lemons market
TRANSCRIPT
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2005, Southwestern
Slides by Pamela L. Hall
Western Washington University
AsymmetricInformation
Chapter 23
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2
Introduction
Managers (insiders) of firms can increase their profit by taking actionsbased on insider information (information that is not available to public)
If insiders obtain positive (negative) information about a company, theybuy (sell) the companys stock with expectation that stocks price will rise
(fall) when positive (negative) information is publicly announced
Such insider trading of securities is illegal However, incorporating information not known by all agents in market pricing is
generally legal
When selling a commodity, agents are not legally required to provide fulldisclosure of information on a commodity
Previously, we generally implicitly assumed or explicitly stated symmetryin market information as a characteristic of market structure
Assumed all agents had costless access to this information
Symmetry existed with both buyers and sellers having the same marketinformation
For example, one of the explicit characteristics of perfect competition is agents perfect
knowledge
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3
Introduction
In general, market information is costly, and this cost may vary betweenbuyers and sellers
Resulting in asymmetric information held by agents
One set of agents may be more knowledgeable about a commodity than anotherset
Information cost may vary among agents as a result of differences ineducation and experience about commodity
Examples include A firm possessing limited information about a potential workers abilities
A used car buyer not having complete repair and maintenance history on an auto
An insurance company not knowing risky behavior of a potential insurer
When commodities are homogeneous and their characteristics arereadily available
Cost of determining these characteristics is small
Assumption of market symmetry would generally hold
For example, symmetric information generally holds for commodity futures market
Where, except for delivery dates, all futures contracts on same commodity haveidentical characteristics
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4
Introduction
In contrast, asymmetric information will generallyexist for heterogeneous commodities withcharacteristics that are costly to determine
An example is the vehicle market Condition of a vehicle is difficult to determine without costly
testing
Heterogeneous nature of used vehicles prevents a generaldetermination of a vehicles condition based on examination of other
like vehicles
A major consequence of asymmetric information ispossible disappearance of markets
Which result in an inefficient allocation of resources
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Introduction
Aim in this chapter is to demonstrate how missing marketsand associated efficiency losses result in presence ofasymmetric information Asymmetry in information generates two types of outcomes
Adverse selection
Where one agents decision depends on unobservable characteristics that
adversely affect other agents
Use used-automobile market to illustrate missing market and resultingmarket inefficiencies
We discuss mechanisms of signaling and screening as second-best Pareto-efficient mechanisms for addressing these inefficiencies
Moral hazard A contract is signed among agents with one agent being dependent on
unobservable actions of other agents
Using a principal-agent model, we derive inefficient level of precaution takenby agents
Evaluate mechanisms (such as coinsurance) designed to addressinefficiencies
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Introduction
Asymmetric information is relatively new area for applied economic analysis In 1970 George A. Akerlof was first to address problems and solutions associated with adverse
selection
Knowledge of moral hazard has been around since advent of insurance in 18th century
However, only recently have applied economists investigated ramifications of moral hazardon economic efficiency
Asymmetric information in a market can result in market inefficiencies If information concerning characteristics of a commodity is not freely available, inefficient
allocations may result
One type of asymmetric information is called adverse selection (also called hiddeninformation)
An informed agents decision depends on unobservable characteristics that adversely affect
uninformed agents
Classic example is market for used cars
Assume used cars can be grouped by quality into two groups
Within each group, used cars are homogeneous and are associated with a single price
Comparing vehicles between groups, they are heterogeneous in quality and thus are not valued by identicalprices
In a free (symmetric) information case, two heterogeneous groups of commodities (used cars) would haveseparate markets with associated prices p1 and p2
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Lemons Market
Generally, sellers of a used car know vehicles history Can determine its market price at zero or very minimal cost
In contrast, buyers do not have this knowledge
Cost of determining information for each group of used cars is prohibitive
Without information, buyers may base their market price determination on
average quality of used cars available Asymmetry in information results in buyers only willing to pay up to
average price of used cars available, p At average price sellers would be willing to supply only
QS = qj(pj)
pj p
qj(pj) is supply of used cars in group j
Above-average used cars, associated with pj > p, will not be offered for sale
