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Asymmetric Information. Chapter 23. Introduction. Managers (insiders) of firms can increase their profit by taking actions based on insider information (information that is not available to public)

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Asymmetric Information

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  • Managers (insiders) of firms can increase their profit by taking actions based on insider information (information that is not available to public)
  • If insiders obtain positive (negative) information about a company, they buy (sell) the company’s stock with expectation that stock’s price will rise (fall) when positive (negative) information is publicly announced
    • Such insider trading of securities is illegal
      • However, incorporating information not known by all agents in market pricing is generally legal
  • When selling a commodity, agents are not legally required to provide full disclosure of information on a commodity
  • Previously, we generally implicitly assumed or explicitly stated symmetry in market information as a characteristic of market structure
    • Assumed all agents had costless access to this information
      • Symmetry existed with both buyers and sellers having the same market information
        • For example, one of the explicit characteristics of perfect competition is agents’ perfect knowledge
  • In general, market information is costly, and this cost may vary between buyers and sellers
    • Resulting in asymmetric information held by agents
      • One set of agents may be more knowledgeable about a commodity than another set
    • Information cost may vary among agents as a result of differences in education and experience about commodity
      • Examples include
        • A firm possessing limited information about a potential worker’s abilities
        • A used car buyer not having complete repair and maintenance history on an auto
        • An insurance company not knowing risky behavior of a potential insurer
  • When commodities are homogeneous and their characteristics are readily available
    • Cost of determining these characteristics is small
    • Assumption of market symmetry would generally hold
      • For example, symmetric information generally holds for commodity futures market
        • Where, except for delivery dates, all futures contracts on same commodity have identical characteristics
  • In contrast, asymmetric information will generally exist for heterogeneous commodities with characteristics that are costly to determine
    • An example is the vehicle market
      • Condition of a vehicle is difficult to determine without costly testing
        • Heterogeneous nature of used vehicles prevents a general determination of a vehicle’s condition based on examination of other like vehicles
  • A major consequence of asymmetric information is possible disappearance of markets
    • Which result in an inefficient allocation of resources
  • Aim in this chapter is to demonstrate how missing markets and associated efficiency losses result in presence of asymmetric information
    • Asymmetry in information generates two types of outcomes
      • Adverse selection
        • Where one agent’s decision depends on unobservable characteristics that adversely affect other agents
          • Use used-automobile market to illustrate missing market and resulting market inefficiencies
        • We discuss mechanisms of signaling and screening as second-best Pareto-efficient mechanisms for addressing these inefficiencies
      • Moral hazard
        • A contract is signed among agents with one agent being dependent on unobservable actions of other agents
        • Using a principal-agent model, we derive inefficient level of precaution taken by agents
          • Evaluate mechanisms (such as coinsurance) designed to address inefficiencies
  • Asymmetric information is relatively new area for applied economic analysis
    • In 1970 George A. Akerlof was first to address problems and solutions associated with adverse selection
  • Knowledge of moral hazard has been around since advent of insurance in 18th century
  • However, only recently have applied economists investigated ramifications of moral hazard on economic efficiency
  • Asymmetric information in a market can result in market inefficiencies
    • If information concerning characteristics of a commodity is not freely available, inefficient allocations may result
  • One type of asymmetric information is called adverse selection (also called hidden information)
    • An informed agent’s decision depends on unobservable characteristics that adversely affect uninformed agents
      • Classic example is market for used cars
  • Assume used cars can be grouped by quality into two groups
    • Within each group, used cars are homogeneous and are associated with a single price
      • Comparing vehicles between groups, they are heterogeneous in quality and thus are not valued by identical prices
      • In a free (symmetric) information case, two heterogeneous groups of commodities (used cars) would have separate markets with associated prices p1 and p2
lemons market
Lemons Market
  • Generally, sellers of a used car know vehicle’s history
    • Can determine its market price at zero or very minimal cost
  • In contrast, buyers do not have this knowledge
    • Cost of determining information for each group of used cars is prohibitive
    • Without information, buyers may base their market price determination on average quality of used cars available
  • Asymmetry in information results in buyers only willing to pay up to average price of used cars available, p
