👨‍🏫 Notes on Lecture 11

Pindyck and Rubinfeld: Sections 17.1 - 17.4

Violations of the Three Conditions for Perfect Competition:

1. Many buyers and sellers (Violations: Monopoly and Imperfect Competition)
2. Well-specified property rights (Violations: Externalities)
3. Complete information - well informed buyers and sellers (Violations: Asymmetric information)

There are three categories of problem that can arise from Asymmetric information:

1. Adverse selection (Occurs prior to a market transaction)
2. Moral hazard (Occurs after a market transaction)
3. Principal-agent problem (A variant of moral hazard)

I. Adverse Selection

• Definition: Any situation in which an uninformed party gets exactly the wrong people wanting to trade with her; there is an “adverse selection” of the (better informed) possible trading partners
• Occurs prior to a market transaction, causing you to do business with the “wrong people.” For example, only unhealthy people buy your health insurance or only people with bad cars try to sell you their cars.
• Examples
  • Used car market (which gives rise to another term for adverse selection—the “lemons problem” - see below)
  • Market for insurance
  • Market for credit

Numerical example of Adverse Selection: The Lemons Problem

	Max price offered by buyers	Min price wanted by sellers	Probability
Peaches	$20,000	$17,000	50%
Lemons	$10,000	$8,000	50%

“The lemon dilemma”, The Economist, Oct. 11, 2001:

Take the frustratingly familiar problem of buying a used car. Assume that used cars come in two types: those that are in good repair, and duds (or “lemons” as Americans and most economists call them). Suppose further that used-car shoppers would be prepared to pay $20,000 for a good one and $10,000 for a lemon. As for the sellers, lemon-owners require $8,000 to part with their old banger, while the one-owner, careful-driver old lady with the well-maintained estate won’t part with hers for less than $17,000. If buyers had the information to tell wheat from chaff, they could strike fair trades with the sellers, the old lady getting a high price and the lemon-owner rather less.

If buyers cannot spot the quality difference, though, as is often the case in the real world, there will be only one market for all used cars, and buyers will be ready to pay only the average price of a good car and a lemon, or $15,000. This is below the $17,000 that good-car owners require; so they will exit the market, leaving only bad cars. This result, when bad quality pushes good quality from the market because of an information gap, is known as “adverse selection”. This was the simple but powerful insight of one of this year’s laureates, George Akerlof, now a professor at Berkeley, in a seminal 1970 paper.

[Note from Rob: the buyers will know that there is adverse selection, so they won’t pay more than $10,000 for any car. While they can’t assess the car to determine it’s a lemon, they can reason that only lemons are being sold, so that this car probably is a lemon and they shouldn’t pay a peach price.]

Max buyer is willing to offer for any given car? They will be willing to pay the EV of their value of the car, assuming that there is a 50% chance the car is a lemon and a 50% chance the car is a peach..

$$EV = 1/2 (\$20{,}000) + 1/2 (\$10{,}000) = \$15{,}000$$

The maximum a buyer is willing to offer for any given car ($15,000) is less than the minimum ($17,000) that the seller of a peach wants for his car.

Result: Peaches will disappear from the market, and only lemons will be sold.

After the peaches disappear from the market, buyers will rationally assume that all cars on the market are lemons. Therefore, a buyer will never be willing to pay more than the buyer’s value of a lemon - ie $10,000 for any used car.

We refer to this phenomena as market failure or market collapse.

1st Remedy for Adverse Selection: Screening

• Screening is the process by which an uninformed party attempts to gather information about the product or service offered by the informed party

2nd Remedy for Adverse Selection: Signaling

• Signaling is the process by which an informed party sends signals to uninformed parties conveying information about the quality of the product or service they’re trying to sell
• Signal must be effective in distinguishing between different levels of quality
• Signal will be more costly for a low-quality producer than for a high-quality producer
• Examples: Branding, Guarantees and warranties, Education, Signals on the job, Reputation, Gifts

Example: Signals on the Job

It may take several years for a firm to recognize someone’s talent. Given this asymmetric information, what policy should employers use to determine promotions and salary increases? Can workers who are unusually talented and productive signal this fact and thereby receive earlier promotions and larger salary increases?

Workers can often signal talent and productivity by working harder and longer hours. Because more talented and productive workers tend to get more enjoyment and satisfaction from their jobs, it is less costly for them to send this signal than it is for other workers.

Many young lawyers, accountants, consultants, investment bankers, and computer programmers regularly work into the night and on weekends, putting in 60- or 70-hour weeks. They are trying to send signals that can greatly affect their careers.

Employers rely increasingly on the signaling value of long hours as rapid technological change makes it harder for them to find other ways of assessing workers’ skills and productivity.

II. Moral hazard

• Definition: the tendency of a transaction to change people’s incentives and therefore their behavior
• Occurs after a market transaction, and causes the people are doing business to be choose “bad behaviors.” For example, people may abuse rental cars or be less careful if they have insurance.
• Examples: Insurance market, on the job

II.A. Principal-agent is a subtype/variant of Moral Hazard

• Someone is supposed to be your agent, but their interests are different than yours and they do what is best for them. For example, employees shirk at work.
• Two conditions necessary for a principal-agent problem
  1. Asymmetric information—it must be difficult or costly for the principal to monitor the actions of the agent
  2. Divergent interests—principal and agent must have different interests or goals
• Some classic examples of Principal-Agent: employees shirking on the job, stock brokers guiding you to investments that make them wealthy rather than you, or a mechanic saying that you need repairs that you don’t need. These people should be acting in your interest, but act in their own interest instead.