CHAPTER 17

Markets with Asymmetric Information

Information Asymmetry

Adverse Selection

Signalling/Guarantee Warranty
Reputation/branding/higher cosrs

Moral Hazard

Monitoring

Principal Agent Problem

managerial/worker incentive

Quality Uncertainty and the Market for Lemons

Asymmetric information
Situation in which a buyer and a seller possess different
information about a transaction
AI leads to adverse selection, market inefficiency and failure since
goods are not priced according to their quality and bad good drive
out the good ones
Adverse selection Different qlty products same price branding,
signaling, incentives can overcome defects of AI and AS
Bad goods drive out good goods
Form of market failure resulting from asymmetric information:
Signalling, Guarantees and Warrantees can be a good signal of
quality : they can overcome AS
Moral Hazard
Due to Moral Hazard social costs/benefits
/benefits

PrivateCosts

Moral hazard When an insured party whose actions are

unobserved can affect the probability or magnitude of a payment
associated with an event
Moral hazard not only alters behavior; it also creates economic
inefficiency. The inefficiency arises because the insured individual
perceives either the cost or the benefit of the activity differently
from the true social cost or benefit.
Moral hazard alters the ability of markets to allocate resources
efficiently. D gives the demand for automatic driving. With no
moral hazard, the marginal cost of transportation MC is $1.50 per
mile; the driver drives 100 miles, which is the efficient amount.
With moral hazard, the driver perceives the cost per mile to be
MC = $1.00 and drives 140 miles.
Used cars sell for much less than new cars because there is
asymmetric information about their quality: The seller of a used
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car knows much more about the car than the prospective buyer
does. The buyer can hire a mechanic to check the car, but the
seller has had experience with it and will know more about it.
Furthermore, they very fact that the car is for sale indicates that it
may be a lemonwhy sell a reliable car? As a result, the
prospective buyer of a used car will always suspicious of its
qualityand with good reason.
Akerlofs analysis goes far beyond the market for used cars. The
markets for insurance, financial credit, and even employment are
also characterized by asymmetric quality information. To
understand the implications of asymmetric information, we will
start with the market for sued cars and then see how the same
principles apply to other markets
Other Examples Restaurants/retail stores seller knows better
than buyer

Lemons Problem

 Exampleof Lemons and Gems why the former drives

away the latter

Let us think of a seconds market for Toyota Camrys. Some
cars are better than average and if consumers knew that they
were buying one of these gems they would be willing to pay
$10,000 for it. Other are lemons and if consumers knew they
were buying a lemon, they would be willing to offer only
$5000.
The problem is that consumers do not know which car is a
lemon and which is a gem.
So at first blush they are willing to pay a price of $7500
reflecting average quality. Sellers do,of course know the
quality of what they are selling
At a price of $7500
- owners of gems that really are worth $10,000 would
not sell for $7500
- owners of lemons that are worth $5000 would be
happy to sell for $7500
- Thus only lemons are sold.
- Now supposing consumers know that only lemons are
being sold then they will only offer $5000. This is ok
for lemon owners, that means more of them will be
sold.
- Thus Bad good(lemon)
drives away the good
one(gems)
- If consumers cannot tell the quality of a product and are willing to

pay only an average price for it, then this price is more attractive
for sellers who have bad products than to sellers who have good
products (hence the term adverse selection).
- Consequently, more bad products (i.e., lemons) will be offered
than good products. Now, if consumers are rational, they should
anticipate this adverse selection and expect that at any given price,
a randomly chosen product is more likely to be a lemon than a good
product.
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- Of course, these expectations imply a lower willingness to pay for