  • At average price sellers would be willing to supply only
    • QS = qj(pj)
    • pj ≤ p
      • qj(pj) is supply of used cars in group j
    • Above-average used cars, associated with pj > p, will not be offered for sale
      • Sellers would be unwilling to supply their cars for less than vehicle’s market value
lemons market8
Lemons Market
  • Buyers realize above-average used cars will not enter market at average price
    • So average quality of used cars offered in market is less than average quality of used cars available
  • They will adjust downward their willingness-to-pay for used cars offered in the market
    • Only sellers who value their cars below this new lower price will supply vehicles
      • Average quality of used cars offered in market will once again decline
  • Tâtonnement process will continue until only lowest-quality group of used cars are offered and sold in market
    • When only lowest-quality group is offered for sale, any asymmetry in information vanishes
  • With symmetric information, buyers’ and sellers’ expected prices match and only a market for lowest-quality group exists
  • Missing markets for other groups of used cars represent market failure
    • These lowest-quality cars are popularly referred to as lemons
      • Market failure associated with adverse selection is called the lemons problem
lemons market9
Lemons Market
  • In Figure 23.1, lemons problem is illustrated for two quality groups of used vehicles, reliable cars, , and lemons, 
  • Curves S and S are supply curves for lemons and reliable cars, respectively
    • Supply curve for reliable cars is above lemons curve
      • Indicates sellers of reliable cars are only willing to supply these higher-valued vehicles at prices above the lemon
    • Demand curves for lemons and reliable cars are represented by D and D, respectively
      • Buyers are willing to pay a higher price for reliable compared with lemons
        • So reliables demand curve is above lemons demand curve
    • Given free information, market is able to discriminate between these two types of cars
      • So market-clearing prices exist for both reliables and lemons markets
        • Equilibrium price and quality for reliables are p and * and for lemons p and *
lemons market11
Lemons Market
  • Asymmetric information in form of adverse selection prevents buyers from freely distinguishing reliable cars from lemons
    • Buyers may know proportion of automobiles that are reliable and lemons
      • But are unable to distinguish quality of a given automobile
  • Overall market demand, QD, facing sellers will be horizontal sum of lemons and reliables demand curves
  • Total supply of cars, QS, is horizontal sum of lemons and reliables supply curves
    • Resulting equilibrium price and quantity are p' and Q'
      • Loss in ability of market to distinguish between reliables and lemons
        • Results in number of lemons offered on market increasing from * to S' and number of reliables declining from * to S'
lemons market12
Lemons Market
  • Demand for lemons decreases from * to D' and demand for reliables increases from * to D'
  • Imbalance within markets will result in some buyers who expect to receive a reliable car instead receiving a lemon
    • As buyers realize ratio of reliables to lemons is declining in market, they will adjust their expected quality downward
    • Participation in number of buyers wanting a reliable car will decline as expectation of obtaining a reliable car in market decreases
      • Resulting downward shift in demand curve further drives reliable cars out of market
        • Further erodes demand for reliable cars
  • Tâtonnement process will continue until buyers only expect lemons to be supplied, so their market demand curve is D
    • Such a market will then supply * automobiles at a price of p*, and a missing market will exist for reliable cars
      • Market is unable to allocate both supply of reliables and lemons efficiently to buyers
        • It is unable to price discriminate across quality differences
lemons market13
Lemons Market
  • An efficient allocation would result in quality discrimination
    • Buyers would have market choice of purchasing either reliable cars or lemons
  • Without market ability to quality discriminate, some buyers may by chance purchase a reliable car
    • But these may not be buyers with highest willingness-to-pay
      • Failure of market to allocate commodities based on willingness-to-pay results in an inefficient allocation
  • Cause of this missing market and inefficient allocation of resources is an externality between sellers of reliable cars and lemons
  • As illustrated in Figure 23.1, as number of sellers offering lemons increases
    • Buyers’ expectations regarding quality of vehicles in market is affected
      • Price buyers are willing to pay declines
        • Adversely affects sellers of reliable cars by preventing them from selling their vehicles and improving efficiency
  • Externality between sellers for reliable cars and lemons has distributional implications
    • Owners of lemons may receive more than their automobile is worth and owners of reliable cars less
  • Buyers possessing limited information generally benefit sellers of lemon products
lemons market14
Lemons Market
  • Problem of adverse selection exists in other markets
    • For example, in insurance market buyers of insurance know more about their general health than any insurance company
      • Unhealthy consumers are more likely to buy insurance
        • Because healthy consumers will find cost of insurance too high
        • Tâtonnement process will continue until only unhealthy consumers purchase insurance
          • Will make selling insurance unprofitable