Sellers would be unwilling to supply their cars for less than vehicles market value
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Lemons Market
Buyers realize above-average used cars will not enter market at average price So average quality of used cars offered in market is less than average quality of used
cars available
They will adjust downward their willingness-to-pay for used cars offered in themarket
Only sellers who value their cars below this new lower price will supply vehicles
Average quality of used cars offered in market will once again decline
Ttonnement process will continue until only lowest-quality group of used carsare offered and sold in market
When only lowest-quality group is offered for sale, any asymmetry in informationvanishes
With symmetric information, buyers and sellers expected prices match and onlya market for lowest-quality group exists
Missing markets for other groups of used cars represent market failure
These lowest-quality cars are popularly referred to as lemons
Market failure associated with adverse selection is called the lemons problem
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Lemons Market
In Figure 23.1, lemons problem is illustrated for two quality groups ofused vehicles, reliable cars, , and lemons,
Curves S and S are supply curves for lemons and reliable cars,respectively
Supply curve for reliable cars is above lemons curve
Indicates sellers of reliable cars are only willing to supply these higher-valuedvehicles at prices above the lemon
Demand curves for lemons and reliable cars are represented by D and D,respectively
Buyers are willing to pay a higher price for reliable compared with lemons So reliables demand curve is above lemons demand curve
Given free information, market is able to discriminate between these twotypes of cars
So market-clearing prices exist for both reliables and lemons markets Equilibrium price and quality for reliables are p and
* and for lemons p and *
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Figure 23.1 Lemons problem
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Lemons Market
Asymmetric information in form of adverse selectionprevents buyers from freely distinguishing reliable cars fromlemons Buyers may know proportion of automobiles that are reliable and
lemons
But are unable to distinguish quality of a given automobile
Overall market demand, QD, facing sellers will be horizontalsum of lemons and reliables demand curves
Total supply of cars, QS, is horizontal sum of lemons and
reliables supply curves Resulting equilibrium price and quantity are p' and Q'
Loss in ability of market to distinguish between reliables and lemons Results in number of lemons offered on market increasing from * to S
' andnumber of reliables declining from * to S
'
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Lemons Market
Demand for lemons decreases from * to D' and demand for reliablesincreases from * to D'
Imbalance within markets will result in some buyers who expect toreceive a reliable car instead receiving a lemon
As buyers realize ratio of reliables to lemons is declining in market, they will
adjust their expected quality downward Participation in number of buyers wanting a reliable car will decline as
expectation of obtaining a reliable car in market decreases
Resulting downward shift in demand curve further drives reliable cars out ofmarket
Further erodes demand for reliable cars
Ttonnement process will continue until buyers only expect lemons to besupplied, so their market demand curve is D
Such a market will then supply * automobiles at a price of p*, and amissing market will exist for reliable cars
Market is unable to allocate both supply of reliables and lemons efficiently to
buyers It is unable to price discriminate across quality differences
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Lemons Market
An efficient allocation would result in quality discrimination Buyers would have market choice of purchasing either reliable cars or lemons
Without market ability to quality discriminate, some buyers may by chance purchase a reliablecar
But these may not be buyers with highest willingness-to-pay
Failure of market to allocate commodities based on willingness-to-pay results in an inefficient allocation
Cause of this missing market and inefficient allocation of resources is an externality betweensellers of reliable cars and lemons
As illustrated in Figure 23.1, as number of sellers offering lemons increases
Buyers expectations regarding quality of vehicles in market is affected
Price buyers are willing to pay declines Adversely affects sellers of reliable cars by preventing them from selling their vehicles and improving efficiency
Externality between sellers for reliable cars and lemons has distributional implications
Owners of lemons may receive more than their automobile is worth and owners of reliable cars less
Buyers possessing limited information generally benefit sellers of lemon products
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Lemons Market
Problem of adverse selection exists in other markets For example, in insurance market buyers of insurance know more about
their general health than any insurance company
Unhealthy consumers are more likely to buy insurance Because healthy consumers will find cost of insurance too high
Ttonnement process will continue until only unhealthy consumers purchase insurance
Will make selling insurance unprofitable
Another example is labor market
Workers potential productivity is unobservable by a hiring firm
But workers themselves know their productive capabilities Ttonnement process will result in only less-productive workers being hired
