ASYMMETRIC INFORMATION - PRE-CONTRACTUAL OPPORTUNISM From an economists viewpoint, contracts are useful because they are the stuff

that binds. But even more important, from an organizational perspective, contracts serve to govern transactions defining relationships between parties. We analyze the crafting of incomplete contracts, agreements that fail to specify actions under every conceivable course of events. When a contract is crafted, the involved parties are forced to forecast future events and acquire costly information. Individuals will never become fully informed because doing so is prohibitively costly. In economic terms, individuals are subject to bounded rationality, that is, they know that large transaction costs will prevent them from being fully informed. Economic efficiency comes in to play here because improvements in the contracting process through minimizing transaction costs will increase organizational productivity. Contract A contract is an interlocking set of mutual promises that are enforceable and acknowledged by some disinterested third party. Generally, a contract specifies actions that each party will take and may assign decision-making powers. Do contracts replace markets? The difference between contracts and markets is that relational contracting becomes important either when a market does not exist or when the transaction costs associated with market transactions are relatively large. Relational means that contracts are almost impossible to specify a mutually agrreabel set of actions for every possible contingency that may arise over the life of the contract. In other words, contracts are incomplete. Competitive markets provide many of the benefits of contracting through market discipline. A functioning, competitive market provides discipline if enough buyers (sellers) learn if a particular sellers (buyers) poor behaviour so as to curtail that sellers activities. Discipline under relational contracting is somewhat harder to identify. Contracting problems fall into two broad categories: those arising from imperfect information and those related to asset specificity. In an environment of imperfect information and boundedly rational individuals, agreements must be crafted with some effort. Rational individuals will fear being taken advantage of by the situation itself or by other parties to the transaction. We define opportunism as individuals pursuing their own interests at the expense of to others with less than complete honesty. Opportunism may arise when the contract is being negotiated, within the contract, or through regenerating on agreed-upon terms.

ASYMMETRIC INFORMATION Pre-Contractual Opportunism This is a situation where there is imperfect knowledge. In particular it occurs where one party has different/less information to another. Prior to signing a contract, the parties involved must reach a consensus as to what contingencies the agreement will govern. One contracting party may be better informed regarding the likelihoods of each of the several possibilities operating environments occurring after the contract date. It is also conceivable that information regarding the alternative opportunities, costs of delay and commitment possibilities of the involved parties may be imperfect. Informational asymmetries give rise to transaction costs and, as much, they hinder arrival at an efficient agreement. A good example is when selling a car; the owner is likely to have full knowledge about its service history and likelihood to break down. The potential buyer, by contrast, will be in the dark and he may not be able to trust the car salesman.

Asymmetric information in Financial Markets Asymmetric information is a problem in financial markets such as borrowing and lending. In these markets the borrower has much better information about his financial state than the lender. The lender has difficulty knowing whether it is likely the borrower will default. To some extent the lender will try to overcome this by looking at past credit history and evidence of salary. However, this only gives limited information. The consequence is that lenders will charge higher rates to compensate for the risk. If there was perfect information, banks wouldn't need to charge this risk premium.

Akerlofs Lemon Problem - Automobile Market

This example provides an alternative explanation for the price difference between new and used cars, i.e., those that have left the showroom. For simplicity, suppose there are new and used cars and good and bad cars.