    • Another example is labor market
      • Workers’ potential productivity is unobservable by a hiring firm
      • But workers themselves know their productive capabilities
        • Tâtonnement process will result in only less-productive workers being hired
  • Market failure resulting from adverse selection explains
    • Why a new automobile declines in value once it is driven off lot
    • Why insurance is so high for a previously uninsured driver or a person with no medical history
    • Why salaries start low with a potential for frequent raises once a person is hired
second best mechanism designs
Second-Best Mechanism Designs
  • U.S. health care costs are nearly double that of other nations and outpace inflation
    • Firms and workers are faced with rising premiums and cutbacks in coverage
  • A national health insurance program can avoid inefficiencies of adverse selection in health care
    • By making purchase of insurance compulsory
      • Unhealthy citizens benefit from insurance premiums below their expected health costs
      • Healthy citizens can purchase insurance at lower rates
        • Such a government policy is called cross-subsidization
          • Healthy consumers pay a portion of health care for unhealthy consumers
  • One justification in favor of Medicare for elderly
    • By providing insurance for all elderly, adverse selection is eliminated
      • However, without knowing agents’ private information, obtaining Pareto-optimal allocation is not possible
      • Acquiring such information is costly
        • So only a constrained or second-best Pareto optimum can be obtained
second best mechanism designs16
Second-Best Mechanism Designs
  • In general, insurance companies can avoid adverse selection by offering group health insurance plans at places of employment
    • Called pooling—both healthy and unhealthy consumers are pooled together
      • Insurance premiums are based on average cost of health care
        • Adverse selection is eliminated by requiring all employees to participate
  • Government agencies can improve functioning of markets by providing free information or requiring product information prior to sale
    • Many government agencies currently provide information useful for making market decisions
      • Examples include U.S. State Department cautioning tourists about visiting a particular region, USDA publishing situations and outlooks for agricultural commodities
  • An example of requiring product information is FDA’s requirement for food labeling on processed foods
  • Both buyers and sellers can potentially benefit from creating markets that were missing due to adverse selection
  • Provides incentives for developing market mechanisms to mitigate market failure associated with adverse selection
  • Signaling
    • Mechanisms that transfer information from informed agent to uninformed agent
  • Naive signal on part of a buyer
    • Asking sellers quality of a commodity—for example, asking a used car dealer condition of a car
      • Cost of such a signal could be high if signal is inaccurate and commodity is purchased
    • An example of a particularly weak signal
      • Where cost of providing a signal is the same for all sellers regardless of quality of their product
    • Appearance can be another weak signal
  • For a strong signal, a signal must have an associated lower cost for sellers offering relatively high-quality commodities
    • Compared with cost for sellers offering poor-quality commodities
      • Examples of strong signals used by firms are reputation and standardization
        • Firms offering higher-quality commodities have an advantage over other firms in establishing a reputation for quality
          • For example, construction subcontractors can provide a signal for quality construction by developing a list of satisfied customers
  • One problem with reputation as a signaling device
    • Delay associated with establishing a reputation
      • Problem may be partially avoided
        • By supplementing reputation with guarantees and warranties as explicit signals of product quality
          • For example, in 1980s, as a counter to Japanese auto manufacturers’ reputation for producing quality cars
          • U.S. manufacturers offered extended 100,000-mile warranties as a signal of improved quality
  • Such signals are useful in cases where buyers lack information on quality of some commodity that they do not purchase on a regular basis
    • For regularly purchased commodities that vary in quality
      • Firms will attempt to standardize commodities they are offering to signal quality
        • For example, a fruit and vegetable wholesaler will attempt to always offer same quality of produce
  • Through standardization, sellers send a strong signal that buyers can expect a quality product from them
    • Some firms advertise such standardization as a market signal
  • In general, a signaling mechanism will be employed by informed agents
    • Agents are not always the seller
      • Agent could be an antique dealer purchasing items for his shop
        • Through experience, dealer will have a greater knowledge about market than sellers
          • A reputable dealer could employ signaling mechanisms to separate him from unreputable dealers
  • Concept of signals was first developed by Michael Spence in a labor market context
    • A strong signal of a person’s labor productivity is education
      • Education generally improves a person’s productivity
        • However, even if it did not, it is still a strong signal of productivity
      • Any admission requirements to a university or college will only result in higher-quality individuals entering the institution