Market failure resulting from adverse selection explains Why a new automobile declines in value once it is driven off lot
Why insurance is so high for a previously uninsured driver or a person withno medical history
Why salaries start low with a potential for frequent raises once a person is
hired
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Second-Best Mechanism Designs
U.S. health care costs are nearly double that of other nations andoutpace inflation
Firms and workers are faced with rising premiums and cutbacks in coverage
A national health insurance program can avoid inefficiencies of adverseselection in health care
By making purchase of insurance compulsory Unhealthy citizens benefit from insurance premiums below their expected health
costs
Healthy citizens can purchase insurance at lower rates Such a government policy is called cross-subsidization
Healthy consumers pay a portion of health care for unhealthy consumers
One justification in favor of Medicare for elderly By providing insurance for all elderly, adverse selection is eliminated
However, without knowing agents private information, obtaining Pareto-optimalallocation is not possible
Acquiring such information is costly
So only a constrained or second-best Pareto optimum can be obtained
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Second-Best Mechanism Designs
In general, insurance companies can avoid adverse selection by offeringgroup health insurance plans at places of employment
Called poolingboth healthy and unhealthy consumers are pooled together
Insurance premiums are based on average cost of health care Adverse selection is eliminated by requiring all employees to participate
Government agencies can improve functioning of markets by providingfree information or requiring product information prior to sale
Many government agencies currently provide information useful for makingmarket decisions
Examples include U.S. State Department cautioning tourists about visiting aparticular region, USDA publishing situations and outlooks for agricultural
commodities
An example of requiring product information is FDAs requirement for
food labeling on processed foods
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Signaling Both buyers and sellers can potentially benefit from creating markets
that were missing due to adverse selection
Provides incentives for developing market mechanisms to mitigatemarket failure associated with adverse selection
Signaling
Mechanisms that transfer information from informed agent to uninformedagent
Naive signal on part of a buyer
Asking sellers quality of a commodityfor example, asking a used cardealer condition of a car
Cost of such a signal could be high if signal is inaccurate and commodity ispurchased
An example of a particularly weak signal
Where cost of providing a signal is the same for all sellers regardless of quality oftheir product
Appearance can be another weak signal
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Signaling For a strong signal, a signal must have an associated lower cost for
sellers offering relatively high-quality commodities
Compared with cost for sellers offering poor-quality commodities
Examples of strong signals used by firms are reputation and standardization Firms offering higher-quality commodities have an advantage over other firms in
establishing a reputation for quality
For example, construction subcontractors can provide a signal for qualityconstruction by developing a list of satisfied customers
One problem with reputation as a signaling device
Delay associated with establishing a reputation
Problem may be partially avoided By supplementing reputation with guarantees and warranties as explicit signals of
product quality
For example, in 1980s, as a counter to Japanese auto manufacturers reputation
for producing quality cars
U.S. manufacturers offered extended 100,000-mile warranties as a signal ofimproved quality
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Signaling Such signals are useful in cases where buyers lack information on
quality of some commodity that they do not purchase on a regular basis
For regularly purchased commodities that vary in quality
Firms will attempt to standardize commodities they are offering to signal quality For example, a fruit and vegetable wholesaler will attempt to always offer same quality
of produce
Through standardization, sellers send a strong signal that buyers canexpect a quality product from them
Some firms advertise such standardization as a market signal
In general, a signaling mechanism will be employed by informed agents
Agents are not always the seller
Agent could be an antique dealer purchasing items for his shop Through experience, dealer will have a greater knowledge about market than sellers
A reputable dealer could employ signaling mechanisms to separate him fromunreputable dealers
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Signaling Concept of signals was first developed by Michael Spence
in a labor market context A strong signal of a persons labor productivity is education
Education generally improves a persons productivity However, even if it did not, it is still a strong signal of productivity
Any admission requirements to a university or college will only result inhigher-quality individuals entering the institution
Quality in quality out is signal sent to employers
Consumers, firms, and government agencies have also used gender,race, color, religion, and national origin as signals for labor productivity
But these signals, besides being illegal in U.S., are generally weak Exceptions are when insurance companies target insurance rates by such
characteristics as age and gender