The consumer purchases a new car without knowing whether it is a good car or a lemon. However, consumers know it is good with probability and a lemon with probability 1 - . After owning the car for awhile the owner is able to re-estimate the probability that its good. The buyers of used cars cannot estimate this probability and so an asymmetry of information exists in the used car market. Since buyers cannot distinguish between good and bad cars, they must all sell at the same price. Clearly, used cars cannot have the same value as new cars since it would allow lemon owners to sell a used car and purchase a new car at a higher probability of being good. The new good car owner is locked in since he cannot receive the true value, or the expected value, of the car. Thus bad cars tend to drive out good cars. The Used Cars uncertainty problem Akerlof's paper uses the market for used cars as an example of the problem of quality uncertainty. A used car is one in which ownership is transferred from one person to another, after a period of use by its first owner and its inevitable wear and tear. There are good used cars ("cherries") and defective used cars ("lemons"), normally as a consequence of several not-always-traceable variables such as the owner's driving style, quality and frequency of maintenance and accident history. Because many important mechanical parts and other elements are hidden from view and not easily accessible for inspection, the buyer of a car does not know beforehand whether it is a cherry or a lemon. So the buyer's best guess for a given car is that the car is of average quality; accordingly, he/she will be willing to pay for it only the price of a car of known average quality. This means that the owner of a carefully maintained, never-abused, good used car will be unable to get a high enough price to make selling that car worthwhile. Therefore, owners of good cars will not place their cars on the used car market. The withdrawal of good cars reduces the average quality of cars on the market, causing buyers to revise downward their expectations for any given car. This, in turn, motivates the owners of moderately good cars not to sell, and so on. The result is that a market in which there is asymmetrical information with respect to quality shows characteristics similar to those described by Gresham's Law: the bad drives out the good (although Gresham's Law applies to a different situation).

"Lemon market" effects have also been noted in other markets, such as used computers. There are also parallels in the insurance market, where, unless those least likely to need insurance (i.e., those least likely to get in accidents) are forced to buy insurance, it is those most likely to need insurance compensation who tend most to buy insurance.

Statistical abstract of the problem Suppose we can use some number, q to index the quality of used cars, where q is uniformly distributed over the interval [0,1]. The average quality of a used car which could be supplied to the market is therefore 1/2. There are a large number of buyers looking for cars who are prepared to pay their reservation price of 3/2q, for a car that is of quality q. There are also a large number of sellers who are prepared to sell a car of quality q for the price q. If quality were observable, the price of used cars would therefore be somewhere between q and 3/2q, and the cars would be sold and everyone would be perfectly happy. If the quality of cars is not observable by the buyers, then it seems reasonable for them to estimate the quality of a car offered to market using the average quality of all cars. Based on this estimation, the willingness to pay for any given car will therefore be 3/2qaverage, where qavg is the average quality of all the cars. Now, assume that the equilibrium price in the market is some price, p, where p > 0. At this price, all the owners of cars with quality less than p will want to offer their cars for sale. Since again, quality is uniformly distributed over the interval from 0 to this p, the average quality of the cars offered for sale at p will be worth only p/2. We know however that for an expected quality worth p/2, buyers will only be willing to pay (3/2)(p/2) = 3/4p. Therefore we can conclude that no cars will be sold at p. Because p is any arbitrary positive price, it is shown that no cars will be sold at any positive price at all. The market for used cars collapses when there is asymmetric information. The paper by Akerlof describes how the interaction between quality heterogeneity and asymmetric information can lead to the disappearance of a market where guarantees are indefinite. In this model, as quality is undistinguishable beforehand by the buyer (due to the asymmetry of information), incentives exist for the seller to pass off low-quality goods as higher-quality ones. The buyer, however, takes this incentive into consideration, and takes the quality of the goods to be uncertain. Only the average quality of the goods will be considered, which in turn will have the side effect that goods that are above average in terms of quality will be driven out of the market. This mechanism is repeated until a no-trade equilibrium is reached. As a consequence of the mechanism described in this paper, markets may fail to exist altogether in certain situations involving quality uncertainty. Examples given in Akerlof's paper include the market for used cars, the death of formal credit markets in developing countries, and the difficulties that the elderly encounter in buying health insurance. However, not all players in a given market will follow the same rules or have the same aptitude of assessing quality. So there will always be a distinct advantage for some vendors to offer lowquality goods to the less-informed segment of a market that, on the whole, appears to be of reasonable quality and have reasonable