        • “Quality in quality out” is signal sent to employers
      • Consumers, firms, and government agencies have also used gender, race, color, religion, and national origin as signals for labor productivity
        • But these signals, besides being illegal in U.S., are generally weak
        • Exceptions are when insurance companies target insurance rates by such characteristics as age and gender
          • Some segments of society may feel use of such discriminatory signals is morally wrong and thus should always be illegal
  • Economic theory does not pass judgment on morality of signals
    • But it does provide a framework for determining economic consequences of restricting such signals
      • Theory would indicate that a government restriction on one signal would result in firms adopting related signaling mechanisms to maintain profits
  • For used car market, reliable car dealers will be able to offer signals
    • For instance, in form of warranties
      • At a lower cost than lemon dealers, as illustrated in Figure 23.2
        • Lower warranty cost will result in lemon dealers being unable to compete in offering warranties
          • Thus, only reliable dealers offer warranties
  • Through these signals market for used vehicles can now be separated into two markets
    • Lemons and reliables
      • Market equilibrium for lemons is Pareto efficient by corresponding to free-information equilibrium (p*, *)
      • Market supply and demand curves for lemons did not shift
        • Introduction of a signal for reliable cars established a separate market for lemons
      • Market supply curve for reliable cars shifts up from S to S'
        • Represents increased cost associated with offering warranties
      • As a result of supply shift, equilibrium quantity of reliable cars is below free-information quantity of *
        • Equilibrium price of p' is above free-information price of p*
          • Results in a deadweight loss area of CAB
  • Such a market equilibrium is called a separating equilibrium
    • It segments pooled market for lemons and reliables into two markets
  • However, this is only a second-best Pareto-efficient outcome
    • Because in markets with free information, sellers do not incur extra expense of signals
      • Deadweight loss of removing inefficiency
        • Cost of removing externality
        • Both producer and consumer surplus loss
  • Proportion of costs paid by buyers and sellers depends on relative elasticities of supply and demand for reliable cars
    • In long run, as elasticity of supply becomes more elastic
      • Larger proportion of signal cost is passed on to buyers
  • Top three techniques to prevent used car scams
    • Have a mechanic inspect vehicle
    • Run a Vehicle History Report
      • Will reveal if vehicle was flooded, rebuilt, salvaged, stolen, or totaled
    • Never sign anything stating “as is, no warranty”
      • Obtain at least a 30-day warranty
  • Symmetric information associated with free information results in a Pareto-efficient allocation
    • Pareto preferred to an allocation with signals
    • However, signals can be a second-best Pareto-efficient outcome if they result in a separating equilibrium, which improves efficiency
      • Not all signals do this
  • Weak signals resulting in a pooling equilibrium
    • Signals of different quality sellers cannot be differentiated
      • Do not separate markets so market efficiency is not improved
    • Buyers may attempt to distinguish or screen various commodities offered
  • Screening exists when a buyer employs a mechanism for sorting commodities offered by sellers
    • Examples of screening are
      • Buyer having a used car inspected prior to purchase
      • Employer offering internships prior to employment
  • In general, screening is employed by uninformed agent
    • Can be either buyer or seller
  • For example, price discrimination, discussed in Chapter 13, is a form of screening
    • Seller does not have information on buyers’ willingness-to-pay for commodity
    • By screening buyers based on their characteristics, sellers can create separate markets and practice price discrimination
  • In some cases, buyers rely on another firm or consumer (third parties) for screening
    • For example
      • A consumer may acquire her dentist, house painter, doctor, or maid through a recommendation from another consumer
      • Or a firm may screen commodities and sell information to potential buyers
      • Magazine Consumer Reports is in the business of screening commodities
    • Major third parties for screening are government agencies providing market information
  • Consider used car market
    • Potential buyers may screen vehicles by having them inspected
  • As illustrated in Figure 23.3, cost of screening will shift demand for both lemons and reliable cars downward
    • From D to D' for lemons market and from D to D' for reliable market
      • Resulting separating-equilibrium prices, p' and p', are lower than free-information equilibrium prices, p* and p*
      • Separating-equilibrium quantities, ' and ', are lower than free-information equilibrium quantities, * and *
        • Cost of screening is sum of deadweight losses in lemons market (shaded area CAB) and reliable market (shaded area DEF)
  • Both signaling and screening have potential for reducing asymmetric information and yielding a second-best Pareto-efficient outcome
    • Cost of reducing asymmetric-information externality
      • Cost of signals or screening may offset any market efficiency gains
        • They may or may not improve social welfare
principal agent models
Principal-Agent Models
  • Concept of moral hazard
    • Developed from study of insurance market
