the Published economics paper "Effect of Information on Product Quality: Evidence from Restaurant Hygiene Cards" looked at impact of 1998 LA law that mandated hygiene quality cards be displayed in restaurant windows.

1: 20% decrease in hospitalizations for foodborne illnesses 2: Consumer demand became sensitive to changes in restaurants' hygiene quality 3: Restaurants with bad grades went out of business!!!

How to fix Market for insurance

1: pool risks 2: government provisions

Adverse Selections vs. Moral Hazard--- the market for insurance:

1:Adverse Selection: problem of selection of high risk individuals into insurance before transaction occurs screening process 2. Moral Hazard: problem of change in behavior to get higher payments after transaction occurs monitoring process

Example 1 of Market Signals: Warranties

A great warranty for a car signals to the buyer that it must be of great quality if they are going to provide this.

Reputation example

A particular store has a reputation of providing high quality goods and therefore people trust shopping there.

Risk-neutral buyer definition

A risk neutral party's decisions are not affected by the degree of uncertainty in a set of outcomes, so a risk neutral party is indifferent between choices with equal expected payoffs even if one choice is riskier.

How to prevent the death spiral of insurance in adverse selection

A. Signaling: B. Propitious Selection: C: Pooling Risks

Implications of Asymmetric information

Adverse Selection, The Market for Insurance, The Market for Credit

Asymmetric information leads to..... Leads to.....

Adverse selection which leads to market signals to stop market failure.

Adverse Selection

Arises when products of different qualities are sold at a single price because buyers or sellers are not sufficiently informed to determine the true quality at the time of purchase.

In reality, there is imperfect information or...

Asymmetric information.

Why can Principal-agent problem arise?

Because goals are not aligned

What happens if there with asymmetric information of cars.

Because only low quality cars will be sold at this price the market for high quality cars will collapse.

Moral Hazard create inefficiencies

Because the insured individual perceives either the cost or the benefit of the activity differently from the true social cost or benefit.

Why do used cars sell so much less than non-used cars even after one time

Because there are questions like why did the owner just change their mind like that? Or is there something wrong? Therefore the asymmetric information about the quality makes the price of used cars less because the seller knows much more.

Purchase of insurance entails difficulties because

Buyers have better information than the sellers.

Because sellers know more about the quality of a good than buyers do,

Buyers may assume that quality is low, causing price to fall and only low-quality goods to be sold.

Case 2: Asymmetric Information for many buyers and many sellers with Used cars

Buyers will only be willing to pay the average price...

Thus far we have assumed that

Consumers and producers have complete information about the economic variables that are relevant for the choice they face.

Example of Market Signaling

Customer guarantee and Carfax vehicle history reports.

How to account for asymmetric information in a market

Develop a reputation or standardization

Risk-neutral buyer example

Does not care about risk when choosing a price to pay.

Guarantees and warranties

Effectively signal product quality because an extensive warranty is more costly for the producer of a low-quality item for the producer of a high-quality item.

Implications and asymmetric information about product quality were first analyzed by

George Akerlof

Changing Incentives:

Give incentives to keep prevent agents from changing behavior such as a co-pay before.

How is adverse selection dealt with

Government intervention (health insurance), development of reputation can help the problem, guarantees and warranties

Pool risks

Have a firm cover insurance for all their employers

Other types of asymmetric information

How one acts or looks can be an implication on the type of person they are. Like being tired or having face tattoos, or watches.

Example of Moral Hazard

If my home is fully insured from thief, then I will be more likely to leave the doors unlocked.

Example 2 of Market Signals: Education in Job Hiring

If one seems more prepared and is able to communicate with an employer more intelligently, this signals information about ones education and value to a firm.

Risk-neutral buyer

If presented with asymmetric information chooses the average

Case 2: Asymmetric Information for many buyers and many sellers with Used cars solution

If there is a 50% chance that the car has high-quality (a $10,000 value for the buyer), and a 50% chance that the car has low-quality (a $5,000 value for the buyer).

Standardization Example

If you can develop a reputation, like McDonalds, you can standardize your product because people know you provide the same ingredients everywhere, even on the side of a highway.

What is Perfect Information?

In economics, perfect information is a feature of perfect competition. With perfect information in a market, all consumers and producers are assumed to have perfect (including instantaneous) knowledge of all markets prices, their own utility, and own cost functions.

B. Propitious Selection:

In some cases those who are more healthy are also more risk averse and want to get a better health insurance.

Under conditions of moral hazard

Insurance companies may be forced to increase premiums for everyone or even refuse to sell insurance because some they can either monitor how many claims people make, or pay larger than expected checks.

Market for...... are also characterized by asymmetric information about product quality.

Insurance, financial credit, and even employment.

Warehouse Moral Hazard

Intitally, insurance is bought while the firefighters have to partake in a fire-prevention program making the probability 0.05. However, after they still have the insurance but the probability goes back up to 0.1%.

Selling a bottle of water

Is not an example of moral hazard

Example of government intervention: Affordable Care Act: Obama Care

It prevents the death spiral forcing everyone to have a health insurance by law. Even the most wealthy.

The Market for Credit

Low-quality borrowers are more likely than high quality borrowers to want bredit, which forces the interest rate up, which increases the number of low quality buyers, which forces interest rate up further and so on.

