Asymmetric information

Question 1

What is moral hazard?

Answer 1

hidden action

Question 2

Give an example of moral hazard with a plumber?

Answer 2

Employing a plumber
Your boiler breaks down
You employ a plumber to Öx your boiler
The plumber knows a lot more about how to Öx boilers than you do
You need to be sure that the plumber takes the right actions and does
not charge you too much

Question 3

What is the problem here in this plumber example?

Answer 3

It is you not the plumber who you employ who bears the cost of doing a bad job.

Question 4

How is there a moral hazard problem in finance?

Answer 4

Traders take risks on behalf of investors.

Question 5

What is adverse selection?

Answer 5

Economic situation which some agents hold private information that is not known to others ( hidden information)
e.g. buying a second hand car ( you want to buy a car, you want know if its reliable, you find and one and the owner tells you its reliable( the owner may be lying), as you are not an expert you cannot check for yourself, so you need trust in owner)

Question 6

What are moral hazard and adverse selection a problem of?

Answer 6

Asymmetric information.

Question 7

Why doesn’t everyone know everything?

Answer 7

Its costly and impossible for everyone to know everything ( hence we have a division of labour for specialisation.

Question 8

What are the implications of moral hazard?

Answer 8

It can have implications for both efficiency and equity.

Question 9

What is the best way to model moral hazard and what are we going to model?

Answer 9

Principal agent problem and we are going to look at the optimal compensation problem.

Question 10

So with the optimal compensation problem who is the principal and agents and what are we interested in?

Answer 10

1) A principal: who designs a contract
2) And agent: who is contracted with

We are interested in the design of optimal contracts where
1) the actions of the agent cannot be monitored directly

Question 11

Now the principal cannot observe the effort of the agent,
What can the outcome of the task be?
What is the princpal payoff ( don’t include costs) if success and failure.
How do we show what the agents effort can be and what is the cost function for agent, and what does this effort mean and why is effort not always 1?

Answer 11

Effort creates a disulitiy with a quadratic cost function

Question 12

Assume that the agent has no wealth so cannot be punished
(financially) for failure
But she can be rewarded for success.
To perform the task, the agent is therefore offered what? and what else does she have?

Answer 12

Question 13

Firstly we are going to look at full information benchmark ( what does this mean) what does this mean for the 2 part contract the agent gets?

Answer 13

The principal can contract on the amount of effort that the agent puts in. Putting e although doesn’t guarantee success. This means you don’t have to give bonus.

Question 14

What is the payoff which makes the agent participate in the contract for full information benchmark, how is the cost function affected what is the lowest possible wage??

Answer 14

What this shows that the higher i contract on effort i have to pay a higher wage, so that it at least = outside option. SO WAGE MUST = OUTSIDE OPTION.( THIS IS THE LOWEST WAGE POSSIBLE)

Question 15

What is the princpal payoff with full information benchmark, where there is no bonus, but the princpal pays a wage ( rearrange the payoff from last flashcard, to solve for w and substitute in princpals payoff)

Answer 15

Probability of success X expected payoff - W.

Question 16

We want to find the optimal effort level with full information benchmark, so how do we do this ( HINT using princpals payoff)?

Answer 16

Maximise principals payoff utility with respect to e and then = 0 then find out what e is.
So e = pie/c ( which is the optimal amount of effort i would want agent to put if i could observe the agents effort.)

Question 17

Let c = 10 and π = 8
Then what is optimal effort?
Why didn’t we choose effort level = 1

Answer 17

If i choose effort level = 100 it would be too expensive.

Question 18

What is incentive compatibility and why does it matter ?

Answer 18

refers to the idea that we know there is asymmetric information but princpals must anticipate this when making contracts. It matters because you would be naive to think that if i you could make a normal contract and you will get what you want without an incentive for the agent.

Question 19

So suppose principal cannot observe effort and the agent gets a fixed wage and a bonus depending on success of task, what is the agents ultity function and what is the optimal level of effort now?

Answer 19

Fixed wage + probability of getting bonus x bonus - cost of effort.