    • An insurer has no control over policyholder not taking precautions toward reducing probability of an insured event from occurring
  • Term moral hazard (also called hidden actions) is derived from condition that a policyholder may take wrong (immoral) action by not taking proper precautions
    • For example, an auto insurance firm has no control over hidden action of a policyholder leaving car keys in an unlocked car
  • Moral hazard lasts over life of some established agreement
  • Moral hazard may result if purchase of a commodity establishes future returns or utility of an agent being dependent on actions of another agent
  • Moral hazard is not restricted to issuance of insurance
    • It generally exists whenever one agent (principal) depends on another agent (agent) to undertake some actions
      • If agent’s actions are hidden from principal, asymmetric information is present
        • Market inefficiencies may result
principal agent models31
Principal-Agent Models
  • In general, contracts establishing such dependence are designed to mitigate potential moral hazard problems
    • Problems in designing contracts result from principal-agent problem
      • Examples include
        • Owners of a firm who are unable to observe a manager’s work ethic
        • Instructor’s inability to observe how hard a student is actually studying
      • In these examples, agents have ability to hide actions
        • Uninformed principal wants to provide informed agent with efficient incentives for fulfilling contract
pareto efficiency with no moral hazard
Pareto Efficiency with No Moral Hazard
  • As an illustration of no moral hazard, assume agents face an expected loss associated with some event
    • Examples are losses from fire damage to their business or an auto accident
  • Without any insurance, consumers face full cost of some negative event, which reduces their welfare
    • Can mitigate negative impact by taking precaution
      • An increase in level of precaution can both reduce likelihood of event occurring and magnitude of loss when event does occur
        • An objective of a consumer is to determine optimal level of precaution, P
  • Assume total cost of precaution at first increases at a decreasing rate and then increases at an increasing rate with level of precaution (Figure 23.4)
    • A basic level of precaution offers a great deal of protection with little increases in cost
      • Examples are driving with traffic instead of against it, locking your car when shopping
    • At basic level of precaution, precaution costs are increasing but at a decreasing rate
      • At some point an additional level of precaution will result in costs increasing at an increasing rate
pareto efficiency with no moral hazard34
Pareto Efficiency with No Moral Hazard
  • If TC(P) is total cost function for precaution
    • Then TC'(P) > 0 and at first TC"(P) < 0 and at some precaution level TC"(P) > 0
  • For example, at first a great deal of fire protection can be purchased with a small investment in a smoke detector
    • For additional protection, fire extinguishers can be purchased at a higher cost per unit
      • Followed by a sprinkler system at an even higher cost per unit
  • Associated with a given level of precaution is an expected loss
    • Expected loss is probability of event occurring times total loss
  • Objective of a consumer is to determine efficient level of precaution that minimizes overall cost (sum of expected losses and cost of precaution)
  • F.O.C. is
    • TC'(P) = -EL'(P)
      • TC'(P) is marginal cost, MC(P)
      • -EL'(P) is marginal benefit of precaution, MB(P)
      • Marginal benefit is reduction in expected losses associated with an increase in precaution
pareto efficiency with no moral hazard35
Pareto Efficiency with No Moral Hazard
  • EL'(P) < 0, so marginal benefit, -EL'(P), is positive (Figure 23.5)
  • Optimal level of precaution, P*
    • Where marginal cost equals marginal benefit
      • If marginal benefit is greater than marginal cost
        • An increase in precaution would reduce EL(P) more than increase in TC(P)
          • So overall costs fall
      • If marginal benefit is less than marginal cost
        • A decrease in precaution would reduce TC(P) by more than increase in EL
          • So overall cost will fall
  • Optimal level of precaution is illustrated in Figure 23.6
    • Positively sloping marginal precaution-cost curve represents assumption of increasing per-unit precaution cost
    • Negatively sloping marginal precaution-benefit curve represents assumption of decreasing reduction in expected loss as precaution increases
    • At P*, where marginal benefit equals marginal cost
      • Overall costs are minimized
    • To left (right) of P*, marginal benefit is greater (less) than marginal cost
      • Consumer has an incentive to increase (decrease) precaution
insurance market with no moral hazard
Insurance Market with No Moral Hazard
  • As discussed in Chapter 18, a risk-averse agent will not voluntarily take on additional risk
    • Will seek out opportunities for avoiding risk
  • Insurance allows an agent to shift risk of a negative event onto another agent (an insurance company)
    • In event of a loss, such as a flood, an insurance company compensates agent for loss
  • Assume contract (policy) between principal (insurance company) and agent (consumer) is actuarially fair insurance
    • If consumer can purchase insurance covering full expected loss for a given level of precaution
      • Consumer no longer suffers a loss from a negative event, EL = 0
    • However, consumer must pay premium, which, for actuarially fair insurance, is equal to EL
