Information theory

1. Information theory Asymmetric information and its effect on market outcomes

2. Information theory • Reminder: Perfect competition is defined by the following 5 conditions: • Large number of agents (Atomicity) • Homogeneous products • Free entry and exit from the market • Perfect information • Perfect mobility of inputs • We now know that these 5 conditions are never fully met in reality: they serve as a benchmark

3. Information theory • We have examined the effect of a limited number of agents; a lack of entry in the market, a lack of homogenous products • But we haven’t explored the consequences of dropping the assumption of perfect information: • Agents constantly are constantly informed, without delay, of the changing market conditions • Agents also know all perfectly all the characteristics of the goods: No hidden defects, etc.

4. Information theory • Clearly this assumption is unrealistic !! • One could even argue it is the most unrealistic of the 5 ! • In reality : • It takes time to gather information (about goods, jobs, opportunities) • This search therefore has an opportunity cost • Therefore, information is intrinsically valuable • If an agent has private information in a given situation, is it in his interest to share it with other agents?

5. Information theory The “market for lemons” Adverse selection Moral hazard The principal-agent problem

6. The “market for lemons” • Akerlof 1970 “The Market for Lemons: Quality, Uncertainty and the Market Mechanism” • Akerlof investigates the effect of asymmetric information on the market equilibrium, based on the example of the used cars market. • Assumptions: • Used cars can either be of a good quality (“plums”), or they can be faulty (“lemons”). • The seller knows the level of quality of his own car • Potential buyers do not know the level of quality and cannot observe it ⇒ asymmetric information • How does this affect the market outcome?

7. The “market for lemons” • The buyer cannot observe the quality of a particular car. • When meeting a car owner, he will only be prepared to offer a price which corresponds to the “average” quality of the cars on the market. • He does not have any information which would allow to tailor his offer for a particular car. • The owner of a lemon: • Has no interest in revealing the information he has about the (low) quality of his car • If he does so, he will receive a lower offer (by improving the information available to the buyer) • By keeping the information for himself, he can expect a price higher than the value of the car ⇒ market power

8. The “market for lemons” • The owner of a plum: • Has no interest of selling his car at the average price offered by the buyers (he knows that the car is really worth more than the average offer) • Crucial aspect: He cannot improve the information of the buyer by revealing the quality of the car ! • This is because the real information (my car is a plum) is “drowned” by the noise made by the owners of lemons !! -“That’s what they all say” • So his best option is to exit the market. • As a result the average qualityof cars on the market decreases

9. The “market for lemons” • Another crucial aspect : • What happens if the buyersrealisethat the goods cars are exiting the market ? • Or if they anticipate this will happen (game theory aspect) • They reduce their average offer in line with the reduction in average quality • Following this reasoning, more owners of plums leave the market • In the end, the market disappears ! • In theory, a “market for lemons” cannot exist for long

10. The “market for lemons” • This is why you don’t see “spontaneous” markets for second-hand cars... • The quality of a second-hand car can vary a lot • Buying a car, even second hand, is expensive (high opportunity cost) • Concealing problems with a car is easy and cheap • So buying a random car from a complete stranger is a big risk !!

11. The “market for lemons” • One of the biggest market for lemons is ?? • eBay !! • Example: MP3/MP4 fraud • You open a seller’s account on eBay • You buy (or manufacture) a shipment of cheap, low capacity MP3 players (128-512MB) • You hack the software so that when plugged into a computer, it declares a high storage capacity (4-8GB). • You sell it for the price of a 4-8GB player

12. The “market for lemons” • Other example: Forgeries • 70% of “Tiffany & Co” jewellery sold on eBay is fake (NYT, 27/11/2007) • In theory, eBay has a feedback mechanism for sellers (which has been changed now) • the negative feed-back (information)should allow these “markets for lemons” to collapse (as the theory says they should) • But fraudsters are smart: They set up multiple, genuine low-value auctions to build up positive feedback.

13. The “market for lemons” • Fraud has become a very big problem for eBay (even though it represents 0.01% of sales) • Fall in confidence from customers • Lawsuits from luxury companies (Tiffany, Vuitton, etc.) • National legislations forcing eBay to monitor the quality of goods sold. • The problem is that the whole point of eBay is that anybody can sell anything anywhere ! • Changing this changes the whole company • Dealing with this asymmetric information problem is a big challenge

14. Information theory The “market for lemons” Adverse selection Moral hazard The principal-agent problem

15. Adverse selection • What is “adverse selection” ? • An asymmetric-information problem that occurs when the quality of the good is unobservable by one of the parties before the transaction / contract occurs • Example: • The “market for lemons” already mentioned • More critically: the insurance market • The sub-prime mortgage crisis.