Question 20

What is now the princpals payoff now without full information? knowing that he has to pay a bonus and fixed wage and profit/ payoff depends on success.
What does the princpal also have to respect, so the agent doesn’t turn down contract. What is the tradeoff here for princpal?

Answer 20

Effort depends on b, but paying more b means improving performance but reducing princpals payoff if success.

Question 21

So we want the contract to be incentive compatible, so given the princpal cannot the agents effort subisutute the incentive compatible level of effort into the the principals payoff and the agents payoff ( sub e = b/c where you see e)

Answer 21

Question 22

So step 2, what are we trying to maxmise in the to find the optimal contract when there is moral hazard? Do we need wage?

Answer 22

Step 2: Maximize the principalís payo§ subject to the agent getting
at least u

Question 23

By plotting the agent and princpals ultity as a function of level of bonus paid, what 3 observations can we make ?

Answer 23

1) Utility for the agent is increasing in B.
2) The optimal level of bonus that maximises princpal payoff whilst trading off the fact that you are paying for more effort, but getting more for it is the stationary point.
3) As b goes over the optimal b the princples ultity is falling as a larger share of the bonus is going to agent

Question 24

What are the 2 cases we want to look at for the optimal contract when such that we maxmise the blue function subject to the agent getting at least a level of utility u.

Answer 24

Case 1 where the outside option is not binding

Case 2 where the outside option is binding.

Question 25

What does outside option is not binding in comparison to the outside option is binding?

Answer 25

Outside option is not binding = you will not commit to outside option and show up and do task. Outside option is binding - the agent chooses whether u take the project

Question 26

Lets look a case 1 when the outside option is not binding. Maximise the principals payoff to and find the optimal bonus when a incentive compatible contract and when will this solution. ( W=0). When will the agent agree to this too.

Answer 26

We know the agents payoff so we sub in b such that its > or equal to u. SO THE BONUS MUST BE GREATER THAN outside option.

Question 27

Show here case 1, ( HINT WE KNOW THAT THE OUTSIDE OPTION IS LESS THAN OPTIMAL BONUS THAT MAXMISES PRINCPLES PAYOFF?

Answer 27

As the outside option is less than optimal bonus pie/2, this is the solution to the the princpal agent problem because the agent gets the next best alternative but its optimal to pay as you get the benefit. So no need to worry about outside option.

Question 28

So we have established that ig c = 10 and π = 8, then what is level of bonus in case 1 we established, when will this be the solution tooo and what is the level of effort of successful completion? What is the problem here?

Answer 28

Because of imperfect information things are not working as well with full info, even though you are dealing optimally with best contract, success is only 0.4.

Question 29

With case 2 would the bonus of pie / 2 be sufficient to persuade agent to work? What can we think of the outside option as? ( optimal bonus)

Answer 29

No. So the outside option is a high demand market opportunity, so the princpal has to increase the bonus to get the agent to work for them

Question 30

So we know that for case 2 the bonus is not enough, the principal needs to pay a higher bonus than this, but not give too much money, so what does he do?

Answer 30

He gives a bonus such that is equal to outside option, then rearrange to find this bonus.

Question 31

Explain case 2 on diagram?

Answer 31

1) U upper bar is very high, so you get bonus to it, and we see bonus is high and effort is high as a resul, but this gives princpal a lower utility.

Question 32

What would be the level of bonus and how does that relate to princpal. what is the level of success?

Answer 32

Most profit goes to agent, but effort is higher | e = b/c

Question 33

What are the implications of all of this?

Answer 33

Naturally the economy has inequality, which is needed in society because of moral hazard, people are paid more than others, despite doing same roles due to demand.

Question 34

Compare Case 1 and 2 with full info ( don't have to ) ?

Answer 34

Question 35

Interesting question suppose that there was 2 identical principals competing for the same agent and the outside option will be high what will happen and Profit is higher than bonus?

Answer 35

The outside option is getting so high that the the princpals pay agents all the profit, meaning that the inefficiency associated with moral hazard goes away. ( Basically you have to give agent all profit as bonus to get to the efficient level of effort when there was perfect information.