      • Assuming no moral hazard, insurance company will want to design a policy where expected payout varies by level of precaution a consumer takes
insurance market with no moral hazard39
Insurance Market with No Moral Hazard
  • Premiums would be higher for a low level of precaution by a consumer
    • Decline as level of precaution increases
  • Let A(P) represent insurance premium, so A'(P) < 0
    • A"(P) > 0
  • Consumer is still faced with problem of determining optimal level of precaution that minimizes overall cost of taking precaution and now paying insurance premium
  • F.O.C. is
    • TC'(P) = -A'(P)
  • Consumer equates marginal precaution cost, TC'(P), to marginal precaution benefit, -A'(P)
    • Marginal precaution benefit is additional savings in premium costs from an additional increase in precaution
  • As illustrated in Figure 23.6, with no moral hazard and actuarially fair insurance
    • Results in same level of precaution as in no-insurance case
  • In general, assuming agents gain some utility from having an insurance company assume risk (assuming agents are risk averse)
    • Then P*, with insurance, is a Pareto-efficient level of precaution
insurance and moral hazard
Insurance and Moral Hazard
  • Unfortunately, Pareto-efficient level of precaution is generally not possible
  • Hidden level of precaution by consumers makes cost of designing an insurance policy where premiums are based on every level of precaution prohibitive
  • In extreme case of moral hazard, where insurance company cannot at all determine level of precaution
    • Insurance premium would not be a function of consumer’s precaution level
  • Assuming insurance company sets premium at Pareto-efficient level of precaution, P*, consumer’s objective is
  • Optimal solution is for consumer to not take any precaution, P = 0
    • Zero level of precaution increases risk of negative event occurring
      • Results in insurance company having to pay higher-than-expected claims
        • This is root of terminology “moral hazard” for insurance company (principal)
insurance and moral hazard41
Insurance and Moral Hazard
  • Unless insurance company can design policies that provide incentives for consumers to take precaution
    • Tâtonnement process will result in no insurance company able to pay all its claims from revenue generated by premiums
      • Inefficiency of zero precaution associated with moral hazard is represented by deadweight loss, area ABC, in Figure 23.6
    • Tâtonnement process toward an equilibrium can also result in instances where agents are overinsured
      • For example, due to falling property values or a failing business, an agent may realize that level of insurance is more than property is worth
        • If this information is hidden from insurance company (adverse selection)
          • Hidden action of not taking any precautions to prevent fire or even causing business to burn down can increase returns
          • For this reason, in fire investigations owners are always possible suspects
  • Deadweight loss associated with moral hazard can be reduced by inducing consumers to take some precaution
  • One type of inducement, employed by many health insurance companies, is coinsurance
    • Require consumer to pay some percentage of cost, so insurance company pays less than 100% of loss
      • Actual percentage paid varies, but a common rate is for an insurance company to pay 80% and consumers to pay remaining 20%
      • As percentage of loss a consumer pays increases, less risk is shifted to insurance company and consumer is more willing to take precaution
        • Consumers will tend to seek lower-cost treatments rather than alternative higher-cost treatments
  • If, for example, consumer pays 20% of cost along with a fixed premium A, then consumer’s objective is
  • F.O.C. is
    • =0.2EL'(P) = TC'(P)
  • As illustrated in Figure 23.7, marginal benefit curve tilts downward and intersects marginal cost curve at second-best Pareto-efficient equilibrium level of precaution PO > 0
    • Deadweight loss is reduced from area ABC to DEC
  • Only when moral hazard can be eliminated will a Pareto-efficient solution P* exist
  • Writing insurance policies with deductibles is another option insurance companies employ for increasing agents’ precaution level
  • Require agents to incur all loss up to some dollar limit
    • For example, if an auto insurance policy has a $500 deductible provision
      • First $500 in damages is paid by car owner, and insurance company pays any remaining damages
      • Generally, the higher the deductible, the lower will be the insurance premiums
  • Insurance companies will incorporate deductibles into their policies when agents’ basic level of precaution is so low that insurance companies cannot earn normal profits
    • For example, without some deductible for auto insurance, our roadways could take on a bumper-car atmosphere
      • Resulting in dramatic insurance premium increases with few if any consumers willing to be insured
  • With deductible provision, optimal level of precaution for a consumer is determined by
      • DA is level of deductible
    • Maximum cost a consumer will incur is deductible DA
      • However, if overall cost of precaution plus expected losses is less than DA
        • Consumer can lower his cost below DA
  • F.O.C. for minimizing cost is
    • TC'(P) = -EL'(P)
      • If DA > min[TC(P) + EL(P)], yielding optimal level of precaution P* (Figure 23.6)
      • If DA < min[TC(P) + EL(P)], a zero level of precaution, P* = 0, is optimal level
        • With DA as lowest possible level of cost
          • Expenditures on precaution will not result in any additional benefits
  • Deductibles allow consumers to insure against large losses
