Markets with Asymmetric

Information
Topics to be Discussed
• Quality Uncertainty and the Market for Lemons
• Market Signaling
• Moral Hazard
• The Principal-Agent Problem
• Managerial Incentives in an Integrated Firm

Chapter 17 2
Introduction
• We can see what happens when some parties know more than others –
asymmetric information
• Frequently a seller or producer knows more about the quality of the
product than the buyer does
• Managers know more about costs, competitive position and investment
opportunities than firm owners

Chapter 17 3
Quality Uncertainty and the Market for
Lemons
• Asymmetric information is a situation in which a buyer and a seller
possess different information about a transaction

• The lack of complete information when purchasing a used car increases the risk
of the purchase and lowers the value of the car
• Markets for insurance, financial credit and employment are also characterized by
asymmetric information about product quality

Chapter 17 4
The Market for Used Cars
• Assume

• Two kinds of cars – high quality and low quality

• Buyers and sellers can distinguish between the cars
• There will be two markets – one for high quality and one for low
quality

Chapter 17 5
The Market for Used Cars
• High quality market
• SH is supply and DH is demand for high quality
• Low quality market
• SL is supply and DL is demand for low quality
• SH is higher than SL because owners of high quality cars need more
money to sell them
• DH is higher than DL because people are willing to pay more for higher
quality

Chapter 17 6
The Lemons Problem
Market price for high quality cars
PH PL is $10,000.
Market price for low quality cars
SH is $5000.
50,000 of each type are sold.
10,000

DH
SL

5,000

DL
DL

50,000 50,000
QH QL
Chapter 17 7
The Market for Used Cars
• Sellers know more about the quality of the used car than the buyer
• Initially buyers may think the odds are 50/50 that the car is high quality
• Buyers will view all cars as medium quality with demand DM
• However, fewer high quality cars (25,000) and more low quality cars
(75,000) will now be sold
• Perceived demand will now shift

Chapter 17 8
The Lemons Problem
Medium quality cars sell for $7500, The increase in QL reduces expectations and
selling 25,000 high quality and demand to DLM. The adjustment process continues
75,000 low quality. until demand = DL.
PH PL

10,000

7,500 7,500
DH
DM
5,000
DM
DLM

DLM DL
DL

25,000 50,000 50,000 75,000

QH9 QL
The Market for Used Cars
• With asymmetric information:

• Low quality goods drive high quality goods out of the market - the
lemons problem
• The market has failed to produce mutually beneficial trade
• Too many low and too few high quality cars are on the market
• Adverse selection occurs; the only cars on the market will be low
quality cars

Chapter 17 10
Market for Insurance
• Older individuals have difficulty purchasing health insurance at almost
any price
• They know more about their health than the insurance company
• Because unhealthy people are more likely to want insurance, the
proportion of unhealthy people in the pool of insured people rises
• Price of insurance rises so healthy people with low risk drop out –
proportion of unhealthy people rises, increasing price more

Chapter 17 11
Market for Insurance
• Ex: Auto insurance companies are targeting a certain population – males
under 25
• They know some of the males have low probability of getting in an
accident and some have a high probability
• If they can’t distinguish among insured, they will base premium on the
average experience
• Some with low risk will choose not to insure, which raises the accident
probability and rates

Chapter 17 12
Market for Insurance
• A possible solution to this problem is to pool risks

• Health insurance – government takes on role as with

Medicare program
• Problem of adverse selection is eliminated
• Insurance companies will try to avoid risk by offering group
health insurance policies at places of employment and
thereby spreading risk over a large pool

Chapter 17 13
Market for Insurance
• The Market for Credit

• Asymmetric information creates the potential that only high risk

borrowers will seek loans
• Can end up with a lemons problem again
• However, banks and credit agencies use credit histories to gauge risk
of borrowers

Chapter 17 14
Importance of Reputation and Standardization
• Asymmetric Information and Daily Market Decisions

• Retail sales – return policies

• Antiques, art, rare coins – real or counterfeit
• Home repairs – unique information
• Restaurants – kitchen status

Chapter 17 15
Implications of Asymmetric Information
• How can these producers provide high-quality goods when
asymmetric information will drive out high-quality goods through
adverse selection?