Consequences of Moral Hazard

Market Inefficiencies

asymmetric information leads to

Market failures

Is this fair? (Market Signals and propitious selection)

Maybe. Think about someone with preexisting conditions? They may need to pay more for something they don't have.

Example 1 of principal agent: The car mechanic + politicans

Mechanic will say more so he can get paid more. Politician makes promises never put into place.

Example 1: The Car Mechanic

Mechanics know more about the car and can charge different parts at different prices.

Example of Pooling Risks

Medicaid for over 65 and group health insurance for a firm.

The Market for Insurance

People who buy insurance know much more about their general health than any insurance company. As a result, adverse selection arises and unhealthy people in the pool expands. Therefore the price rises, and more healthy/low-risk people leave. Therefore the pool expands again and the price rises again.

We have been using perfect information for

Perfect competition

principal-agent problem

Problem arising when agents (e.g., a firm's managers) pursue their own goals rather than the goals of principals (e.g., the firm's owners).

Market signaling

Process by which sellers send signals to buyers conveying information about product quality

Review: Market Signaling

Process by which sellers send signals to buyers conveying information about product quality

Market Signaling

Process by which sellers send signals to buyers conveying information about product quality

Review: Adverse Selection

Products of different qualities are sold at a single price + Asymmetric information = too much of the low-quality product too little of the high-quality product are sold.

Adverse Selection Slideshow

Products of different qualities are sold at a single price + Asymmetric information = too much of the low-quality product too little of the high-quality product are sold.

Example 4: Insurance Companies

Property Insurance, Car Insurance, Health Insurance

Government provisions

Providing medicaid for everyone over 65

How do customers solve the death spiral?

Reputation and Standardization (Retail stores,Restaurants, Roofers, plumbers, and electricians)

Example 3: Restaurant Hygiene in Los Angeles

Restaurant inspectors giving health grade cards. This gives the consumer market signals about how the quality of their food or product is.

Markets with asymmetric information

Retail stores, Dealers of paintings and coins (are they real), Roofers, plumbers, restaurants

Review: Asymmetric Information

Situation in which a buyer and a seller possess different information about a transaction.

Asymmetric information

Situation in which a buyer and a seller possess different information about a transaction.

2. Improve information

Such as GPS for taxi drivers or yelp/google to see the worth of a product.

Market Signals

Such as driving license records, physical examinations.

Example 2: Taxi Driver

Taxi driver can go wherever they want because the tourist does not know the area meaning a higher fare.

George Akerloff (1970):

The Market for `Lemons': Quality Uncertainty and the Market Mechanism

Example of Asymmetric information

The market for used cars

Moral Hazard

The possibility that an individual's behavior may change because of insurance.

Market signals are ways for

The seller to avoid some of the problems associated with asymmetric information by giving signals about the quality of the product.

Asymmetric information

The study of decisions in transactions where one party has more or better information than the other.

How do you prevent the death spiral for the market for credit?

They can somewhat use computerized credit histories to distinguish low quality candidates from high quality. However, this may be a infringement of privacy.

Example 3: shareholders (principal) and CEOs (agent)

Tim Cook CEO of Apple has successfully raised stock prices... However, he listen to himself even tho Shareholders wanted cook to cancel unprofitable projects

Market Inefficiencies

Transactions may not take place or Transactions might take place at prices that are too high....Agents do not perceive correctly the costs and benefits of their actions

Case 1: Perfect Information for many buyers and many sellers with Used cars

Transactions will take place and the price for low quality cars will be 5,000 and for high quality cars will be 10,000.

With Adverse Selection

Unless sellers provide information about quality to buyers, low quality goods and services will drive out high quality ones and there will be a market failure.

Reputation

When a firm has a reputation there is more information for the customer to evaluate. (Customer reviews)

Moral Hazard definition

When one party is fully insured and cannot be accurately monitored by an insurance company with limited information, the insured party may take action that increases the likelihood that an accident or injury will occur.

Moral Hazard

When someone's actions are unobserved and can affect the probability or magnitude of a payment associated with an event

principal agent problem in private enterprises

When the manager feels like they have less information because of the stockholders and employees informing the owner.

Sellers asymmetric information

When they know more about quality than consumer

Worker asymmetric information

When they know more about their skills and abilities than employers.

Asymmetric information

Where there is a knowledge gap for either the buyer or seller.

The lemons problem

With asymmetric information, low-quality goods can drive high-quality goods out of the market.

Example of Moral Hazard

With medical insurance I may visit the doctor more often than

"The Market for Lemons: Quality Uncertainty and the Market Mechanism" is a well-known 1970 paper by economist George Akerlof which examines

how the quality of goods traded in a market can degrade in the presence of information asymmetry between buyers and sellers, leaving only "lemons" behind.

C. Pooling risks

large group of people can prevent adverse selection

Consumers can correctly view extensive warranties as signals

of high quality and will pay more for products that offer them.

a risk-neutral buyer would be willing to pay what for the two cars?

pay at most $7,500

A subcategory of moral hazard!

principal-agent problem

A principal agent problem arises

when agent pursue their own goals rather than the goals of the principal.