products and so the proportion of good products that is actually
offered falls further. Eventually, this process may lead to a complete
break down of the market.
- This lemons idea is also important for corporate finance: if
investors cannot observe the value of firms before they buy them
then they would be willing to pay only an average price for the
equity of firms.
Given that the price is average, selling equity on the market
is much more attractive to owners of bad firms than to owners of
good firms so the average value of firms that are actually offered on
the market should be below average.
- This implies that investors should be suspicious that if they are
offered equity then it must mean that the firms value is more likely
to be below the average. Hence, investors will no longer be willing
to pay an average price for the equity of firms once they have
offered to buy this equity
Insurance Companies
Reason for insurance companies to charge different premiums
depending on risk levels banks higher interest rates to drive away
high risk borrowers
If insurance companies must charge a single premium because they
cannot distinguish between high-risk and low-risk individuals,
more high-risk individuals will insure, making it unprofitable to sell
insurance
People who buy insurance know much more about their general
health than any insurance company can hope to know, even if it
insists on a medical examination. As a result, adverse selection
arises, much as it does in the market for used cars. Because
unhealthy people are more likely to want insurance, the proportion
of unhealthy people in the pool of insured people increases. This
forces the price of insurance to rise, so that more healthy people,
aware of their low risks, elect not to be insured. This further
increases the proportion of unhealthy people among the insured,
which forces the price of insurance up more. This process continues
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until nearly all people who want to buy insurance are unhealthy. At
that point, selling insurance becomes unprofitable

Adverse Selection in e Bay

In 2000 Robert and Teri La Plant paid $ 2950 for a 1.41 carat
marquise cot diamond on e Bay. Power user Mr Watch was the seller.
When they noticed a visible chip on the diamond they returned it. Al
Bagon who does business as Mr Watch refused to refund the money
alleging that the Plants had chipped it to avoid paying. Mr Bagon noted
that an appraisal accompanied the diamond when it was shipped. The
La Plants countered by saying that the appraisal was 18 months old and
that they have collected the $200 insurance policy that eBAy offers for
all its purchases. E Bay refuses to suspend Mr Watch from the site
noting that he had 1800 positive and only 8 negative responses .
Problems like this arise because e Bay sellers have better info about the
qualityof goods sold being offered for sale.Buyers offer less and sellers
are willing to sell less of high quality goods.
E Bay tries to solve the problem of adverse selection by using
authentication grading and escrow services and insurance against
fraud. Sellers can als0 build good reputations as custoners rate each
transaction with the seller. Sellers who have good reputation command
higher prices on e Bay for the same items. An increase in a sellers
rating by 10% leads to a 1.3% higher expected price,rise

Adverse Selection in Financial Markets: Enron,Satyam and

Sarbanes Oxley
During the late 1990s many investors in US became less
cautious and more willing to invest in firms about which they
had little information. They focused on stock prices and hence
pressure increased for firms to report that they had earned
profits at least as high as investment analysts were forecasting
they would. Firms reporting profits that were lower than what
analysts had forecast experience a sharp decline in their stock
prices. The situation of cooking the books became the order
leading to scandals

Financial statements when cooked lead investment analysts to

evaluate differently than what is the true situation. Creates
moral hazard problems for investors. The management of the
firm knows more about the firms finances than any outside
investor knows. Satyam in India did this. Enron managed to
keep much of its debts from being included on its balance
sheet. Eventually declaring its bankcruptcy.
Citigroup Inc also is stated to have misled investors by not
properly disclosing the amount of troubled mortgage assets it
held as the market began to implode in 2007. The result is that
investors increasingly became distrustful of firms own
estimates and regulators (SEC) began examining measurement
methods and disclosures.
In the US a spate of false financial statements led to loss of
faith of investors in the reliability of financial statements
leading to a wave of selling that hit the US stock markets in the
summer of 2002 which led the Congress to pass the SarbanesOaxley Act of 2002 to strengthen US security laws. The Bill
authorizes the SEC to set up a govt board to oversee auditing
of financial statements.
Obamas Financial Regulation Bill is also designed to avoid Ass
Inf and Adverse Selection
Arsene Wenger Capitalizes on Assymmetric Info in Players
Transfer Market for Arsenal
Inter-Club Transfer markets in Soccer are characterized by
Asymmetric Information where the club selling/transferring a
player knows more about the worth of the transferred player.
Arsene Wenger, Manager, Arsenal for some years now, is a trained
economist who also can judge a players peaking before others.
Sold Emmanuel Petit for $10.5 million, Thierry Henry for $30
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million in 2007 to Barcelona (bought from Juventis at Pd 10