• Reputation
• You hear about restaurants or stores that have good or bad service and quality
• Standardization
• Chains that keep production the same everywhere – McDonald’s, Olive Garden

Chapter 17 16
Implications of Asymmetric Information

• You look forward to a Big Mac when traveling, even if you would not
typically buy one at home, because you know what to expect

• Holiday Inn once advertised “No Surprises” to address the issue of

adverse selection

Chapter 17 17
Lemons in Major League Baseball
• Rules in baseball changed so that after 6 years a player could
either re-sign with their team or become a free agent and try to
sign with another team
• Free agents create a secondhand market in baseball players
• If a lemons market exists, free agents should be less reliable (disabled)
than renewed contracts

Chapter 17 18
Player Disability

Days on Disabled List per Season

Pre Post Percent
Contract Contract Change
All Players
4.73 12.55 165.4

Renewed
4.76 9.68 103.4
Players
Free Agents
4.67 17.23 268.9

Chapter 17 19
Lemons in Major League Baseball
• Findings
• Days on the disabled list increase for both free agents and
renewed players
• Free agents have a significantly higher disability rate than
renewed players
• This indicates a lemons market

Chapter 17 20
Market Signaling
• The process of sellers using signals to convey information to
buyers about the product’s quality

• For example, how do workers let employers know they are

productive so they will be hired?

Chapter 17 21
Market Signaling
• Weak signal could be dressing well
• Is weak because even unproductive employees can dress well
• Strong Signal
• To be effective, a signal must be easier for high quality sellers to give
than low quality sellers
• Example
• Highly productive workers signal with educational attainment level

Chapter 17 22
Model of Job Market Signaling
• Assume two groups of workers
• Group I: Low productivity
• Average Product & Marginal Product = 1
• Group II: High productivity
• Average Product & Marginal Product = 2
• The workers are equally divided between Group I and Group II
• Average Product for all workers = 1.5

Chapter 17 23
Model of Job Market Signaling
• Competitive Product Market
• P = $10,000
• Employees average 10 years of employment
• Group I Revenue = $100,000
• (10,000/yr. x 10 years)
• Group II Revenue = $200,000
• (20,000/yr. X 10 years)

Chapter 17 24
Model of Job Market Signaling
• With Complete Information
• w = MRP
• Group I wage = $10,000/yr.
• Group II wage = $20,000/yr.
• With Asymmetric Information
• w = average productivity
• Group I & II wage = $15,000/yr.

Chapter 17 25
Model of Job Market Signaling
• If use signaling with education
• y = education index (years of higher education)
• Assume all benefits encompassed in years of education
• C = cost of attaining educational level y
• Tuition, books, opportunity cost, etc.

• Group I  CI(y) = $40,000y

• Group II  CII(y) = $20,000y

Chapter 17 26
Model of Job Market Signaling
• Cost of education is greater for the low productivity group than for high
productivity group

• Low productivity workers may simply be less studious

• Low productivity workers progress more slowly through degree

program

Chapter 17 27
Model of Job Market Signaling
• Assume education does not increase productivity with only value as a
signal
• Find equilibrium where people obtain different levels of education and
firms look at education as a signal
• Decision Rule:
• y* signals GII and wage = $20,000
• Below y* signals GI and wage = $10,000

Chapter 17 28
Model of Job Market Signaling
• Decision Rule:

• Anyone with y* years of education or more is a Group II person

offered $20,000
• Below y* signals Group I and offered a wage of $10,000
• y* is arbitrary, but firms must identify people correctly

Chapter 17 29
Model of Job Market Signaling
• How much education will individuals obtain given that firms
use this decision rule?
• Benefit of education B(y) is increase in wage associated with
each level of education
• B(y) is initially 0, which is the $100,000 base 10 year earnings
• Continues to be zero until reach y*

Chapter 17 30
Model of Job Market Signaling
• There is no reason to obtain an education level between 0 and
y* because earnings are the same

• Similarly, there is no incentive to obtain more than y* level of

education because once hit the y* level of pay, there are no
more increases in wages

Chapter 17 31
Model of Job Market Signaling
• How much education to choose is a benefit cost analysis
• Goal: obtain the education level y* if the benefit (increase in earnings) is
at least as large as the cost of the education
• Group I:
• $100,000 < $40,000y*, y* >2.5
• Group II:
• $100,000 < $20,000y*, y* < 5

Chapter 17 32
Model of Job Market Signaling
• This is an equilibrium as long as y* is between 2.5 and 5
• If y* = 4
• People in Group I will find education does not pay and will not obtain any
• People in Group II will find education DOES pay and will obtain y* = 4
• Here, firms will read the signal of education and pay each group
accordingly

Chapter 17 33
Signaling
Value of Group I Value of Group II
College College
Educ. Educ.

