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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

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information theory

Information theory

Asymmetric information and its effect on market outcomes

information theory2
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 theory3
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 theory4
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 theory5
Information theory

The “market for lemons”

Adverse selection

Moral hazard

The principal-agent problem

the market for lemons
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 lemons7
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 lemons8
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 lemons9
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 lemons10
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 lemons11
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 lemons12
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 lemons13
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 theory14
Information theory

The “market for lemons”

Adverse selection

Moral hazard

The principal-agent problem

adverse selection
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.
adverse selection16
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
adverse selection17
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.
information theory18
Information theory

The “market for lemons”

Adverse selection

Moral hazard

The principal-agent problem

moral hazard
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 hazard20
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!
moral hazard21
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 hazard22
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 theory23
Information theory

The “market for lemons”

Adverse selection

Moral hazard

The principal-agent problem

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 problem25
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 problem26
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 problem27
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 problem28
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 problem29
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 problem30
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 problem31
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 problem32
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!!