guarantees of certainty. This is part of the basis for the idiom, buyer beware. There is no reciprocal danger of a market for a good product collapsing in this manner when the asymmetry is in favour of the buyer, that is to say, when the buyers can assess more accurately the quality of the products than the sellers. In this case, regular market forces of supply and demand will prevail, the sellers will get the highest price paid, and the trend will be to weed out products with prices in excess of their quality. This is likely the basis for the idiom that an informed consumer is a better consumer. An example of this might be the subjective quality of fine food and wine. Individual consumers know best what they prefer to eat, and quality is almost always assessed in fine establishments by smell and taste before they pay. That is, if a customer in a fine establishment orders a lobster and the meat is not fresh, he can send the lobster back to the kitchen and refuse to pay for it. However, a definition of 'highest quality' for food eludes providers. Thus, a large variety of better quality and higher priced restaurants are supported. Critical reception George E. Hoffer and Michael D. Pratt, profoundly missing the point that information asymmetry may exist in the market for all goods, state that the economic literature is divided on whether a lemons market actually exists in used vehicles." The authors research supports the hypothesis that known defects provisions, used by US states (e.g., Wisconsin) to regulate used car sales have been ineffectual, because the quality of used vehicles sold in these states is not significantly better than the vehicles in neighbouring states without such consumer protection legislation.[1] Both the American Economic Review and the Review of Economic Studies rejected the paper for "triviality," while the reviewers for Journal of Political Economy rejected it as incorrect, arguing that if this paper was correct, then no goods could be traded. Only on the 4th attempt did the paper get published in Quarterly Journal of Economics. [2] Today, the paper is one of the most-cited papers in modern economic theory (more than 8,530 citations in academic papers as of May 2011),[3] and has profoundly influenced economic thinking in virtually every field of economics, from industrial organisation and public finance to macroeconomics and contract theory. Criteria A lemon market will be produced by the following: 1. Asymmetry of information, in which no buyers can accurately assess the value of a product through examination before sale is

2. 3. 4.

5.

made and all sellers can more accurately assess the value of a product prior to sale An incentive exists for the seller to pass off a low quality product as a higher quality one Sellers have no credible disclosure technology (sellers with a great car have no way to disclose this credibly to buyers) Either a continuum of seller qualities exists or the average seller type is sufficiently low (buyers are sufficiently pessimistic about the seller's quality) Deficiency of effective public quality assurances (by reputation or regulation and/or of effective guarantees/warranties)

Impact on markets The article draws some conclusions about the cost of dishonesty in markets in general: The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.

P D0

Using Price to Infer Quality in The Used Car Market

= excess supply

Po S D1 S Q Q0 Q1

The shape of the demand curve shows that in general, quality increases with price; but at some point diminishing returns enter. In other words, quality increases with price at a decreasing rate: in the lower price ranges, price increases lead to large quality increases perceived and so demand for the product rises, but as the price rises even further, quality increases are relatively smaller. If we define value as the quality-price ratio, then there will be a single quality-price ratio

that represents maximum value. This is the point where the two demand curves meet i.e. the point where the additional increase in price would lead to a fall in demand rather than a rise. This occurs at Po. This price in effect becomes the market price for used cars. At any price less than Po, the quantity demanded falls because the product is perceived as a lemon. The mechanics of this positive relationship between price and quantity depend crucially on the asymmetric information and the notion of value as a quality-price ratio. Lowering price indicates that a given car offers lower quality than other similar cars. A price increase indicates that a given car is better than other similar cars. This could not be sustained as equilibrium. Supply curve: as the price of the product rises, sellers are willing to supply more. In the case of used cars, one likely argument is that as the prices rise more people are willing to sell their cars. Causal empiricism indicates that the used car market is typically characterized by excess supply at any point in time, confirming buyers wariness when facing sellers with superior information. *Strategic misrepresentation is the source of the problem in this example. Haggling over a sales price is an attempt by a buyer and a seller strategically to misrepresent their valuation of a transaction. This is possible, given the basic economics behind exchange. Consumers buy an item because it yields them positive utility. Implicitly, buyers place a valuation, termed reservation price, on an item (given their preferences, income and prices of other goods). The reservation price is the maximum amount a consumer would pay for the item. Consumers strive to maximize the net value of their purchases by paying a price as far below their reservation price as is possible. In the same way, sellers place a floor on what they will provide the good for the minimum supply price. Bargaining over a sales price typically involves the seller desiring a high price and the buyer offering a low price. If buyers and sellers are less than truthful about the valuations they place on goods, it is possible that efficient exchanges may not take place. Sellers of used cars can use parts and labour warranties to signal their confidence regarding the quality of their product. Furthermore, a seller who wants to signal that he is confident of the actuarially fair prices he offers, could promote price match with other sellers plus reward guarantees by retailers i.e. offering to refund the difference in the price plus a bonus. Asymmetric information in Insurance Another example of asymmetric information is with regard to insurance. When insuring a good the insurer is uncertain how well the customer will look after a piece of property. For example, if a consumer