Question 36

If there are more agents than princpals, is there competition and what is optimal effort levels?

Answer 36

Because the outside option doesn't really exist or carry weight, the alternative is unemployment, hence the effort level will be the same of that in case 1.

Question 37

What are the welfare costs/ potential benefit of moral hazard?

Answer 37

1) Expected output is lower 2) Although its pareto efficient ( as the only way you can make agent better off is by making principal worse off. 3) There is also inequality issues as some agents who are successful get b and others fail.

Question 38

So we are now going to look at moral hazard in teams, so in teams what is success determined by, hence what is rewards determined by? Suppose that there are 2 team members A & B.

Answer 38

Probability of success depends on both team members, so you cant observe individual effort but team,

Question 39

As success in teams are public good how do teams deal with moral hazard problem and free riding?

Answer 39

Teams find ways of dealing with free riding, via peer pressure and private punishments.

Question 40

What does intrinsic motivation mean?

Answer 40

you do an action because its naturally satisfying to you. ( not just for monetary sake)

Question 41

With intrinsic motivation, what does paying people do?

Answer 41

they may resent being paid and do a worse job ( motivation crowding out)

Question 42

We want to incorporate intrinsic motivation in our model, so what is the notation we are going to use to show a physic reward you get( HINT its a function of B. and decreasing function)

Answer 42

why a decreasing function? the more you pay me, the less motivated i am to do a task?

Question 43

With intrinsic motivation what is the worker essentially doing and can there be u(b) increasing function and why is it good for the princple?

Answer 43

So the agent is essentially working a certain amount for free. ( remember though the oppoiste can occur, so u(b) may be an increasing function, so the more you pay me, the more i look forward to doing it. ) The principal is may as they are getting intrinsic motivation that they don't have to pay for

Question 44

Why might be the case that u(B) is increasing?

Answer 44

offering more money sends a signal that the task is more dangerous and difficult, so must be important.

Question 45

When an Israeli day care centre started fining parents for picking up their children late More parents showed up late They felt that they were paying for the right to show up late So the fine did not act as a deterrent What is this evidence of?

Answer 45

Intrinsic motivation

Question 46

What is the utility function of an agent with intrinsic motivation and what is effort? and how can we interpret it ?

Answer 46

If u(b) is positive you put more effort into the task because the pyshic benefit associate with task

Question 47

How does effort depend on b? (hint you take derative with respect to b? Supposing the u(b is a decreasing function>

Answer 47

Question 48

So now we want to look at how intrinsic motivation affect incentives, so suppose that know what u(b) and that alpha reflects the degree of crowding out ( the higher, the more you think money has a negative effect upon you) , so by subbing this into the princpals payoff and and finding option bonus, what can we say about the bonus when there is intrinsic motivation.

Answer 48

If alpha( the degree of crowding out is high then you don't use incentives at all.

Question 49

By plotting the expected utlity as a function of bonus what can we extract here?

Answer 49

Intrinsic motivation shifts the up the utility of principle and agent as the agents gets pleasure from putting effort in. The principal utility function shifts up as he gets benefits from intrinsic motivation, as he gets more effort per unit of bonus, Finally as you can see the optimal level of bonus us one the left to what we had without intrinsic motivation.

Question 50

What do firms try and do because of the benefits they get from agents being intrinstically motivated ?

Answer 50

Firms try to brainwash employees into the memo of the firm to try and get this intrinsic motivation.

Question 51

Thus can incentives backfire?

Answer 51

Yes

Question 52

What are examples of Adverse selection ( hidden information) ?

Answer 52

product quality in goods markets, riskiness of people in insurance markets.

Question 53

What are the 2 consequences of adverse selection?

Answer 53

efficiency - in particular in the amount of trade | Disturbtion - there are gainers and losers.

Question 54

Lets say you want to buy a product online amazon, and there are many different payback options at different prices but all cheaper than in person, hence where is the adverse selection?