16. Adverse selection • Car insurance market example • Imagine you want to get insurance for a new car... • But you’ve been stopped once already for drunk driving, and you’ve had a speeding ticket. • What will happen if you reveal this information to your insurer? • Similar problems with medical insurance • Companies only want to insure healthy people! • Which is why health insurance is often public

17. Adverse selection • Avoidance mechanisms: • The problem is the asymmetric information prior to the transaction, • Most methods rely on revealing this information • 2nd hand cars: Servicing history, MOT, etc. • Labour market: Interviews and trial periods • Insurance market: Insurance history, questionnaires, etc. • Health insurance: health checks, age limit, etc.

18. Information theory The “market for lemons” Adverse selection Moral hazard The principal-agent problem

19. Moral hazard • What is “Moral hazard”? • An asymmetric-information problem that occurs when the behaviour of one party is unobservable by the other party after a contract is agreed • The terms the contract were agreed on change once the contract is signed • Examples: • The insurance market (again!) • The labour market (shirking)

20. Moral hazard • Car insurance example: • Your get third-party insurance for your car (legal minimum insurance) • You’re late for an appointment, you park your car. On your way, you can’t remember if you removed the car-radio/tom-tom, etc. • What do you do ? • How does your decision change if you have comprehensive insurance ? • Your level of risk changes with the level of insurance!

21. Moral hazard • Labour market example: • You are hired by a private firm, your contract is fixed-term and your pay is result-based. • A big deadline is close: Do you work Saturdays? • You are hired to become a civil servant. Your career track is guaranteed, you can’t be fired and your pay and pension are inflation protected. • Do you still turn up to work on Saturdays? • Your level of effort changes with the characteristics of your contract!

22. Moral hazard • Avoidance mechanisms: • The problem is the asymmetric information on behaviour after the transaction • Most mechanisms involve monitoring behaviour or incentives/disincentives. • Car insurance: excess fees, bonus-malus systems • Labour market: annual monitoring reports, results-based incentives (stock-options, bonuses)

23. Information theory The “market for lemons” Adverse selection Moral hazard The principal-agent problem

24. The principal-agent problem • Most of these aspects of asymmetric information can be grouped into the “principal-agent problem” • An agency problem is a situation where a person (the principal) hires another person (the agent) to carry out a task in his name. Hires A P Performs

25. The principal-agent problem • The assumption is that the agent has more knowledge than the principal about the effort action being carried (division of labour). • The agent can use this to reduce his effort (self interest) without the principal noticing. Hires A P Performs

26. The principal-agent problem • This framework can be used to identify and deal with the information asymmetries in the design of contracts: • What information revealing-mechanisms to use to minimise the asymmetry. • The optimal intensity of monitoring (which is costly to the principal) • The optimal intensity of incentives (which are costly and can lead to rent-seeking behaviour)

27. The principal-agent problem • An applied example: Stock markets • The principals are the shareholders of a firm • They want the firm to do well (get a good return on their investments) • But there are a lot of shareholders! • They don’t know much about management... • Or they don’t have the time... • Or they disagree...

28. The principal-agent problem • So they hire an agent: the CEO • He will run the firm for the shareholders’ benefit • But there is a massive information asymmetry! • The CEO only reports to shareholders once a quarter (at best) ... • And he can always find a good reason to justify bad results, or use some “creative accounting” to hide losses. • How can they make sure that the CEO doesn’t follow his self interest?

29. The principal-agent problem • The principals can use: • Monitoring of the CEO: principals can hire audit cabinets to certify accounts (they have to by law) • Incentivise the CEO: bonuses and stock options • But there are two possible problems • The CEO can try and “cook the books” to hide his self interest effort... • The hiring of audit cabinets is in itself and agency problem: they can be self interested and lie as well!!

30. The principal-agent problem • Illustration : The Enron scandal of December 2001: 23 billion $ worth of hidden debts!! • How was this not picked up by the audit cabinet (Arthur Andersen) ? Hires CEO P Performs Monitors Appoints AA

31. The principal-agent problem • Well it was... But they lied about the accounts! • Arthur Andersen was closed down in 2002 for destroying evidence of Enron’s management practices Hires CEO P Performs Monitors Appoints AA

32. The principal-agent problem • The Enron Collapse illustrates the problems involved in “contract design” • We already know that NO incentives leads to self interested behaviour... • But CEO Incentives that are too high can lead to rent seeking behaviour which is just as bad. • Monitoring institutions can worsen the problem rather than improve it if they themselves succumb to an agency problem • See the notation agencies role in the subprime mortgage crisis!!