was careless with locking his bike, the insurer would not want to insure it. This problem can lead to the related problem of adverse selection. To overcome asymmetric information in insurance, insurers will give big discounts for 'no claims bonuses' this is the best way of gaining better information about 'careful' and 'unlucky' consumers. Asymmetric information can also be analysed with game theory. For example, when deciding whether to cut or increase prices, firms will be uncertain about how their rivals will behave and react. They will have to make decisions whilst trying to second guess how other firms will respond. Adverse selection problem: high-risk individuals have more to gain from an actuarially fair insurance. Some low risk individuals will opt out if an average price is set. The result is worsening the quality of the pool an adverse selection from it. The problem facing the insurance companies is fairly simple. Those most likely to file a claim against a policy are also those most likely to purchase insurance. Those who are at least likely to collect, i.e. those who are safety and health conscious, may still buy some insurance, but will not pay too high a price for it. In insurance markets, the information regarding policyholder risks is asymmetrically held. The party buying the policy has much more information regarding the potential risks they pose than does the insurance firm. Suppose that an insurancecompany is making losses; that is, that revenues from policy premiums and investments are less than the amount paid out for claims. Can the insurer simply raise rates? The answer is no. Increasing premiums will result in a more serious adverse selection problem for the insurer. At higher rates, those customers who pose lower risks will opt out of the market, contact another underwriter or purchase less insurance. High-risk policyholders, on the other hand, are less likely to opt out. Opting out would mean that they would have to find a new insurer who will want to assess the risks posed by the client independently. This examination may lay bare the true risks posed by the client and result in even higher premiums for him. Screening Screening means that the uninformed parties to an agreement undertake activities in order to cause the informed parties to distinguish between themselves. Screening means that one contracting partner demands certain elements in the set of observed characteristics that are correlated with unobserved but desirable elements. Screening is then a strategy available to an uninformed

party that, if successful, will get the better-informed party to reveal information. So what can insurers do? Gather data about potential clients and price insurance accordingly. Estimate health care needs using factors such as age, race, sex, location, BMI, smoking status, etc. BUT, collecting data about health is costly. Also, statistical discrimination may be undone by legislation. Study and evaluate the dangers from peoples pre-existing conditions. Insurers would not cover conditions for a period of time that were known to exist prior to coverage e.g. if they have diabetes, the insurance policy would not cover expenses related to diabetes. BUT, this reduces turnover in insurance. It may also create job lock (will do later). Group insurance: gather people (by area, employer, union, community i.e. schools) and use a price policy by pooling the risk. BUT, insurers need to require purchase in this case (otherwise the low risks opts out). Construct policies that appeal to high and low risk customers individually - offer menus of contracts. Their choice of insurance reveals valuable information about themselves. BUT, sometimes a person who chooses full coverage of his automobile does not necessarily mean that he is a reckless driver and is more likely to be involved in an accident but rather simply that he is riskaverse. Signalling Signalling occurs when the better-informed party makes certain verifiable facts known, which, when properly interpreted, may indicate the presence of other unobservable but desirable characteristics. In other words, one gets to signal his type to the uninformed party.

