Session 3 Review: Asymmetric Information Adverse Selection

Economic concepts

Adverse selection pertains to hidden characteristics, while moral hazard pertains to hidden actions When sellers have more information than buyers, surplusgenerating trades may not occur Akerlofs paper shows how a market can unravel completely because of adverse selection Remedies Lemons x2 Cows Credit scoring
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Examples

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Adverse Selection Example: Cows in India

Farmers report easier to sell cows when giving milk than when dry Prospective buyers can:

Test milk the animal See that the animal can get pregnant Differential between milking and dry cows is smaller when theres a drought in sellers village

Prices are influenced

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Remedies for Adverse Selection

Market-based

Government

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Two Types of Asymmetric Information

Hidden fixed characteristics at the time of contracting; we call this adverse selection (last time)

How good a driver are you? How likely are you to stay healthy? How smart or hard-working are you?

Hidden actions following contracting; we call this moral hazard (todays session)

As CEO, are you going to seek long-term value or shortterm profits? As a sharecropper, are you going to work hard and contribute complementary inputs?

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Where do bureaucrats interests align?

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Asymmetric Information Moral Hazard

Economic concepts

Adverse selection pertains to hidden characteristics, while moral hazard pertains to hidden actions In a principal-agent problem,

A conflict is present between the interests of the principal and the interests of the agent; Hidden actions by the agentor at least non-contractible actions can prevent the action under the contract from being efficient; Often the inefficiency arises because the principal wants to give the agent incentives to perform, while the agent wants to be insured against losses

Examples

CEO compensation Bailouts Bureaucrats

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Examples of Moral Hazard

i.e., principals and their respective agents

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A Canonical Model of Moral Hazard

Two people, a Principal P and an Agent A

A can contribute effort e or effort 0, or A can drop out and receive u0. Output equals 0 with probability 1 if effort is 0 Output equals y with probability q if effort is e Cost to A of contributing e is c P can pay a wage w that depends on output but not on effort P chooses w(y) and w(0) to maximize expected output minus expected wages
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Canonical Model, cont.

Ps profit:

If effort = e: If effort = 0:

As utility

= qy (1 q )w(0 ) qw( y ) = 0 w(0 )

If effort = e: U = (1 q )u (w(0 )) + qu (w( y )) c If effort = 0: U = u (w(0 ))

Incentive compatibility: wages have to suffice to motivate effort (incentives) Individual rationality: wages have to suffice to motivate participation (insurance)
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Canonical Model, cont.

IC: (1 q )u (w(0)) + qu (w( y )) c u (w(0))

q[u (w( y )) u (w(0 ))] c

P never wants to implement 0 effort, so ignore IR0. IC will always hold with equality IRe: (1 q )u (w(0 )) + qu (w( y )) c u0
u (w(0 )) u0

u (w(0 )) + q[u (w( y )) u (w(0 ))] c u0

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IRe will always hold with equality, too

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Canonical Model, cont.

Substituting in, w(0 ) = u 1 (u0 )

= qy qu 1 (c / q + u0 ) (1 q )u 1 (u0 )

w( y ) = u 1 (c / q + u0 )

If effort were contractible, P would pay a flat wage w to induce effort e; there would be no IC constraint; IR would be u (w) c u0

= qy u (u0 + c )
1

w = u 1 (u0 + c )

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If u is concave, its inverse is convex, so wages higher and profits lower under MH
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Market failure?

What if y is small, or u is very strongly concave?

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Canonical Model Comments

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A dramatic oversimplification Continuous effort choices, continuous outcome possibilities Many tasks Repeated interactions (career concerns) Reliance on others (teams) Many ways to provide compensation Other preferences Incentive problems for P, too
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Executive Compensation
Shareholders/Owners Maximize Economic Performance
Votes Accountable to

Board of Directors Monitor Managers

Selects, Delegates, Monitors Accountable to

Corporations Managers Maximize personal benefits

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Views of pay

Optimal contracting Managerial power

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Facts

ExecuComp 7.89% of profits

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Facts

ExecuComp 7.89% of profits

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Facts

Average director compensation:

$152,626 (Enron: $380,000)

Perks Reappointments, often on executive-drafted slates

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Determinants of pay

Considerations (as discussed by Bebchuk and Fried)

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Principal-Agent Problems and Government

Prendergast, The Motivation and Bias of Bureaucrats What if bureaucrats care about their jobs?

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Three main results

Bureaucrats should be biased Depending on the case, the optimal bias can go in either direction Self-selection to bureaucracies is likely to be bifurcated

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Bailouts

What does it mean to be too big to fail? Who is the principal, and who is the agent? What is the desired solution?

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Limits to insurance
American companies are now failing at the rate of 500 a week. The wild cheering on the floor of the New York Stock Exchange and around the financial district last week did not spread much beyond Wall Street. Across the U.S. there is still deepening gloom about the economy, and no single group is more painfully aware of it than the beleaguered owners of American businesses. This year their ranks are being trimmed by bankruptcy faster than at any time since the Depression. I've long said that capitalism without bankruptcy is like Christianity without hell. But it's hard to see any good news in this. -- Chairman of Eastern Air Lines Frank Borman, 10/18/1982

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Bailouts in the future?

Our overriding goal in restructuring our financial architecture should be that taxpayers never again have to save a failing financial institution... To address the moral hazard issue, the government needs broad-based authority to liquidate any failing financial institution without going through the bankruptcy process, which is not well-suited for such complex firms in the midst of a financial crisis. We must send a clear signal to market participants that whenever this process is put in motion, the outcome is liquidation; we cannot leave any hope that we would inject taxpayer dollars to preserve the failing firm in its present form. Henry Paulson, NYTimes, 2/16/2010

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Summary

Economic concepts

Adverse selection pertains to hidden characteristics, while moral hazard pertains to hidden actions In a principal-agent problem,

A conflict is present between the interests of the principal and the interests of the agent; Hidden actions by the agentor at least non-contractible actions can prevent the action under the contract from being efficient; Often the inefficiency arises because the principal wants to give the agent incentives to perform, while the agent wants to be insured against losses

Examples

CEO compensation Bureaucrats Bailouts

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