Information theory

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# Information theory - PowerPoint PPT Presentation

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

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### Information theory

Asymmetric information and its effect on market outcomes

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
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.
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?
Information theory

The “market for lemons”

Moral hazard

The principal-agent problem

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?
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
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
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
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 !!
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
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.
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
Information theory

The “market for lemons”

Moral hazard

The principal-agent problem

• 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.
• 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
• 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.
Information theory

The “market for lemons”

Moral hazard

The principal-agent problem

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)
Moral hazard
• Car insurance example:
• 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!
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!
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)
Information theory

The “market for lemons”

Moral hazard

The principal-agent problem

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

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

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)
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...
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?
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!!
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

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

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!!