Answer 54

You don't know the quality of the online book, you may not end up with the book, or it could be damaged.

Question 55

( ADVERSE SELECTION MODEL) Focus in on the case of a demand for a single good or service of unknown quality Consumers are contemplating buying a one unit of a good/service They can also choose not to buy it at all. They have a Fixed income and utility is linear in consumption What do consumers want to maxmise and what can the good or service be ? Do the consumers know the quality of the goods?

Answer 55

They will maximize their expected utility given their prices and income. The good/service may be one of two kinds a peach - it works a lemon - it fails Consumers don't know whether its a peach or lemon.

Question 56

(ADVERSE SELECTION MODEL) What is the utility from having a peach and what is the utility of a lemon. As consumers cannot observe whether it is. a peach or not, what is going to be the market price?

Answer 56

Question 57

( ADVERSE SELECTION PROBLEM) What will you denote as to show whether you decide or not to buy a good or service, and what is the probability of buying a good in the market that is a peach. What is therefore the expected utility of consumer? What if you buy a lemon?

Answer 57

if § = 0 then your expected utltiy comes from income the probabily of buying a good thats a peach is little delta If you buy a lemon without knowing you get 0 utlitiy so your expected utility is just -p + m

Question 58

( ADVERSE SELECTION PROBLEM) When you do buy a good a good § E {0,1]

Answer 58

you will always buy the good when your valuation exceeds the price

Question 59

(ADVERSE SELECTION PROBLEM) Suppose u is distributed with distribution function G (u) What is the demand such that all people who value the good are willing to take risk to buy it.

Answer 59

Question 60

(ADVERSE SELECTION PROBLEM) What are the 2 kind of suppliers and how many suppliers are there?

Answer 60

Question 61

(ADVERSE SELECTION PROBLEM) Now lets look at the case with full information, so we know each type of producer picks a price P for peach producer and L for lemon producer, With full information will there be any lemons sold and y and therefore what is the demand function?

Answer 61

Question 62

(ADVERSE SELECTION PROBLEM) Now as there are 2 peach firms What is the be the supply ( cost), will there be any proifts (HINT BETRAND COMPETITION)? So again who will buy a peach?

