Lecture 9 - Information Asymmetry PDF

Welcome to Intermediate Economics Semester 1, 2024 1  Lecture 9 INFORMATION ASYMMETRY 5ECON010C-n Intermediate Microeconomics Lecture Outline LECTURE OUTLINE 1. Quality, Uncertainty and the Market for Lemons 2. Market Signaling 3. M...

Welcome to Intermediate Economics Semester 1, 2024 1  Lecture 9 INFORMATION ASYMMETRY 5ECON010C-n Intermediate Microeconomics Lecture Outline LECTURE OUTLINE 1. Quality, Uncertainty and the Market for Lemons 2. Market Signaling 3. Moral Hazard 4. The Principal–Agent Problem 5. Managerial Incentives in an Integrated Firm 6. Asymmetric Information in Labor Markets: Efficiency Wage Theory Copyright © 2016, 2012, 2009 Pearson Education, Inc. All Rights Reserved Quality Uncertainty and the Market for Lemons Asymmetric information: Situation in which a buyer and a seller possess different information about a transaction. Consumer knows less about the product than the producer The employee knows more about work process than the manager Used cars sell for much less than new cars because there is asymmetric information about their quality. The seller of a used car knows much more about the car than the prospective buyer does. As a result, the prospective buyer will always be suspicious of its quality—and with good reason. The markets for insurance, financial credit, and even employment are also characterized by asymmetric information about product quality.  Quality Uncertainty and the Market for Lemons FIGURE 17.1 THE MARKET FOR USED CARS When sellers of products have better information about product quality than buyers, a “lemons problem” may arise in which low- quality goods drive out high quality goods. In (a) the demand curve for high-quality cars is DH. However, as buyers lower their expectations about the average quality of cars on the market, their perceived demand shifts to DM. Quality Uncertainty and the Market for Lemons FIGURE 17.1 THE MARKET FOR USED CARS Likewise, in (b) the perceived demand curve for low-quality cars shifts from DL to DM. As a result, the quantity of high-quality cars sold falls from 50,000 to 25,000, and the quantity of low-quality cars sold increases from 50,000 to 75,000. Eventually, only low quality cars are sold.  Product Quality: Adverse Selection Over time, less and less high-quality cars will be sold (as the market is offering lower than actual price for them) This will result in market with only low-quality cars – the lemon problem The tendency of large quantities of low-quality product being sold in the market due to asymmetric information is called adverse selection Adverse selection: Form of market failure resulting when products of different qualities are sold at a single price because of asymmetric information, so that too much of the low-quality product and too little of the high-quality product are sold. 5ECON010C Microeconomics Information Asymmetry: Consumer knows more 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. Because unhealthy people are more likely to want insurance, the proportion of unhealthy people in the pool of insured people increases. This forces the price of insurance to rise, so that more healthy people elect not to be insured. The process continues until most people who want to buy insurance are unhealthy. At that point, insurance becomes very expensive, or—in the extreme—insurance companies stop selling the insurance. One solution to the problem of adverse selection is to pool risks. By providing insurance for all people over age 65, the government eliminates the problem of adverse selection. Likewise, insurance companies offer group health insurance policies at places of employment. Information asymmetry: Consumers know more THE MARKET FOR CREDIT Borrowers have better information—i.e., they know more about whether they will pay than the lender does. Again, the lemons problem arises. Low-quality borrowers are more likely than high-quality borrowers to want credit, which forces the interest rate up, which increases the number of low-quality borrowers, which forces the interest rate up further, and so on. Credit card companies and banks can, to some extent, use computerized credit histories to distinguish low-quality from high-quality borrowers. Without these histories, even the creditworthy would find it extremely costly to borrow money. Asymmetric Information: Sellers know more The Importance of Reputation and Standardization Asymmetric information is also present in many other markets. Here are just a few examples: Retail stores: Will the store repair or allow you to return a defective product? Dealers of rare stamps, coins, books, and paintings: Are the items real or counterfeit? Roofers, plumbers, and electricians: When a roofer repairs or renovates the roof of your house, do you climb up to check the quality of the work? Restaurants: How often do you go into the kitchen to check if the chef is using fresh ingredients and obeying health laws? Reputation and brand is key here – if the producer of certain brand was able to earn consumers’ trust as the supplier of high-quality goods, it can overcome adverse selection Sellers of high-quality goods and services have a big incentive to build a reputation. Since reputation may be difficult to build, standardization can solve the lemons problem. For example, you know exactly what you will be buying at McDonald’s. Market Signaling Market signaling: Process by which sellers send signals to buyers conveying information about product quality. Can potential employees convey information about their productivity? Dressing well for the job interview might convey some information, but even unproductive people can dress well. Dressing well is thus a weak signal—it doesn’t do much to distinguish high-productivity from low- productivity people. To be strong, a signal must be easier for high-productivity people to give than for low- productivity people to give, so that high-productivity people are more likely to give it. For example, education is a strong signal in labor markets. More productive people are more likely to attain high levels of education in order to signal their productivity to firms and thereby obtain better-paying jobs. Market Signaling: Durable Goods Guarantees and Warranties Consider the markets for such durable goods as televisions, stereos, cameras, and refrigerators. If consumers could not tell which brands tend to be more dependable, the better brands could not be sold for higher prices. To make consumers aware of the difference. They