Information asymmetries

Transcription

1 Adverse selection 1

2 Repeat: Information asymmetries Problems before a contract is written: Adverse selection i.e. trading partner cannot observe quality of the other partner Use signaling g or screening Problem after contract is written: Moral hazard i.e. trading partner cannot be sure if the other is behaving ok after contract is written Nobel prize in economics 2001 for informational asymmetries (Akerlof, Spence and Stiglitz) 2

3 OBJECTIVES Explain how managers can use their informational advantage to increase performance and how managers at an information disadvantage can mitigate the effect by using creative defenses.

4 Market for lemons Ackerlof s model: used car market used cars are either gems (which is good) or lemons (which is bad) information asymmetry means that sellers have more information about the quality of the car they are selling than the buyer does. buyers might know about average quality of cars (by reading consumer reports) and do not want to pay more than average price to break even in expectation

5 Market for lemons Ackerlof s model: used car market cont d sellers do not want to sell above-average quality cars for such low price only sellers with a lemon want to sell their cars, buyers know that and assume all offered cars are lemons eventually, the average price of a used car will be equal to the value of a lemon because no one will sell a gem. mean quality on the market must fall willingness to pay will fall even more 5

6 Market for lemons Ackerlof s model: used car market cont d this is a case of adverse selection in that the market dynamic leads to only lemons being offered for sale on the used car market. market can break down completely 6

7 Adverse selection in the car insurance market Model Drivers are either high risk or low risk. Both types of drivers start with wealth = 125 and a loss will reduce wealth to 25. Insurance company wants to cover expected losses: High-risk drivers have a loss with probability 0.75 and their expected loss is therefore (0.75)(100) = 75. Low-risk drivers have a loss with probability 0.25 and their expected loss is therefore (0.25)(100) = 25.

8 Adverse selection in the car insurance market Perfect Information high-risk drivers will be charged 75 and low-risk drivers will be charged 25 and, because both are risk averse, both will buy insurance. Assume that U = (Wealth) 0.5 for both types of drivers: High risk without insurance U = (0.25)(125) (0.75)(25) = High risk with insurance U = (125-75) 0.5 = Low risk without t insurance U = (0.75)(125) (0.25)(25) = Low risk with insurance U = (125-25) 0.5 = 10

9

10 Adverse selection in the car insurance market Asymmetric Information If the insurer cannot distinguish between high- and low riskdrivers, and there are equal numbers of each, then the average premium should be 50. High-risk drivers will buy insurance at this price, but low-risk drivers will not (Low risk with high insurance U = (125-50) 0.5 = 8.660) Since only high-risk drivers will buy insurance, the insurance premium must increase to 75. Insurers can compete by collecting better information so that lower premiums can be charged to low-risk drivers, but perfect information is not attainable.

11 Resolving adverse selection through Full insurance: When every loss is paid in full Deductible: self-selection When the insurer does not pay the full loss but pays the loss minus some fixed amount Self-selection menu: buyers act in their own self-interest and use their private information about their loss probabilities to select policies

12 Resolving adverse selection through Example 1 self-selection Policy A: High premium and full insurance (designed to appeal to high-risk drivers) Policy B: Low premium and high deductible (designed to appeal to low-risk drivers) Example 2 Policy C: High premium that is constant from year to year (designed to appeal to high-risk drivers) Policy D: High premium at first that declines from year to year if there are no claims (designed to appeal to low-risk drivers)

13 Resolving adverse selection through self-selection Simple Adverse Selection Policy 1: Premium of 75 and full insurance (designed to appeal to high-risk drivers); W = = 50 Policy 2: Premium is 2.5 and payoff is 10 (designed to appeal to low-risk drivers) With no loss: W = = With a loss: W = = 32.5 Separating equilibrium: This solution to adverse selection induces policy holders to selective their relative risk types.