Some segments of society may feel use of such discriminatory signalsis morally wrong and thus should always be illegal
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Signaling Economic theory does not pass judgment on morality of
signals But it does provide a framework for determining economic
consequences of restricting such signals
Theory would indicate that a government restriction on one signal would
result in firms adopting related signaling mechanisms to maintain profits
For used car market, reliable car dealers will be able to offersignals For instance, in form of warranties
At a lower cost than lemon dealers, as illustrated in Figure 23.2 Lower warranty cost will result in lemon dealers being unable to compete in
offering warranties
Thus, only reliable dealers offer warranties
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Figure 23.2 Signaling
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Signaling Through these signals market for used vehicles can
now be separated into two markets
Lemons and reliables Market equilibrium for lemons is Pareto efficient by
corresponding to free-information equilibrium (p*, *) Market supply and demand curves for lemons did not shift
Introduction of a signal for reliable cars established a separatemarket for lemons
Market supply curve for reliable cars shifts up from S to S' Represents increased cost associated with offering warranties
As a result of supply shift, equilibrium quantity of reliable cars isbelow free-information quantity of*
Equilibrium price of p' is above free-information price of p*
Results in a deadweight loss area of CAB
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Signaling Such a market equilibrium is called a separating equilibrium
It segments pooled market for lemons and reliables into two markets
However, this is only a second-best Pareto-efficientoutcome
Because in markets with free information, sellers do not incur extraexpense of signals
Deadweight loss of removing inefficiency Cost of removing externality
Both producer and consumer surplus loss
Proportion of costs paid by buyers and sellers depends onrelative elasticities of supply and demand for reliable cars In long run, as elasticity of supply becomes more elastic
Larger proportion of signal cost is passed on to buyers
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Screening
Top three techniques to prevent used car scams Have a mechanic inspect vehicle
Run a Vehicle History Report
Will reveal if vehicle was flooded, rebuilt, salvaged, stolen, or totaled
Never sign anything stating as is, no warranty
Obtain at least a 30-day warranty Symmetric information associated with free information results in a
Pareto-efficient allocation
Pareto preferred to an allocation with signals
However, signals can be a second-best Pareto-efficient outcome if they
result in a separating equilibrium, which improves efficiency Not all signals do this
Weak signals resulting in a pooling equilibrium
Signals of different quality sellers cannot be differentiated
Do not separate markets so market efficiency is not improved
Buyers may attempt to distinguish or screen various commodities offered
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Screening
Screening exists when a buyer employs a mechanism for sortingcommodities offered by sellers
Examples of screening are
Buyer having a used car inspected prior to purchase
Employer offering internships prior to employment
In general, screening is employed by uninformed agent Can be either buyer or seller
For example, price discrimination, discussed in Chapter 13, is a form ofscreening
Seller does not have information on buyers willingness-to-pay for
commodity By screening buyers based on their characteristics, sellers can create
separate markets and practice price discrimination
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Screening
In some cases, buyers rely on another firm orconsumer (third parties) for screening
For example A consumer may acquire her dentist, house painter, doctor, or
maid through a recommendation from another consumer Or a firm may screen commodities and sell information to
potential buyers
Magazine Consumer Reports is in the business of screeningcommodities
Major third parties for screening are governmentagencies providing market information
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Screening
Consider used car market Potential buyers may screen vehicles by having them inspected
As illustrated in Figure 23.3, cost of screening will shift demand for bothlemons and reliable cars downward
From D to D' for lemons market and from D to D' for reliable market
Resulting separating-equilibrium prices, p' and p', are lower than free-information equilibrium prices, p* and p*
Separating-equilibrium quantities, ' and ', are lower than free-informationequilibrium quantities, * and *
Cost of screening is sum of deadweight losses in lemons market (shaded area CAB)and reliable market (shaded area DEF)
Both signaling and screening have potential for reducing asymmetricinformation and yielding a second-best Pareto-efficient outcome
Cost of reducing asymmetric-information externality
Cost of signals or screening may offset any market efficiency gains They may or may not improve social welfare
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Figure 23.3 Screening
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Principal-Agent Models
Concept of moral hazard Developed from study of insurance market
An insurer has no control over policyholder not taking precautions toward reducingprobability of an insured event from occurring
Term moral hazard (also called hidden actions) is derived from condition thata policyholder may take wrong (immoral) action by not taking proper precautions