million in 1999) and Patrick Viera for $25 million in 2005 and
none did well after leaving Arsenal. Though each of these players
was a superstar, they had peaked by the time Arsenal agreed to
transfer them. Wenger never made them know his true reason for
transferring them. In effect Arsenal sold them at a higher price than
what they were worth.
National Agriculture Insurance Schemes (NIAS) in India:
Case of both Adverse Selection and Moral Hazard
For an insurance policy to be viable its premiums should be equal to
or greater than claims + administrative expenses plus normal profits.
The periodic increase in premiums is supposed to take into
consideration enhanced admn costs
The NAIS has been implemented in India since Rabi season of 19992000. It was supposed that within 5 years the NIAS is supposed to
become financially sustainable charging farmers premium based on
actuarial rates and administrative costs. NIAS charges premiums of
1.5% to 3.5% varying from crop to crop. Although this is higher than
CCIS rates they are still not high enough to cover claims and
administrative expenses.
CCIS is 100% coverage of crop loan and is mandatory. The policy
charges premiums of 1-2% while claims were 9% of the sum
insured. Factoring in administrative costs participating farmers as a
whole would have to pay approx 15% of the sum insured without
subsidy.
Govt companies get subsidies as compared to pvt sector and this
discourages private sector.
Moral Hazard occurs when an individual farmer purposely allows
his yield to be less in order to collect insurance premiums.
Agri insurance fails because the insurance companies lack the
capacity to to administer the scheme at the individual farmer
level.
Farmers know about their risks better than the Govt or the
private sector
To avoid adverse selection companies will like to set premium
rates higher for high risk areas
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 But CCIS does not allow this- in fact it subsidizes premium rates

A Numerical involving Automobile Insurance

Good drivers pay low premium: bad ones high: But insurance
companies are not able to make out who is good and who is bad?
Otherwise he could have had differential premium.
Let us assume that each policy holder has a wealth level of $ 125,
but a loss can reduce the wealth to 25 ie loss of 100 in the event of
an accident. For the high risk category the prob of an accident is
0.75 while the same is 0.25 for low risk drivers.
A competitive premium will be charged based on expected loss ie
75 and 25 respy for high risk and low risk drivers).
Given Utility function that reflects risk aversion
Utility = (wealth)0.5
For the 2 categories the situations are as follows:
Low Risk
Utility with insurance = (125 25) 0.5 = 10
Utility without insurance = (0.75)(125) 0.5 + (0.25)(25) 0.5 = 9.635
for the high risk group
Utility with insurance = (125 75) 0.5 = 7.071
Utility without insurance = (0.25)(125) 0.5 + (0.75)(25) 0.5 = 6.545
If the insurance company cant distinguish between high risk and
low risk drivers, they will charge a uniform average premium rate
of (25+75) = 50
For this premium the high risk driver will go for policy since her
utility with insurance is higher than without
Utility with insurance = (125 50) 0.5 = 8.660
Utility without insurance = (0.25)(125) 0.5 + (0.75)(25) 0.5 = 6.545
The low risk driver will not go for this since utility with insurance
is lower than without
Utility with insurance = (125 50) 0.5 = 8.660
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Utility without insurance = (0.75)(125) 0.5 + (0.25)(25) 0.5 = 9.635

So the low risk drivers will not buy the policy while the high risk
ones will crowd in. This is not good for the insurance companies.

Preventing Adverse Selection : Drivers Case Again

Competition amongst insurers may help reduce the problem of AS in 2
ways.
-Competition induces insurers to seek and compile information about loss
expectations that enables them to use premium structures that discriminate
among risk groups. In a competitive market AS is reduced to the level that
reflects the cost of information
- Offering a choice to each driver (high risk and low risk) of 2 policies. This
is self-selection which will make the company have an idea of the risk type
to which a person belongs. One policy has a high premium and offers full
insurance - the other policy has a lower premium but a big deductible which
means that the insurer does not pay the full loss but pays loss minus some
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fixed amount.for a bad driver the deductible is a big deterrent so she goes`
for policy 1. The good driver goes for low premium, but deductible one.

Market Signaling
Education is a strong signal in labor markets. A persons
educational level can be measured by several thingsthe number
of years of schooling, degrees obtained, the reputation of the
university or college that granted the degrees, the persons grade
point average, and so on.
Of course, education can directly and indirectly improve a
persons productivity by providing information, skills, and
general knowledge that are helpful in work.
But even if education did not improve productivity, it would still
be a useful signal of productivity because more productive people
find it easier to attain high levels of education.
Not surprisingly, productive people tend to be more intelligent,
more motivated, more disciplined, and more energetic and hardworkingcharacteristics that are also helpful in school. More
productive people are therefore more likely to attain high levels of
education in order to signal their productivity to firms and
thereby obtain better-paying jobs. Thus firms are correct in
considering education a signal of productivity.