$200K $200K
CI(y) = $40,000y CII(y) = $20,000y

$100K $100K
B(y) B(y)

0 1 2 3 4 5 6 Years of 0 1 2 3 4 5 6 Years of
Optimal choice of College Optimal choice of College
y for Group I y* y for Group II y*
Signaling

• Education provides a useful signal about individual work habits and

productivity even if that education does not change productivity.

Chapter 17 35
Moral Hazard
• Moral hazard occurs when the insured party whose actions are
unobserved can affect the probability or magnitude of a payment
associated with an event

• If my home is insured, I might be less likely to lock my doors or install a security

system
• Individual may change behavior because of insurance – moral hazard

Chapter 17 36
Moral Hazard
• Determining the Premium for Fire Insurance
• Warehouse worth $100,000
• Probability of a fire:
• .005 with a $50 fire prevention program
• .01 without the program
• If the insurance company cannot monitor to see if the program was run,
how do they determine premiums?

Chapter 17 37
Moral Hazard
• With the program the premium is:
• 0.005 x $100,000 = $500
• Once insured owners purchase the insurance, the owners no longer have an
incentive to run the program, therefore the probability of loss is 0.01
• $500 premium will lead to a loss because the expected loss is now $1,000
(0.01 x $100,000)

Chapter 17 38
Moral Hazard
• Moral hazard is not only a problem for insurance companies, but it alters
the ability of markets to allocate resources efficiently
• Consider the demand (MB) of driving
• If there is no moral hazard, marginal cost of driving is MC
• Increasing miles will increase insurance premium and the total cost of driving

Chapter 17 39
The Effects of Moral Hazard
Cost
per With moral hazard
Mile
insurance, companies cannot
measure mileage. MC goes to $1.00 and
miles driven increases to 140
$2.00
miles/week – inefficient allocation.

$1.50 MC (no moral hazard)

$1.00 MC’ (w/moral hazard)

$0.50 D = MB

50 100 140 Miles per Week

Chapter 17 40
Reducing Moral Hazard – Warranties of
Animal Health
• Scenario

• Livestock buyers want disease-free animals

• Asymmetric information exists
• Many states require warranties
• Buyers and sellers no longer have an incentive to reduce disease
(moral hazard)

Chapter 17 41
The Principal – Agent Problem

• Owners cannot completely monitor their employees – employees are

better informed than owners
• This creates a principal-agent problem which arises when agents
pursue their own goals, rather than the goals of the principal

Chapter 17 42
The Principal – Agent Problem
• Company owners are principals
• Workers and managers are agents
• Owners do not have complete knowledge
• Employees may pursue their own goals even at a cost of reduced profits

Chapter 17 43
The Principal – Agent Problem
• The Principal – Agent Problem in Private Enterprises
• Only 16 of 100 largest corporations have individual family or financial institution
ownership exceeding 10%
• Most large firms are controlled by management
• Monitoring management is costly (asymmetric information)

Chapter 17 44
The Principal – Agent Problem – Private Enterprises

• Managers may pursue their own objectives

• Growth and larger market share to increase cash flow and therefore
perks to the manager
• Utility from job, from profit, and from respect of peers, power to
control corporation, fringe benefits, long job tenure, etc.

Chapter 17 45
The Principal – Agent Problem – Private
Enterprises
• Limitations to managers’ ability to deviate from objective of
owners
• Stockholders can oust managers
• Takeover attempts if firm is poorly managed
• Market for managers who maximize profits – those that perform get
paid more so incentive to act for the firm

Chapter 17 46
The Principal – Agent Problem – Private
Enterprises
• The problem of limited stockholder control shows up in
executive compensation
• Business Week showed that average CEO earned $13.1 million
and has continued to increase at a double-digit rate
• For the 10 public companies led by the highest paid CEOs,
there was negative correlation between CEO pay and company
performance

Chapter 17 47
CEO Salaries

Workers CEOs

1970 $32,522 $1.3 Mil.

1999 $35,864 $37.5 Mil.