For example, an auto insurance firm has no control over hidden action of apolicyholder leaving car keys in an unlocked car
Moral hazard lasts over life of some established agreement
Moral hazard may result if purchase of a commodity establishes future returns orutility of an agent being dependent on actions of another agent
Moral hazard is not restricted to issuance of insurance It generally exists whenever one agent (principal) depends on another agent (agent)
to undertake some actions
If agents actions are hidden from principal, asymmetric information is present Market inefficiencies may result
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Principal-Agent Models
In general, contracts establishing such dependenceare designed to mitigate potential moral hazardproblems
Problems in designing contracts result from principal-
agent problem Examples include
Owners of a firm who are unable to observe a managers work ethic
Instructors inability to observe how hard a student is actually
studying
In these examples, agents have ability to hide actions Uninformed principal wants to provide informed agent with efficient
incentives for fulfilling contract
Pareto Efficienc ith No Moral
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Pareto Efficiency with No Moral
Hazard
As an illustration of no moral hazard, assume agents face an expected lossassociated with some event
Examples are losses from fire damage to their business or an auto accident
Without any insurance, consumers face full cost of some negative event, whichreduces their welfare
Can mitigate negative impact by taking precaution
An increase in level of precaution can both reduce likelihood of event occurring andmagnitude of loss when event does occur
An objective of a consumer is to determine optimal level of precaution, P
Assume total cost of precaution at first increases at a decreasing rate and thenincreases at an increasing rate with level of precaution (Figure 23.4)
A basic level of precaution offers a great deal of protection with little increases in cost
Examples are driving with traffic instead of against it, locking your car when shopping At basic level of precaution, precaution costs are increasing but at a decreasing rate
At some point an additional level of precaution will result in costs increasing at an increasingrate
Figure 23 4 Total and marginal
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Figure 23.4 Total and marginal
cost curves for precaution
Pareto Efficiency with No Moral
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Pareto Efficiency with No Moral
Hazard
If TC(P) is total cost function for precaution Then TC'(P) > 0 and at first TC"(P) < 0 and at some precaution level TC"(P) > 0
For example, at first a great deal of fire protection can be purchased with a smallinvestment in a smoke detector
For additional protection, fire extinguishers can be purchased at a higher cost per unit
Followed by a sprinkler system at an even higher cost per unit
Associated with a given level of precaution is an expected loss Expected loss is probability of event occurring times total loss
Objective of a consumer is to determine efficient level of precaution thatminimizes overall cost (sum of expected losses and cost of precaution)
F.O.C. is
TC'(P) = -EL'(P) TC'(P) is marginal cost, MC(P)
-EL'(P) is marginal benefit of precaution, MB(P)
Marginal benefit is reduction in expected losses associated with an increase in precaution
Pareto Efficiency with No Moral
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Pareto Efficiency with No Moral
Hazard
EL'(P) < 0, so marginal benefit, -EL'(P), is positive (Figure 23.5) Optimal level of precaution, P*
Where marginal cost equals marginal benefit
If marginal benefit is greater than marginal cost An increase in precaution would reduce EL(P) more than increase in TC(P)
So overall costs fall
If marginal benefit is less than marginal cost A decrease in precaution would reduce TC(P) by more than increase in EL
So overall cost will fall
Optimal level of precaution is illustrated in Figure 23.6
Positively sloping marginal precaution-cost curve represents assumption of increasingper-unit precaution cost
Negatively sloping marginal precaution-benefit curve represents assumption ofdecreasing reduction in expected loss as precaution increases
At P*, where marginal benefit equals marginal cost
Overall costs are minimized
To left (right) of P*, marginal benefit is greater (less) than marginal cost
Consumer has an incentive to increase (decrease) precaution
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Figure 23.5 Expected losses
Fi 23 6 P t ffi i t ti
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Figure 23.6 Pareto-efficient precautionlevel with no moral hazard
Insurance Market with No Moral
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Insurance Market with No Moral
Hazard
As discussed in Chapter 18, a risk-averse agent will not voluntarily takeon additional risk
Will seek out opportunities for avoiding risk
Insurance allows an agent to shift risk of a negative event onto anotheragent (an insurance company)
In event of a loss, such as a flood, an insurance company compensatesagent for loss
Assume contract (policy) between principal (insurance company) andagent (consumer) is actuarially fair insurance
If consumer can purchase insurance covering full expected loss for a given
level of precaution Consumer no longer suffers a loss from a negative event, EL = 0
However, consumer must pay premium, which, for actuarially fair insurance,is equal to EL
Assuming no moral hazard, insurance company will want to design a policy whereexpected payout varies by level of precaution a consumer takes
