Lemons Market

7/30/2019 Lemons Market

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2005, Southwestern

Slides by Pamela L. Hall

Western Washington University

AsymmetricInformation

Chapter 23


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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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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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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



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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



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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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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



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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



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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



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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



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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



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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



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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



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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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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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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

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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

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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

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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

Lemons Market

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