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Information theory


Information theory Asymmetric information and its effect on market outcomes * Information theory Reminder: Perfect competition is defined by the following 5 ... – PowerPoint PPT presentation

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Title: Information theory

Information theory
  • Asymmetric information and its effect on market

Information theory
  • Reminder Perfect competition is defined by the
    following 5 conditions
  • Large number of agents (Atomicity)
  • Homogeneous products
  • Free entry and exit from the market
  • Perfect information
  • Perfect mobility of inputs
  • We now know that these 5 conditions are never
    fully met in reality they serve as a benchmark

Information theory
  • We have examined the effect of a limited number
    of agents a lack of entry in the market, a lack
    of homogenous products
  • But we havent explored the consequences of
    dropping the assumption of perfect information
  • Agents constantly are constantly informed,
    without delay, of the changing market conditions
  • Agents also know all perfectly all the
    characteristics of the goods No hidden defects,

Information theory
  • Clearly this assumption is unrealistic !!
  • One could even argue it is the most unrealistic
    of the 5 !
  • In reality
  • It takes time to gather information (about goods,
    jobs, opportunities)
  • This search therefore has an opportunity cost
  • Therefore, information is intrinsically valuable
  • If an agent has private information in a given
    situation, is it in his interest to share it with
    other agents?

Information theory
The market for lemons
Adverse selection
Moral hazard
The principal-agent problem
The market for lemons
  • Akerlof 1970 The Market for Lemons Quality,
    Uncertainty and the Market Mechanism
  • Akerlof investigates the effect of asymmetric
    information on the market equilibrium, based on
    the example of the used cars market.
  • Assumptions
  • Used cars can either be of a good quality
    (plums), or they can be faulty (lemons).
  • The seller knows the level of quality of his own
  • Potential buyers do not know the level of quality
    and cannot observe it ? asymmetric information
  • How does this affect the market outcome?

The market for lemons
  • The buyer cannot observe the quality of a
    particular car.
  • When meeting a car owner, he will only be
    prepared to offer a price which corresponds to
    the average quality of the cars on the market.
  • He does not have any information which would
    allow to tailor his offer for a particular car.
  • The owner of a lemon
  • Has no interest in revealing the information he
    has about the (low) quality of his car
  • If he does so, he will receive a lower offer (by
    improving the information available to the buyer)
  • By keeping the information for himself, he can
    expect a price higher than the value of the car ?
    market power

The market for lemons
  • The owner of a plum
  • Has no interest of selling his car at the average
    price offered by the buyers (he knows that the
    car is really worth more than the average offer)
  • Crucial aspect He cannot improve the information
    of the buyer by revealing the quality of the car
  • This is because the real information (my car is a
    plum) is drowned by the noise made by the
    owners of lemons !! -Thats what they all
  • So his best option is to exit the market.
  • As a result the average quality of cars on the
    market decreases

The market for lemons
  • Another crucial aspect
  • What happens if the buyers realise that the goods
    cars are exiting the market ?
  • Or if they anticipate this will happen (game
    theory aspect)
  • They reduce their average offer in line with the
    reduction in average quality
  • Following this reasoning, more owners of plums
    leave the market
  • In the end, the market disappears !
  • In theory, a market for lemons cannot exist for

The market for lemons
  • This is why you dont see spontaneous markets
    for second-hand cars...
  • The quality of a second-hand car can vary a lot
  • Buying a car, even second hand, is expensive
    (high opportunity cost)
  • Concealing problems with a car is easy and cheap
  • So buying a random car from a complete stranger
    is a big risk !!

The market for lemons
  • One of the biggest market for lemons is ??
  • eBay !!
  • Example MP3/MP4 fraud
  • You open a sellers account on eBay
  • You buy (or manufacture) a shipment of cheap, low
    capacity MP3 players (128-512MB)
  • You hack the software so that when plugged into a
    computer, it declares a high storage capacity
  • You sell it for the price of a 4-8GB player

The market for lemons
  • Other example Forgeries
  • 70 of Tiffany Co jewellery sold on eBay is
    fake (NYT, 27/11/2007)
  • In theory, eBay has a feedback mechanism for
    sellers (which has been changed now)
  • the negative feed-back (information) should allow
    these markets for lemons to collapse (as the
    theory says they should)
  • But fraudsters are smart They set up multiple,
    genuine low-value auctions to build up positive

The market for lemons
  • Fraud has become a very big problem for eBay
    (even though it represents 0.01 of sales)
  • Fall in confidence from customers
  • Lawsuits from luxury companies (Tiffany, Vuitton,
  • National legislations forcing eBay to monitor the
    quality of goods sold.
  • The problem is that the whole point of eBay is
    that anybody can sell anything anywhere !
  • Changing this changes the whole company
  • Dealing with this asymmetric information problem
    is a big challenge

Information theory
The market for lemons
Adverse selection
Moral hazard
The principal-agent problem
Adverse selection
  • What is adverse selection ?
  • An asymmetric-information problem that occurs
    when the quality of the good is unobservable by
    one of the parties before the transaction /
    contract occurs
  • Example
  • The market for lemons already mentioned
  • More critically the insurance market
  • The sub-prime mortgage crisis.