Insurance Market with No Moral
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Insurance Market with No Moral
Hazard Premiums would be higher for a low level of precaution by a consumer
Decline as level of precaution increases
Let A(P) represent insurance premium, so A'(P) < 0
A"(P) > 0
Consumer is still faced with problem of determining optimal level of precaution thatminimizes overall cost of taking precaution and now paying insurance premium
F.O.C. is
TC'(P) = -A'(P)
Consumer equates marginal precaution cost, TC'(P), to marginal precaution benefit, -A'(P)
Marginal precaution benefit is additional savings in premium costs from an additional increase in
precaution
As illustrated in Figure 23.6, with no moral hazard and actuarially fair insurance
Results in same level of precaution as in no-insurance case
In general, assuming agents gain some utility from having an insurance company assumerisk (assuming agents are risk averse)
Then P*, with insurance, is a Pareto-efficient level of precaution
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Insurance and Moral Hazard
Unfortunately, Pareto-efficient level of precaution is generally notpossible
Hidden level of precaution by consumers makes cost of designing aninsurance policy where premiums are based on every level ofprecaution prohibitive
In extreme case of moral hazard, where insurance company cannot atall determine level of precaution
Insurance premium would not be a function of consumers precaution level
Assuming insurance company sets premium at Pareto-efficient level ofprecaution, P*, consumers objective is
Optimal solution is for consumer to not take any precaution, P = 0
Zero level of precaution increases risk of negative event occurring Results in insurance company having to pay higher-than-expected claims
This is root of terminology moral hazard for insurance company (principal)
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Insurance and Moral Hazard
Unless insurance company can design policies that provideincentives for consumers to take precaution Ttonnement process will result in no insurance company able to
pay all its claims from revenue generated by premiums
Inefficiency of zero precaution associated with moral hazard is
represented by deadweight loss, area ABC, in Figure 23.6 Ttonnement process toward an equilibrium can also result in
instances where agents are overinsured
For example, due to falling property values or a failing business, anagent may realize that level of insurance is more than property is worth
If this information is hidden from insurance company (adverse selection) Hidden action of not taking any precautions to prevent fire or even
causing business to burn down can increase returns
For this reason, in fire investigations owners are always possiblesuspects
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Coinsurance Deadweight loss associated with moral hazard can be
reduced by inducing consumers to take some precaution
One type of inducement, employed by many healthinsurance companies, is coinsurance
Require consumer to pay some percentage of cost, so insurancecompany pays less than 100% of loss
Actual percentage paid varies, but a common rate is for an insurancecompany to pay 80% and consumers to pay remaining 20%
As percentage of loss a consumer pays increases, less risk is shifted toinsurance company and consumer is more willing to take precaution
Consumers will tend to seek lower-cost treatments rather than alternativehigher-cost treatments
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Coinsurance If, for example, consumer pays 20% of cost along with a fixed
premium A, then consumers objective is
F.O.C. is
=0.2EL'(P) = TC'(P)
As illustrated in Figure 23.7, marginal benefit curve tiltsdownward and intersects marginal cost curve at second-bestPareto-efficient equilibrium level of precaution PO > 0
Deadweight loss is reduced from area ABC to DEC Only when moral hazard can be eliminated will a Pareto-
efficient solution P* exist
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Figure 23.7 Coinsurance
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Deductibles
Writing insurance policies with deductibles is another option insurancecompanies employ for increasing agents precaution level
Require agents to incur all loss up to some dollar limit
For example, if an auto insurance policy has a $500 deductible provision
First $500 in damages is paid by car owner, and insurance company pays anyremaining damages
Generally, the higher the deductible, the lower will be the insurance premiums
Insurance companies will incorporate deductibles into their policieswhen agents basic level of precaution is so low that insurance
companies cannot earn normal profits
For example, without some deductible for auto insurance, our roadwayscould take on a bumper-car atmosphere
Resulting in dramatic insurance premium increases with few if any consumerswilling to be insured
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Deductibles
With deductible provision, optimal level of precaution for a consumer isdetermined by
DA is level of deductible
Maximum cost a consumer will incur is deductible DA
However, if overall cost of precaution plus expected losses is less than DA Consumer can lower his cost below DA
F.O.C. for minimizing cost is
TC'(P) = -EL'(P)
If DA > min[TC(P) + EL(P)], yielding optimal level of precaution P* (Figure 23.6)
If DA < min[TC(P) + EL(P)], a zero level of precaution, P* = 0, is optimal level With DA as lowest possible level of cost
Expenditures on precaution will not result in any additional benefits
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Deductibles