14 Resolving adverse selection through High risk drivers: self-selection No insurance:.25 (125)^ ( )^.5 = Policy 1: (125-75)^.5 = Policy 2:.25 ( )^ ( )^.5 = Low risk drivers: No insurance:.75 (125)^ ( )^.5 = Policy 1: (125-75)^.5 5 = Policy 2:.75 ( )^ ( )^.5 = 9.726

15 Other examples Private health insurance: only bad risk people will buy insurance contract if health is unobservable to the insurance company will drive price for insurance contract up. Private insurance may be impossible group insurance or government tintervention necessary Pflichtversicherung or Versicherungspflicht Example: crises in an enterprise, total wage bill must be reduced Cut wages for all workers? Dismiss i some? Who will be dismissed? i d? 15

16 Remedies for Adverse Selection: Signaling g and screening Often the better informed party would benefit from communicating this information. Simply pyclaiming I m high quality y( (or low risk) is not convincing, because also the bad risks will tell you so. Signaling: g the informed party takes the lead. High-quality seller must do something costly and verifiable to signal quality convincingly. Screening: the uninformed part takes the lead Offer different contracts 16

17 Signaling examples Signal must be so expensive that low-quality supplier is unable to do so ==> low and high-quality suppliers are separated Set very low prices to signal low cost (in order to prevent entry of other firm in the market) Education certificates Product warranty, money-back guarantee 17

18 Using education as a signal: adverse selection in the job market Information asymmetry in job markets: Applicants know more about their job skills, abilities, and ambitions than a potential employer. Premise: Highly skilled applicants can complete courses at a lower cost than applicants with low skills. Therefore, the employer can get applicants to self-select based on the number of courses they are required to complete to get a higher paying job.

19 Using warranties as signals: adverse selection in the product market How Managers Can Construct Warranties to Mitigate Adverse Selection Experience goods: Goods that can be evaluated with regard to their quality only after they have been consumed There is an incentive for producers of high-quality goods to signal their quality and increase the willingness of buyers to pay a higher price. Product warranties can accomplish this goal by acting as a separating a mechanism.

20 Using warranties as signals: adverse selection in the product market How Managers Can Construct Warranties to Mitigate Adverse Selection Model P H = consumer reservation price for high-quality good P L = consumer reservation price for low-quality good (P L < P H ) C H = cost of producing the high-quality h good C L = cost of producing the low-quality good (C L < C H ) Warranty cost of a high-quality good is XW H and for a lowquality good it is XW L, where W L > W H

21 Using warranties as signals: adverse selection in the product market How Managers Can Construct Warranties to Mitigate Adverse Selection Scenario 1: Consumers perceive any good with a warranty (X) to be a high-quality good. Profit from a high-quality good with a warranty is P H C H - XW H. Profit from a high-quality good without a warranty is P L -C H. The high-quality producer will not issue a warranty if P L -C H < P H C H XW H X < (P H P L ) / W H

22 Using warranties as signals: adverse selection in the product market How Managers Can Construct Warranties to Mitigate Adverse Selection Scenario 1: Consumers perceive any good with a warranty (X) to be a high-quality good. (Continued) Profit from a low-quality good with a warranty is P H C L -XW L. Profit from a low-quality good without a warranty is P L C L. The low-quality producer will not issue a warranty if P H C L XW L < P L C L X > (P H P L ) / W L Credible warranty: (P H P L )/W H > X > (P H P L )/W L

23 Using warranties as signals: adverse selection in the product market How Managers Can Construct Warranties to Mitigate Adverse Selection Scenario 2: Consumers perceive the good with the longer warranty (X) to be the high-quality good. The longest warranty a low-quality producer can afford to offer is X = Y L where Y L = (P H P L )/W L. The longest warranty a high-quality producer can afford to offer is X = Y H where Y H = (P H P L )/W H. Since W L > W H, Y H > Y L. In practice, the high-quality product will have a warranty Y H = Y L + 1 and the low-quality product will not have a warranty.

24 Screening Under screening the uninformed part takes the lead. Check the other s quality Specific tests in applicant selection Self-selection contracts offered Car insurance (example from before) offer different age/wage profiles in order to reduce turnover pay based on performance attracts most productive workers Offer a menu of contracts to salespeople: those with the best region (motivation) will select high-commission, lowsalary contracts 24

25 Self selection in recruitment Wage Wage profile II Wage profile I t 1 t 2 Time Firm has to train the worker, is interested in workers who stay longer (loyal workers) Firm offers two wage profiles, (or: general market pays profile I, our firm pays profile II) takes only worker who chooses profile II 25

26 Books for reading: you will enjoy them! 26