A university education serves not just to educate but also to signal the ability to learn. Businesses often desire employees who are able to adapt to changing circumstances and who can easily and readily learn new strategies and approaches. Education signals such abilities because it will be easier for quick learners to perform well at university. A simple model suffices to illustrate the point. Suppose there are two types of people. Type A has a low cost cA of learning, and type B has a higher cost cB of learning. It is difficult to determine from an interview whether someone is type A or type B. Type A is worth more to businesses, and the competitive wage wA (expressed as a present value of lifetime earnings) for type As is higher than the wage wB for type Bs. A person can signal that she is a type A by pursuing a sufficient amount of education. Suppose the person devotes an amount of time x to learning at university, thus incurring the cost cA x. If x is large enough so that wA cA x > wB > wA cB x, it pays

the type A to obtain the education, but not the type B, if education in fact signals that the student is type A. Thus, a level of education x in this case signals a trait (ease of learning) that is valued by business, and it does so by voluntary choicethose with a high cost of learning choose not to obtain the education, even though they could do it. This works as a signal because only type A would voluntarily obtain the education in return for being perceived to be a type A. There are several interesting aspects to this kind of signalling. First, the education embodied in x need not be valuable in itself; the student could be studying astronomy or ancient Greek, neither of which are very useful in most businesses but are nevertheless strong signals of the ability to learn. Second, the best subject matter for signalling is that in which the difference in cost between the type desired by employers and the less desirable type is greatestthat is, where cB cA is greatest. Practical knowledge is somewhat unlikely to make this difference great; instead, challenging and abstract problem solving may be a better separator. Clearly, it is desirable to have the subject matter be useful, if it can still do the signalling job. But interpreting long medieval poems could more readily signal the kind of flexible mind desired in management than studying accounting, not because the desirable type is good at it or that it is useful, but because the less desirable type is so much worse at it. Third, one interprets signals by asking, What kinds of people would make this choice? while understanding that the person makes the choice hoping to send the signal. Successful law firms have very fine offices, generally much finer than the offices of their clients. Moreover, there are back rooms at most law firms, where much of the real work is done, that arent nearly so opulent. The purpose of the expensive offices is to signal success, essentially proclaiming, We couldnt afford to waste money on such expensive offices if we werent very successful. Thus, you should believe we are successful. The law firm example is similar to the education example. Here, the cost of the expenditures on fancy offices is different for different law firms because more successful firms earn more money and thus value the marginal dollar less. Consequently, more successful firms have a lower cost of a given level of office luxury. What is interesting about signalling is that it is potentially quite wasteful (typically the signaller must make a commitment to an investment which will be a sunk cost if in any resulting transactions he/she emerges as a low-quality worker). A student spends 4 years studying boring poems and dead languages in order to demonstrate a love of learning, and a law firm pays $75,000 for a conference table that it rarely uses and gets no pleasure out of in order to convince a client that the firm is extremely successful. In both cases, it seems like a less costly solution should be available. The student can take standardized tests, and the law firm could show its win-loss record to the potential client. But standardized tests may measure test-taking skills rather than learning ability, especially if what matters is the learning ability over a long time horizon. Win-loss records can be massaged, and in the majority of all legal disputes, the case settles and both sides consider themselves the winner. Consequently, statistics may not be a good indicator of success, and the expensive conference table may be a better guide. Rationing goods and services

Adverse selection may also occur in markets as a rationing device when price increases are not permitted in order to reduce excess demand. A good example of this phenomenon is the market for loanable funds and credit rationing by banks and other lenders. In this setting of imperfect information, borrowers are more aware of the actual risks they pose than are lenders. An informational asymmetry exists, preventing efficient exchange.