Deductibles allow consumers to insure against large losses But be responsible for any relatively small expected losses below deductible
Reduces deadweight loss associated with moral hazard
As DA increases, deadweight loss is reduced, as consumers will likelychoose no-insurance level of precaution, P*
Consumers who are more willing to take risk will self-insure by seekinghigher insurance deductibles
However, with increases in DA, risk-averse consumers are worse off since theyare less able to shift this risk to another agent (insurer)
Other options available to insurance companies for increasing agents
precaution level are
Combinations of coinsurance and deductibles
Subsidizing preventive care
Health insurance policies will generally Have both deductibles and coinsurance provisions
May also offer preventive care such as annual physical examinations and routine blood
tests at reduced cost
Employer and Employee
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Employer and Employee
Relations Moral hazard exists whenever asymmetric information in theform of hidden actions is prevalent in a principal-agent
agreement For example, moral hazard can exist between an employer
(principal) and an employee (agent)
Unless an employer can constantly monitor productivity of employees Employees can engage in leisure while working (shirking) by reducing their
level of effort
For example, employees surfing the Net has become a major form of
shirking
Asymmetric information on level of employees productivitycreates inefficiencies
An objective of employers is to design contracts that provideemployee incentives directed at improving productivity and
reducing shirking
Pareto Efficiency with No Moral
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Pareto Efficiency with No Moral
Hazard Major incentive for employees effort is
compensation they receive for supplying their labor,in form of wage income
Assuming symmetric information (no moral hazard)
Can determine Pareto-efficient level of employee effort,E*
By considering employers objective function and an employeesparticipation constraint
No moral hazard implies that an employer canobserve an employees level of effort
Assume employer determines labor contract and
employee can then either accept or reject contract
Pareto Efficiency with No Moral
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Pareto Efficiency with No Moral
Hazard An employer is concerned with productivity of an employee
Denoted by production function q = f(E)
q is some output level
Given a per-unit output price of p and wage rate based on anemployees effort w(E)
Employers objective is maximizing profit from this employee
Employee has a cost of increasing effort in form of total opportunity costfrom lost shirking, TCE(E)
Let MCE(E) represent marginal cost of effort So MCE(E) = TCE(E)/E
In general, as illustrated in Figure 23.8, this marginalopportunity cost is U-shaped
Figure 23 8 Employees marginal
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Figure 23.8 Employee s marginal
opportunity cost of effort
Pareto Efficiency with No Moral
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Pareto Efficiency with No Moral
Hazard Marginal cost of effort may at first decline
For very low levels of effort (to left of EM), additional effort results inmarginal cost of effort declining
Spending so much time shirking, a little additional effort results in lowermarginal opportunity cost
At relatively higher effort levels (to right of EM), any additional effortraises this marginal opportunity cost
Employees payoff for E level of effort is
Difference in wage income, w(E)E, and total opportunity cost, TCE(E)
w(E)E TCE(E)
Instead of working for this particular employer, employee could beengaged in other activities
Being employed by another employer, being self-employed, or beingimmersed in total leisure
Pareto Efficiency with No Moral
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Pareto Efficiency with No Moral
Hazard Assume next-highest payoff from these alternatives is U
Employee will be willing to work for an employer if payoff is at least asgreat as U
Specifically, if w(E)E TCE(E) U
U is reservation-utility level, and equation is participation constraint
Employer must pay at least level U if he expects to hire employee Employers objective is then
Subject to w(E)E TCE(E) = U
Constraint is an equality because if w(E)E - TCE(E) > U Employer could lower wages and still hire employee
Pareto Efficiency with No Moral
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Pareto Efficiency with No Moral
Hazard Substituting constraint into objective function yields
F.O.C. is MRPE = MCE
For profit maximization, employer will equate marginalrevenue product of an employees effort, MRPE To employees marginal opportunity cost of effort, MCE
Solving this F.O.C. for E results in Pareto-efficient level of
employee effort, E* Illustrated in Figure 23.9, where MRPE is equated to MCE
Figure 23 9 Pareto-efficient level of
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Figure 23.9 Pareto-efficient level of
effort for a risk-averse employee
Pareto Efficiency with No Moral
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Pareto Efficiency with No Moral
Hazard Compensation scheme necessary for obtaining employeeeffort level E*
Where level of compensation just equals reservation-utility level plusemployees cost of effort
w(E)E = U + TCE(E)
If employer is risk neutral and employee risk averse, employer willfully insure employee against any wage risk
Employer will offer a fixed wage rate, w* = w(E*)
Optimal contract when effort is observable Specifies Pareto-efficient effort level E*
Fully insures a risk-averse employee against income losses