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Signaling

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Guarantees and Warrantees and Moral Hazard

We have stressed the role of signaling in labor markets, but it can also
pay an important role in many other markets in which there is
asymmetric information. Consider the markets for such durable goods
as televisions, stereos, cameras, and refrigerators. Many firms produce
these items, but some brands are more dependable than others. If
consumers could not be more dependable, the better brands could not
be sold for higher prices. Firms that produce a higher-quality, more
dependable product must therefore make consumers aware of this
difference. But how can they do it in a convincing way? The answer is
guarantees and warranties.
Guarantees and warranties effectively signal product quality because an
extensive warranty is more costly for the producer of a low-quality item
than for the producer of a high-quality item. The low-quality item is
more likely to require serving under the warranty, which the producer
will have to pay for. As a result, in their own self-interest, producers of
low-quality items will not offer extensive warranties. Thus consumers
can correctly view an extensive warranty as a signal of high quality, and
they will pay more for products that offer one.

Short Sellers as Signallers

Short- selling brings information into the marketplace that is incredibly
useful and valuable. It signals the performance or expected performance of
companies. To restrict s-s , as what the US SEC wants to do is to put bumps
on descent of stocks during volatile times.

Principal Agent Problem

PA problem arises from Information Assymetry
Perk enjoying manager looks to high growth and large
market share at the cost of Profit ( in US after the
onset of the economic crisis, loss making concerns

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giving huge compensation(bonuses) to its executives

has been a big issue)
PSUs can grow into big empires without regard to
efficiency because it is costly to monitor performance
of managers
To avoid IA set an Incentive wage and monitor results
Efficiency wage theory non shirk wages - set it fewer employment ascending wage - forced to be
efficient- market clearing wage gives incentive to
shirk
Managerial incentive in such a manner that you
declare correct capacities and thus perform
authentically
Creditors as Principals: Why they do not have the will to
Oversee
In the wake of the recent global economic crisis, many
mismanaged companies in US were propped up just
because they were too big to be allowed to fail- job
markets impacts, economic credibility etc were the
issues at stake. Satyam has been the outstanding case
in India where Govt had to step in to save the
company
However derivatives in the USA caused many
company stakeholders not to care to keep and check
the companies they had invested in.
A credit default swap is a derivative that insures a
creditor from credit default by its customer company.
Here comes the problem . A creditor who buys the
swap does not care whether the company remains in
business or not. This undermines creditor watch over
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client companies and undermines corporate

governance and debt governance mechanism.
Goldman Sachs had hedged its exposure to AIG by
purchasing credit default swaps on AIG thus
weakening its resolve to watch AIG
From the Derivatives industry perspective, it
encounters moral hazard from its clients who get
careless due to the hedge

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How Siva Jyothis (SJ) extra information helped

Goldman Sachs
Sep 11 2001- immediately after the planes crashed
into WTC, Mr SJ, then Head, Proprietary
Trading at GS in London at the Trading floor,
looked up the weather at New York . Found it a
pleasant morning, realized that it was not a
crash but an act of terror. This was an hour and
half before the world realized it was a terror
attack. SJ closed out on all trading positions of
his division which was likely to be affected by
a terror attack and moved swiftly to buying call
options on Government Bonds at a set price in
future.
Within 24 hours of his doing this other investors were
crowding to the safe haven of Govt bonds
driving up prices. SJ bought a big bonanza for
GS through the Call Option.- aided by the
superior info he possessed mostly selfgenerated and aided by his sharp intuition

Franchising
Growth of franchising in India in recent years is
a solution to the P-A incentive conflict. The
principal of the parent company that owns a
popular brand.like KFC. As the company grows
it has a choice it can open up company owned
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stores or it can let franchisees open and run

stores. The franchisees then pay the company a
fee for the right to use the parent company
brand. In this case what matters is whether
franchize organizational form is more profitable
to the parent company or not. In a company
owned structure managers do not work as hard
as they can if they owned the restaurant ( moral
Hazard) and the salaried managers may attract
lazy managers. (adverse selection). The agency
cost disappear once a franchisee owns the firm
because the agent and the principal become one
and the same. Running a franchised store can be
thought of a strong form of incentive
compensation you turn a manager into a owner
(franchisee) when you give him the profit from
running the store.

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