Banks are well aware of the risk-return trade-off characterizing most investment projects. Higher returns can be earned only by bearing

higher risk. To a lender, this trade-off presents a unique environment. At low interest rates, potential borrowers representing different levels of risks are plentiful. Notwithstanding the efforts of the bank to identify the risks associated with each borrower, the odds of any borrower presenting a small risk are relatively high. At high interest rates, the pool of potential borrowers is larger; and further, a significantly larger percentage of these borrowers will pose high risks. This is because of the trade-off mentioned previously: only high-risk borrowers will anticipate the returns necessary to pay the higher interest rates. *Borrower incentives: higher prices cause borrowers to select riskier projects.

There are two offsetting components to the expected returns for the lender. Initially, as interest rates increase, returns to the lender increase. This is because, in the lower range of interest rates, risky borrowers comprise a smaller percentage of the pool of potential borrowers. Thus defaults are fairly low. In the higher range of interest rates, the returns to the lender are still increasing but at a diminishing rate. In the higher range of interest rates, an even riskier pool of borrowers emerges. The higher the interest rates, the greater are the chances that a borrower will default on his loan. At some point - after r* - the gains from further increases in the interest rate are more than offset by the increased proportion of riskier borrowers attracted. r* is the rate which maximizes the expected return to lenders.

S Interest % r

The Stiglitz-Weiss Credit Rationing Model

S Amount Lent

In opposition to the used car market, here lenders are price setters and not takers. As illustrated also by the previous graph, lenders are willing to lend money as the interest rate rises and as their expected return rises at an increasing rate. After r however, the lenders expected return starts decreasing and so the perverse supply curve. The demand curve illustrates that as interest rates increase, the demand for loans falls as low risk borrowers exit the market. At r therefore, there is an excess demand for credit with lenders using non-price rationing ( credit rationing i.e. setting an interest rate that will clear the loanable funds market). Role of legislation/regulation In some markets the state (or some body licensed by the state) may monitor suppliers on behalf of suppliers clients. For example, suppliers of long-run financial products (life assurance, pensions, etc.) are typically monitored to try and assure quality. In the US federal legislation prohibits insurers from designing policies based on statistical facts about the clients. Professional services (law, medicine) are typically overseen by professional bodies that have a legal monopoly to control practitioners. Other solutions to the problem of asymmetric information: Third party arbitration Reputation: building a name, a status Advertising: a way to invest in reputation Bundling: that is the strategy of grouping multiple items together and selling them as a group. Bundling allows sellers to better predict the demand for the bundle. While it is difficult to know which items in the group an individual person wants, they are likely to value some of the items enough to purchase the bundle, even if they don't value any of the items enough to buy it separately. However, this only works when it doesn't cost much to sell extra

items in a bundle that are unwanted. Information goods fit this profile since it doesn't cost anything to make extra copies. Intermediation: in markets where a severe problem of asymmetric information exists such as the used cars market, trade mostly occurs between buyers and intermediaries i.e. car dealers. This allows the reputation of the intermediary to support the trade; otherwise infrequent trading would leave the potential buyer uninformed about the seller. Creation of sellers rating systems by neutral parties or the buyers: e.g. ebay

Some problems still remain however. For example, with financial products, especially pensions have the characteristics that defects are only observed after a long time. Market solutions such as the reputation of the seller, and regulation are partial and typically observed and thus do not provide that much information. Two-sided market intermediaries

A market in which market makers (or specialists) are required to give both a firm bid and firm ask for each security in which they make a market. In other words, those making the market must be willing to both buy and sell at the prices they quote. Two-sided market intermediaries not new: a newspaper or TV station brings together advertisers and readers/viewers. But the digital age has increased the importance of two-sided markets. Example: a games console supplier provides a platform bringing together games developers and players. Supplier endorsement signals minimum quality. Price comparison sites (Shopbots) (Shopper.com, NexTag.com etc.) provide information and bring consumers to sellers and sellers to consumers. These sites encourage rating of suppliers and de-list highly unsatisfactory suppliers. Shopbots help solve the information asymmetry by direct provision of information and indirectly by policing the behaviour of listing sellers.