    • But be responsible for any relatively small expected losses below deductible
    • Reduces deadweight loss associated with moral hazard
  • As DA increases, deadweight loss is reduced, as consumers will likely choose no-insurance level of precaution, P*
    • Consumers who are more willing to take risk will self-insure by seeking higher insurance deductibles
      • However, with increases in DA, risk-averse consumers are worse off since they are less able to shift this risk to another agent (insurer)
  • Other options available to insurance companies for increasing agents’ precaution level are
    • Combinations of coinsurance and deductibles
    • Subsidizing preventive care
      • Health insurance policies will generally
        • Have both deductibles and coinsurance provisions
        • May also offer preventive care such as annual physical examinations and routine blood tests at reduced cost
employer and employee relations
Employer and Employee Relations
  • Moral hazard exists whenever asymmetric information in the form of hidden actions is prevalent in a principal-agent agreement
    • For example, moral hazard can exist between an employer (principal) and an employee (agent)
      • Unless an employer can constantly monitor productivity of employees
        • Employees can engage in leisure while working (shirking) by reducing their level of effort
          • For example, employees’ surfing the Net has become a major form of shirking
  • Asymmetric information on level of employees’ productivity creates inefficiencies
  • An objective of employers is to design contracts that provide employee incentives directed at improving productivity and reducing shirking
pareto efficiency with no moral hazard49
Pareto Efficiency with No Moral Hazard
  • Major incentive for employees’ effort is compensation they receive for supplying their labor, in form of wage income
  • Assuming symmetric information (no moral hazard)
    • Can determine Pareto-efficient level of employee effort, E*
      • By considering employer’s objective function and an employee’s participation constraint
  • No moral hazard implies that an employer can observe an employee’s level of effort
  • Assume employer determines labor contract and employee can then either accept or reject contract
pareto efficiency with no moral hazard50
Pareto Efficiency with No Moral Hazard
  • An employer is concerned with productivity of an employee
    • Denoted by production function q = f(E)
      • q is some output level
    • Given a per-unit output price of p and wage rate based on an employee’s effort w(E)
      • Employer’s objective is maximizing profit from this employee
      • Employee has a cost of increasing effort in form of total opportunity cost from lost shirking, TCE(E)
  • Let MCE(E) represent marginal cost of effort
    • So MCE(E) = TCE(E)/E
  • In general, as illustrated in Figure 23.8, this marginal opportunity cost is U-shaped
pareto efficiency with no moral hazard52
Pareto Efficiency with No Moral Hazard
  • Marginal cost of effort may at first decline
    • For very low levels of effort (to left of EM), additional effort results in marginal cost of effort declining
      • Spending so much time shirking, a little additional effort results in lower marginal opportunity cost
    • At relatively higher effort levels (to right of EM), any additional effort raises this marginal opportunity cost
  • Employee’s payoff for E level of effort is
    • Difference in wage income, w(E)E, and total opportunity cost, TCE(E)
      • w(E)E – TCE(E)
    • Instead of working for this particular employer, employee could be engaged in other activities
      • Being employed by another employer, being self-employed, or being immersed in total leisure
pareto efficiency with no moral hazard53
Pareto Efficiency with No Moral Hazard
  • Assume next-highest payoff from these alternatives is U°
    • Employee will be willing to work for an employer if payoff is at least as great as U°
  • Specifically, if
    • w(E)E – TCE(E) ≥ U°
    • U° is reservation-utility level, and equation is participation constraint
      • Employer must pay at least level U° if he expects to hire employee
        • Employer’s objective is then
          • Subject to w(E)E – TCE(E) = U°
  • Constraint is an equality because if w(E)E - TCE(E) > U°
    • Employer could lower wages and still hire employee
pareto efficiency with no moral hazard54
Pareto Efficiency with No Moral Hazard
  • Substituting constraint into objective function yields
      • F.O.C. is
        • MRPE = MCE
  • For profit maximization, employer will equate marginal revenue product of an employee’s effort, MRPE
    • To employee’s marginal opportunity cost of effort, MCE
  • Solving this F.O.C. for E results in Pareto-efficient level of employee effort, E*
    • Illustrated in Figure 23.9, where MRPE is equated to MCE
pareto efficiency with no moral hazard56
Pareto Efficiency with No Moral Hazard
  • Compensation scheme necessary for obtaining employee effort level E*
    • Where level of compensation just equals reservation-utility level plus employee’s cost of effort
      • w(E)E = U° + TCE(E)
    • If employer is risk neutral and employee risk averse, employer will fully insure employee against any wage risk
      • Employer will offer a fixed wage rate, w* = w(E*)
      • Optimal contract when effort is observable
        • Specifies Pareto-efficient effort level E*
        • Fully insures a risk-averse employee against income losses
    • When employee is also risk neutral, insurance is not necessary
      • Any compensation scheme where wages are a function of profits, with w(π)E = U° + TCE(π) will be efficient
inefficiency with moral hazard
Inefficiency with Moral Hazard