 CEO compensation has gone from 40 times

Chapter 17 48
CEO Salaries
• Although originally thought that executive compensation
reflected reward for talent, recent evidence suggests managers
have been able to manipulate boards to extract compensation
out of line with economic contribution

Chapter 17 49
CEO Salaries
• How have they been able to do this?
1. Boards don’t typically have necessary information and
independence to negotiate effectively
2. Managers have introduced forms of compensation that camouflage
the extraction of rents from shareholders

Chapter 17 50
CEO Salaries
• Rent extraction has increased as consultants are hired to determine
appropriate pay for CEO
• Firm usually wants to provide at least the average of other companies, so
salaries have been rising rapidly
• With publicity increasing, CEO salaries seem to be rising less rapidly

Chapter 17 51
The Principal – Agent Problem – Public
Enterprises
• Observations
• Managers’ goals may deviate from the agencies’ goals (size)
• Oversight is difficult (asymmetric information)
• Market forces are lacking

Chapter 17 52
The Principal – Agent Problem
• Limitations to Management Power
• Managers choose a public service position
• Managerial job market
• Legislative and agency oversight (GAO & OMB)
• Competition among agencies

Chapter 17 53
The Managers of Non-Profit Hospitals as
Agents
• Are non-profit organizations more or less efficient than for-profit firms?
• 725 hospitals from 14 hospital chains
• Return on investment (ROI) and average cost (AC) measured

Chapter 17 54
The Managers of Non-Profit Hospitals as
Agents
Return on Investment

1977 1981

For-Profit 11.6% 12.7%

Non-Profit 8.8% 7.4%

Chapter 17 55
The Managers of Non-Profit Hospitals as Agents
• After adjusting for differences in services:
• AC/patient day in non-profits is 8% greater than profits
• Conclusion
• Profit incentive impacts performance
• Costs and benefits of subsidizing non-profits must be considered

Chapter 17 56
Incentives in the Principal-Agent Framework
• Designing a reward system to align the principal’s and agent’s
goals--an example
• Watch manufacturer
• Uses labor and machinery
• Owners’ goal is to maximize profit
• Machine repairperson can influence reliability of machines and
profits

Chapter 17 57
Incentives in the Principal-Agent Framework
• Designing a reward system to align the principal’s and agent’s
goals--an example
• Revenue also depends, in part, on the quality of parts and the
reliability of labor
• High monitoring costs make it difficult to assess the repairperson’s
work

Chapter 17 58
Incentives in the Principal-Agent Framework
• Small manufacturer uses labor and machinery to produce
watches
• Goal is to maximize profits
• High monitoring costs keep owners from measuring the effort
of the repairperson directly

Chapter 17 59
The Revenue from Making Watches

Poor Luck Good Luck

Low Effort
$10,000 $20,000
(a = 0)

High Effort
$20,000 $40,000
(a = 1)

Chapter 17 60
Incentives in the Principal-Agent Framework
• Designing a reward system to align the principal’s and agent’s goals--an
example
• Repairperson can work with either high or low effort
• Revenues depend on effort relative to the other events (poor or good
luck)
• Owners cannot determine a high or low effort when revenue =
$20,000

Chapter 17 61
Incentives in the Principal-Agent Framework
• Designing a reward system to align the principal’s and agent’s goals--an
example
• Repairperson’s goal is to maximize wage net of cost
• Cost = 0 for low effort
• Cost = $10,000 for high effort
• w(R) = repairperson’s wage based only on output

Chapter 17 62
Incentives in the Principal-Agent Framework
• Choosing a wage:
• w = 0; a = 0; R = $15,000
• R = $10,000 or $20,000, w = 0
• R = $40,000; w = $24,000
• R = $30,000; Profit = $18,000
• Net wage = $2,000
• w = R - $18,000
• Net wage = $2,000
• High effort

Chapter 17 63
Incentives in the Principal-Agent Framework
• Conclusion
• Incentive structure that rewards the outcome of high levels of effort can induce
agents to aim for the goals set by the principals

Chapter 17 64
Managerial Incentives in an Integrated Firm
• In integrated firms, division managers have better (asymmetric)
information about production than central management
• Two Issues
• How can central management elicit accurate information?
• How can central management achieve efficient divisional production?