can offer guarantees and warranties. The low-quality item is more likely to require servicing under the warranty, for which the producer will have to pay. In their own self-interest, therefore, producers of low-quality items will not offer extensive warranties. Thus, consumers can correctly view extensive warranties as signals of high quality and will pay more for products that offer them. A Simple Model of Job Market Signaling FIGURE 17.3 SIGNALING Education can be a useful signal of the high productivity of a group of workers if education is easier to obtain for this group than for a low- productivity group. In (a), the low-productivity group will choose an education level of y = 0 because the cost of education is greater than the increased earnings resulting from education. However, in (b), the high-productivity group will choose an education level of y* = 4 because the gain in earnings is greater than the cost. A Simple Model of Job Market Signaling COST–BENEFIT COMPARISON People in each group make the following cost-benefit calculation: Obtain the education level y* if the benefit (i.e., the increase in earnings) is at least as large as the cost of this education. Therefore, Group I will obtain NO education as long as $𝟏𝟎𝟎, 𝟎𝟎𝟎 < $𝟒𝟎, 𝟎𝟎𝟎𝒚∗ or 𝒚∗ > 𝟐. 𝟓 and Group II will obtain an education level y* as long as $𝟏𝟎𝟎, 𝟎𝟎𝟎 > $𝟐𝟎, 𝟎𝟎𝟎𝒚∗ or 𝒚∗ < 𝟓 These results give us an equilibrium as long as y* is between 2.5 and 5. High-productivity people will obtain a college education to signal their productivity; Firms will read this signal and offer them a high wage. Moral Hazard In some cases, information asymmetry creates a problem of different nature Moral hazard: When a party whose actions are unobserved can affect the probability or magnitude of a payment associated with an event. Suppose, you have insured your house against fire This will cause you to feel more relaxed about fire safety You will leave electric devices plugged-in, you might think of decorating your rooms with candles etc. So, you become morally less responsible just due to the fact that you are insured and the other party cannot monitor your actions. 5ECON010C Microeconomics Information Asymmetry at the Workplace Information asymmetry between the manager (agent) and the owner (principal) of the business can also create many problems This is true also for public organizations – there the officials are the agents and the government is the principal The agent knows the process better and the principal might not be able to fully monitor the work of the agent So, the agent may misuse his position and prioritize his own interest over the interest of other stakeholders This case is called a principal-agent problem 5ECON010C Microeconomics The Principal–Agent Incentives in the Principal–Agent Framework How can owners design reward systems so that managers and workers come as close as possible to meeting owners’ goals? TABLE 17.2: REVENUE FROM MAKING WATCH Black BAD LUCK GOOD LUCK Low effort (a = 0) $10,000 $20,000 High effort (a = 1) $20,000 $40,000 The owners’ goal is to maximize expected profit, given the uncertainty of outcomes and the fact that the repairperson’s behavior cannot be monitored. The best payment scheme depends on the nature of production, the degree of uncertainty, and the objectives of both owners and managers. Facing a wage of 0, the repairperson has no incentive to make a high level of effort. A fixed payment will lead to an inefficient outcome. When a = 0 and w = 0, the owner will earn an expected revenue of $15,000 and the repairperson a net wage of 0. The Principal–Agent Problem Incentives in the Principal–Agent Framework Both the owners and the repairperson will be better off if the repairperson is rewarded for his productive effort. Suppose, for example, that the owners offer the repairperson the following payment scheme: If 𝑹 = $𝟏𝟎, 𝟎𝟎𝟎 𝒐𝒓 $𝟐𝟎, 𝟎𝟎𝟎, 𝒘 = 𝟎 If 𝑹 = $𝟒𝟎, 𝟎𝟎𝟎, 𝒘 = $𝟏𝟐, 𝟎𝟎𝟎 Under this bonus arrangement, a low effort generates no payment. A high effort, however, generates an expected payment of $12,000, and an expected payment less the cost of effort of $12,000 - $10,000 = $2000. Under this system, the repairperson will choose to make a high level of effort. This arrangement makes the owners better off than before because they get an expected revenue of $30,000 and an expected profit of $18,000. Asymmetric Information in Labor Markets: Efficiency Wage Theory In the presence of high unemployment, why don’t we see firms cutting wage rates, increasing employment levels, and thereby increasing profit? Can our models of competitive equilibrium explain persistent unemployment? Efficiency wage theory: Explanation for the presence of unemployment and wage discrimination which recognizes that labor productivity also depends on the wage rate. Shirking model: Principle that workers still have an incentive to shirk if a firm pays them a market-clearing wage, because fired workers can be hired somewhere else for the same wage. Once hired, workers can either work productively or slack off (shirk). But because information about their performance is limited, workers may not get fired for shirking. Information Asymmetry in Labor Market Efficiency wage theory suggests that wage is the best tool to resolve principal-agent problem It assumes that at market wage rate workers tend to shirk, as they know that they can find job for the same wage elsewhere, should they lose their current job Thus, the employer should keep their wages higher than competitive market rate 5ECON010C Microeconomics Information Asymmetry in Labor Market That higher wage is called efficiency wage, as that’s the wage paid to workers not just for being at work, but for being productive The more productive labor the firm needs, the higher efficiency wage it needs to offer Thus, we see upward-sloping non-shirking constraint curve 5ECON010C Microeconomics Information Asymmetry in Labor Market Due to efficiency wage 𝒘𝒆 being higher than competitive market wage 𝒘∗ , the firm ends up hiring less workers 𝑳𝒆 than the existing labor force 𝑳∗ , which leaves the labor market with the unemployment level of 𝑳∗ − 𝑳𝒆 5ECON010C Microeconomics Reading Mandatory reading Pindyck & Rubinfeld (2015). “Microeconomics”, 8th edition. Chapter 17 Optional reading https://www.harper-adams.ac.uk/events/ifsa/papers/5/5.4%20Minarelli.pdf Online Customer Reviews: Their Impact on Restaurants (1,300 words) https://hospitalityinsights.ehl.edu/online-customer-reviews-restaurants 5ECON010C Microeconomics