Adverse selection
  • Car insurance market example
  • Imagine you want to get insurance for a new
  • But youve been stopped once already for drunk
    driving, and youve had a speeding ticket.
  • What will happen if you reveal this information
    to your insurer?
  • Similar problems with medical insurance
  • Companies only want to insure healthy people!
  • Which is why health insurance is often public

Adverse selection
  • Avoidance mechanisms
  • The problem is the asymmetric information prior
    to the transaction,
  • Most methods rely on revealing this information
  • 2nd hand cars Servicing history, MOT, etc.
  • Labour market Interviews and trial periods
  • Insurance market Insurance history,
    questionnaires, etc.
  • Health insurance health checks, age limit, etc.

Information theory
The market for lemons
Adverse selection
Moral hazard
The principal-agent problem
Moral hazard
  • What is Moral hazard?
  • An asymmetric-information problem that occurs
    when the behaviour of one party is unobservable
    by the other party after a contract is agreed
  • The terms the contract were agreed on change once
    the contract is signed
  • Examples
  • The insurance market (again!)
  • The labour market (shirking)

Moral hazard
  • Car insurance example
  • Your get third-party insurance for your car
    (legal minimum insurance)
  • Youre late for an appointment, you park your
    car. On your way, you cant remember if you
    removed the car-radio/tom-tom, etc.
  • What do you do ?
  • How does your decision change if you have
    comprehensive insurance ?
  • Your level of risk changes with the level of

Moral hazard
  • Labour market example
  • You are hired by a private firm, your contract is
    fixed-term and your pay is result-based.
  • A big deadline is close Do you work Saturdays?
  • You are hired to become a civil servant. Your
    career track is guaranteed, you cant be fired
    and your pay and pension are inflation protected.
  • Do you still turn up to work on Saturdays?
  • Your level of effort changes with the
    characteristics of your contract!

Moral hazard
  • Avoidance mechanisms
  • The problem is the asymmetric information on
    behaviour after the transaction
  • Most mechanisms involve monitoring behaviour or
  • Car insurance excess fees, bonus-malus systems
  • Labour market annual monitoring reports,
    results-based incentives (stock-options, bonuses)

Information theory
The market for lemons
Adverse selection
Moral hazard
The principal-agent problem
The principal-agent problem
  • Most of these aspects of asymmetric information
    can be grouped into the principal-agent problem
  • An agency problem is a situation where a person
    (the principal) hires another person (the agent)
    to carry out a task in his name.

The principal-agent problem
  • The assumption is that the agent has more
    knowledge than the principal about the effort
    action being carried (division of labour).
  • The agent can use this to reduce his effort (self
    interest) without the principal noticing.

The principal-agent problem
  • This framework can be used to identify and deal
    with the information asymmetries in the design of
  • What information revealing-mechanisms to use to
    minimise the asymmetry.
  • The optimal intensity of monitoring (which is
    costly to the principal)
  • The optimal intensity of incentives (which are
    costly and can lead to rent-seeking behaviour)

The principal-agent problem
  • An applied example Stock markets
  • The principals are the shareholders of a firm
  • They want the firm to do well (get a good return
    on their investments)
  • But there are a lot of shareholders!
  • They dont know much about management...
  • Or they dont have the time...
  • Or they disagree...

The principal-agent problem
  • So they hire an agent the CEO
  • He will run the firm for the shareholders
  • But there is a massive information asymmetry !
  • The CEO only reports to shareholders once a
    quarter (at best) ...
  • And he can always find a good reason to justify
    bad results, or use some creative accounting to
    hide losses.
  • How can they make sure that the CEO doesnt
    follow his self interest?

The principal-agent problem
  • The principals can use
  • Monitoring of the CEO principals can hire audit
    cabinets to certify accounts (they have to by
  • Incentivise the CEO bonuses and stock options
  • But there are two possible problems
  • The CEO can try and cook the books to hide his
    self interest effort...
  • The hiring of audit cabinets is in itself and
    agency problem they can be self interested and
    lie as well!!

The principal-agent problem
  • Illustration The Enron scandal of December
    2001 23 billion worth of hidden debts!!
  • How was this not picked up by the audit cabinet
    (Arthur Andersen) ?

The principal-agent problem
  • Well it was... But they lied about the accounts!
  • Arthur Andersen was closed down in 2002 for
    destroying evidence of Enrons management

The principal-agent problem
  • The Enron Collapse illustrates the problems
    involved in contract design
  • We already know that NO incentives leads to self
    interested behaviour...
  • But CEO Incentives that are too high can lead to
    rent seeking behaviour which is just as bad.
  • Monitoring institutions can worsen the problem
    rather than improve it if they themselves succumb
    to an agency problem
  • See the notation agencies role in the subprime
    mortgage crisis!!