Chapter 17 65
Managerial Incentives in an Integrated Firm
• We will focus on firms that are integrated
• Horizontally integrated
• Several plants produce the same or related products
• Vertically integrated
• Firm contains several divisions, with some producing parts and components that
others use to produce finished products

Chapter 17 66
Managerial Incentives in an Integrated Firm
• Possible Incentive Plans
1. Give plant managers bonuses based on either total output or operating
profit
• Would encourage managers to maximize output
• Would penalize managers whose plants have higher costs and lower capacity
• No incentive to obtain and reveal accurate cost and capacity information

Chapter 17 67
Managerial Incentives in an Integrated Firm
2. Ask managers about their costs and capacities and then base bonuses
on how well they do relative to their answers
• Qf = estimate of feasible production level
• B = bonus in dollars
• Q = actual output
• B = 10,000 - .5(Qf - Q)
• Incentive to underestimate Qf

Chapter 17 68
Managerial Incentives in an Integrated Firm
• If manager estimates capacity to be 18,000 rather than 20,000, and if the
plant only produces 16,000, her bonus increases from $8000 to $9000
• Don’t get accurate information about capacity and don’t insure efficiency
• Bonus still tied to accuracy of forecast

Chapter 17 69
Managerial Incentives in an Integrated Firm
• Modify scheme by asking managers how much their plants can feasibly
produce and tie bonuses to it
• Bonuses based on more complicated formula to give incentive to reveal
true feasible production and actual output
• If Q > Qf ,B = .3Qf + .2(Q - Qf)
• If Q  Qf ,B = .3Qf - .5(Qf - Q)

Chapter 17 70
Managerial Incentives in an Integrated Firm
• Assume true production limit is Q* = 20,000
• Line for 20,000 is continued for outputs beyond 20,000 to illustrate the bonus
scheme but dashed to signify the infeasibility of such production
• Bonus is maximized when firm produces at its limit of 20,000; the bonus is then
$6000

Chapter 17 71
Incentive Design in an Integrated Firm
Bonus
($ per If Qf = 10,000,
bonus is $5,000.
Qf = 30,000
year)
Qf = 20,000
10,000
If Qf = Q* = 20,000, Qf = 10,000
bonus is $6,000.
8,000

6,000

If Qf = 30,000,
4,000 bonus is $4,000,
the maximum
amount possible.
2,000
Output
0 10,000 20,000 30,000 40,000 (units per year)
Chapter 17 72
Efficiency Wage Theory
• In a competitive labor market, all who wish to work will find
jobs for a wage equal to their marginal product

• However, most countries’ economies experience unemployment

Chapter 17 73
Efficiency Wage Theory
• The efficiency wage theory can explain the presence of
unemployment and wage discrimination
• In developing countries, productivity depends on the wage rate for
nutritional reasons

Chapter 17 74
Efficiency Wage Theory
• The shirking model can be better used to explain unemployment and
wage discrimination in the United States
• Assumes perfectly competitive markets
• However, workers can work or shirk
• Since performance information is limited, workers may not get fired

Chapter 17 75
Efficiency Wage Theory
• If workers are paid market clearing wage w*, they have incentive to shirk
• If they get caught and fired, they can immediately get a job elsewhere for
same wage
• Firms have to pay a higher wage to make loss higher from shirking
• Wage at which no shirking occurs is the efficiency wage

Chapter 17 76
Efficiency Wage Theory
• All firms will offer more than market clearing wage, w*, say we (efficiency
wage)

• In this case, workers fired for shirking face unemployment because demand
for labor is less than market clearing quantity

Chapter 17 77
Unemployment in a Shirking Model
Demand for Without shirking, the market wage is w*, and full-
Wage Labor employment exists at L*
No-Shirking
Constraint
SL
The no-shirking constraint gives the wage necessary
to keep workers from shirking.

At the equilibrium wage, We the firm hires Le workers

creating unemployment of L* - Le.
we

w*

Quantity of
Le L* Labor

Chapter 17 78
Efficiency Wages at Ford Motor Company
• Labor turnover at Ford
• 1913: 380%
• 1914: 1000%
• Average pay = $2 - $3
• Ford increased pay to $5

Chapter 17 79
Efficiency Wages at Ford Motor Company
• Results
• Productivity increased 51%
• Absenteeism was halved
• Profitability rose from $30 million in 1914 to $60 million in 1916

Chapter 17 80