When employee is also risk neutral, insurance is not necessary
Any compensation scheme where wages are a function of profits, withw()E = U + TCE() will be efficient
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Inefficiency with Moral Hazard
In many cases, cost of monitoring effort prohibits constantlyobserving an employees level of effort For example, an employer is generally unable to observe a night
clerk at a convenience store or a truck driver for a furniture company
When effort is not observable, Pareto-efficient effort levelcomes in conflict with result of full insurance Only method for increasing employee effort is relating wages to
firms profit
Random nature of profit results in employee assuming some uninsuredrisk
Such conflicts create inefficiencies unless employee is risk neutral
A risk-neutral employee is only concerned with expected profit
Would not be concerned with any random nature of profit
Indifferent with taking uncertain profit in place of a certain wage
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Inefficiency with Moral Hazard
In contrast, when an employee is risk-averse Increased share of profit relative to a certain
wage does affect employee
Incentives for increased effort are directlyassociated with an employees cost of increasedrisk
Results in an additional constraint on employer
Employer not only maximizes profit subject to participationconstraint
w(E)E TCE(E) U
But also is subject to an incentive-compatibility constraint
Must offer a compensation scheme that gives an
employee an incentive to choose required effort level
I ffi i i h M l H d
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Inefficiency with Moral Hazard
When employer can directly observe employeesefforts
Employees will put forth required level of effortregardless of their desire
In contrast, when effort is not directly observable Employees can shirk by not putting forth required level of
effort To avoid such shirking, employers must offer a compensation
scheme to induce employee to offer E* units of effort Determined by setting employees payoff associated with E* at least
as great as payoff for any other level of effort
w(E*)E* TCE(E*) w(E)(E) TCE(E)
For all levels of effort E
At any wage below this constraint, employee will shirk
I ffi i i h M l H d
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Inefficiency with Moral Hazard
In the extreme case, not considering this incentive-compatibility constraint
Results in an employee seeking an effort level independent of his wages
Employee would minimize his total effort Optimal solution is for employee to totally shirk and not exert any effort
Analogous to zero level of precaution associated with insurance
Illustrated in Figure 23.6
Unless employer can design contracts that provide incentives for employees to choose effort
Ttonnement process will result in a zero level of effort
Inefficiency of E = 0 associated with moral hazard is represented by deadweightloss, area ABC in Figure 23.9
Designing employment contracts with compensation mechanisms that take intoconsideration this incentive-compatibility constraint will provide incentives foremployees to increase their work efforts
Will reduce inefficiency associated with wages not directly linked with level of effort
However, such contracts will be second-best Pareto-efficient allocations Still result in risk-averse employee not being fully insured
Only with symmetric information associated with no hidden action on part ofagent (employee) will a Pareto-efficient allocation exist
R id l Cl i
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Residual Claimant Large poultry enterprises use residual claimant production contracts with
independent farmers to raise chickens
By having farmers assume risk of raising chickens
Farmers will have incentives to take necessary effort to prevent disease and otherpossible adverse effects on chickens
USDA Economic Research Service estimates 52% of approximately
50,000 farms with poultry or egg production in 1995 reported use ofproduction contracts
Value of poultry and eggs produced under such contracts accounted for 85%of total value of all poultry and egg production
Farmers without contracts tended to be either large owner-integrated
operations or independents providing poultry and poultry products tolocal markets
In poultry contracting, employees are residual claimant to output
An example of a second-best Pareto-efficient compensation schemeincorporating incentive compatibility
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Residual Claimant A residual claimant is an agent (farmer) who
receives payoff from output after any fees are paidto a principal (poultry enterprise)
An employee will maximize payoff by
Equating marginal revenue product of employees effort toemployees marginal opportunity cost of effort
Examples of residual claimant contracts are franchises andemployee buyouts
Fast-food enterprises are a typical example of franchising
Owner of a fast-food establishment pays parent company afixed fee for right to operate (franchise)
Employees become residual claimant
Compensation is now dependent on profits of firm minus lumpsum payment to owners
R id l Cl i t
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Residual Claimant
Specifically, employees objective is to maximize consumersurplus plus economic rent minus franchise fee
F.O.C. is
MRPE = MCE
Although marginal benefit equals marginal cost, risk-averseemployees are not able to fully insure against losses Results in a second-best Pareto-efficient allocation
Such residual claimant contracts are very popular when employees areable to take precautions and reduce possible losses in profits at a lowercost than owners