  • In many cases, cost of monitoring effort prohibits constantly observing an employee’s level of effort
    • For example, an employer is generally unable to observe a night clerk at a convenience store or a truck driver for a furniture company
  • When effort is not observable, Pareto-efficient effort level comes in conflict with result of full insurance
    • Only method for increasing employee effort is relating wages to firm’s profit
      • Random nature of profit results in employee assuming some uninsured risk
        • Such conflicts create inefficiencies unless employee is risk neutral
        • A risk-neutral employee is only concerned with expected profit
          • Would not be concerned with any random nature of profit
          • Indifferent with taking uncertain profit in place of a certain wage
inefficiency with moral hazard58
Inefficiency with Moral Hazard
  • In contrast, when an employee is risk-averse
    • Increased share of profit relative to a certain wage does affect employee
    • Incentives for increased effort are directly associated with an employee’s cost of increased risk
      • Results in an additional constraint on employer
        • Employer not only maximizes profit subject to participation constraint
          • w(E)E – TCE(E) ≥ U°
        • But also is subject to an incentive-compatibility constraint
          • Must offer a compensation scheme that gives an employee an incentive to choose required effort level
inefficiency with moral hazard59
Inefficiency with Moral Hazard
  • When employer can directly observe employees’ efforts
    • Employees will put forth required level of effort regardless of their desire
  • In contrast, when effort is not directly observable
    • Employees can shirk by not putting forth required level of effort
      • To avoid such shirking, employers must offer a compensation scheme to induce employee to offer E* units of effort
        • Determined by setting employee’s payoff associated with E* at least as great as payoff for any other level of effort
          • w(E*)E* – TCE(E*) ≥ w(E)(E) – TCE(E)
          • For all levels of effort E
        • At any wage below this constraint, employee will shirk
inefficiency with moral hazard60
Inefficiency with Moral Hazard
  • In the extreme case, not considering this incentive-compatibility constraint
    • Results in an employee seeking an effort level independent of his wages
      • Employee would minimize his total effort
        • Optimal solution is for employee to totally shirk and not exert any effort
          • Analogous to zero level of precaution associated with insurance
          • Illustrated in Figure 23.6
      • Unless employer can design contracts that provide incentives for employees to choose effort
        • Tâtonnement process will result in a zero level of effort
  • Inefficiency of E = 0 associated with moral hazard is represented by deadweight loss, area ABC in Figure 23.9
  • Designing employment contracts with compensation mechanisms that take into consideration this incentive-compatibility constraint will provide incentives for employees to increase their work efforts
    • Will reduce inefficiency associated with wages not directly linked with level of effort
      • However, such contracts will be second-best Pareto-efficient allocations
        • Still result in risk-averse employee not being fully insured
  • Only with symmetric information associated with no hidden action on part of agent (employee) will a Pareto-efficient allocation exist
residual claimant
Residual Claimant
  • Large poultry enterprises use residual claimant production contracts with independent farmers to raise chickens
    • By having farmers assume risk of raising chickens
      • Farmers will have incentives to take necessary effort to prevent disease and other possible adverse effects on chickens
  • USDA Economic Research Service estimates 52% of approximately 50,000 farms with poultry or egg production in 1995 reported use of production contracts
    • Value of poultry and eggs produced under such contracts accounted for 85% of total value of all poultry and egg production
  • Farmers without contracts tended to be either large owner-integrated operations or independents providing poultry and poultry products to local markets
  • In poultry contracting, employees are residual claimant to output
    • An example of a second-best Pareto-efficient compensation scheme incorporating incentive compatibility
residual claimant62
Residual Claimant
  • A residual claimant is an agent (farmer) who receives payoff from output after any fees are paid to a principal (poultry enterprise)
    • An employee will maximize payoff by
      • Equating marginal revenue product of employee’s effort to employee’s marginal opportunity cost of effort
        • Examples of residual claimant contracts are franchises and employee buyouts
          • Fast-food enterprises are a typical example of franchising
          • Owner of a fast-food establishment pays parent company a fixed fee for right to operate (franchise)
          • Employees become residual claimant
          • Compensation is now dependent on profits of firm minus lump sum payment to owners
residual claimant63
Residual Claimant
  • Specifically, employees’ objective is to maximize consumer surplus plus economic rent minus franchise fee
  • F.O.C. is
    • MRPE = MCE
  • Although marginal benefit equals marginal cost, risk-averse employees are not able to fully insure against losses
    • Results in a second-best Pareto-efficient allocation
      • Such residual claimant contracts are very popular when employees are able to take precautions and reduce possible losses in profits at a lower cost than owners