Answer 62

``` Model price setting as Bertrand Competition both producers have the same cost Look for a Nash equilibrium Any producer that undercuts the other will take the whole market Then P = C (marginal cost) There are zero proÖts Then demand is therefore 1 - G (C) ``` Then anyone for whom u > C will buy a peach

Question 63

(ADVERSE SELECTION PROBLEM) How does the diagram look like when there is full info?

Answer 63

Everyone who has a valuation of u>c will buy the good and no one will be able who wants the good not to get it.

Question 64

(ADVERSE SELECTION MODEL) ( iMPERFECT INFO SO CONSUMERS KNOW THAT 2/3 ARE PEACH AND 1/3 ARE LEMON) 1) As firms are all charging the same price, what does it mean for consumers. 2) As lemon mimics price of peach will they make a profit? and can peach producers make a profit. 3) As consumers know that 2/3 of the time they are buying a peach, when will they have a peach? 4) what is now the demand for a peach and how does that compare to the full information case.

Answer 64

So what is happening in short, is that price hasn't changed but t some failing goods are being traded in equilibrium with those with the highest valuation.

Question 65

(ADVERSE SELECTION MODEL WITH IMPERFECT INFO) What is the consequences of this? ( HINT THINK ABOUT AS WE ARE LOOKING AT ONE POPULATION SIZE, HENCE REPRESENTATIVE CONSUMER, THINK ABOUT CULUMATIVE DISTRUBTION OF U?

Answer 65

If no one has a valuation higher than U<3/2C because of the risk is too high buying lemon then market collapses completely

Question 66

Why is this consequence pareto inferior compared to full information and how does the case of imperfect information look on a price and quantity diagram? What does it mean for lemon producers ?

Answer 66

Lemon producers can make a profit and enter in the market

Question 67

What has happened to trust in the market economy since the 2008 financial crisis and how do firms get trust?

Answer 67

Trust has fallen after 2009 | Firms try to develop reputations

Question 68

Name 2 market solutions to adverse selection?

Answer 68

Guarantees | Information providers

Question 69

How does Guarantees work ?

Answer 69

In the event of product failure, the producer offers to pay b to the consumer

Question 70

So we are going to look at how guarantees solve the adverse selection problem, so with guarantees when will consumer buy the good supposing that P = C? Does a peach producer ever have to pay for guarantee?

Answer 70

The peach producer never had to pay the guarantee and so produces at that price.

Question 71

Will a lemon producer offer b at price C, when will he not and how might they get found out?

Answer 71

Hence if guarantees are high they make no profit and leave the market.

Question 72

What does offering guarantees require and what is a disadvantage of it?

Answer 72

Legal framework required. Consumers can abuse the product making it fail hence guarantees are not perfect.

Question 73

Information providers, give examples of them what are the disadvantages of them?

Answer 73

Rating agencies Customer reviews Although they can be costly in terms of time and money and unreliable

Question 74

So suppose consumers pay sigh to become informed before they shop when will i do this/HOW MUCH WILL I BE WILLING TO DO THIS?

Answer 74

I will be willing to pay for that information if the increase value of buying a peach over a lemon, is sufficient to compensate me for the cost of doing it.

Question 75

Due to people be willing to pay for information if the extra value compensates the cost, then there are 3 possibilities of people. If the cost of being unformed > cost of being informed then what will happen? How does the diagram look?

Answer 75

Then people will get informed and demand but the extra cost does reduce demand but there is less efficiency than from no infomation ( those you good the good at C, but will not buy the good at sight + c

Question 76

How does adverse selection cause inequality?

Answer 76

Costs of information differ hence those who cannot afford information providers will still buy failing products ( equity problem here) in our example earlier we assumed everyone had the same costs.

Question 77

What are some government remedies to adverse selection?

Answer 77

1) Fine or tax producers of lemons 2) introduce product quality standards and licensing( you must be licensed before you sell ( important in medical care) 3) provide regulation 4) direct provision of some goods

Question 78

What reading relates to this topic?

Answer 78

Compensation and incentives in the workplace - Edward P. Lazear ( 2018).

Question 79

What is this paper about? Compensation and incentives in the workplace - Edward P. Lazear ( 2018).

Answer 79

The evidence of compensation affecting worker behaviour is overwhelming. At the most basic level almost all of the labour component of GDP that is derived from work is paid rather than voluntary. Research shows that manipulating the pay structure alters workers behaviour, by affecting either hours of work or output associated with it.

Question 80

According to Compensation and incentives in the workplace - Edward P. Lazear ( 2018) What kinds of incentive schemes exist?

Answer 80

Input based schemes - the relative input workers are paid per unit of time( e.g. months years). Workers have no flexibility over the amount of time worked, in discrete input based schemes. With continuous incentives workers have a choice over the amount of input supplied. Altogether there is a benchmark for this though. Output based schemes- discrete output based incentives schemes induce all workers to focus on a particular level of output ( e.g. fixed payment for completion of construction project.) It is difficult when there is heterogenity at a firm. With continuous output schemes, the number of output produced isnt fixed.

Question 81

According to Compensation and incentives in the workplace - Edward P. Lazear ( 2018). What are tournament incentives? When can they be used? What is a problem of this?

Answer 81

1) Worker who does the best receives a promotion with high pay. But there are relative incentives. So there is an optimal spread between prize of winner and the runner up, so this inticies people to elicit efficient effort, providing the spread of wages is high enough across 2 positions is high enough to induce effort. Also the winner shouldn't get a wage thats too high compared to start wage, because it will not entice people to work for you. 2) It might induce uncooperative behaviour from people and people taking more risks on the business.

Question 82

According to Compensation and incentives in the workplace - Edward P. Lazear ( 2018). What are team-based incentives? When can they be used? What is a problem of this?

Answer 82

Pay based upon output of whole team. Problem: a high skilled team worker might not have the right incentives to motivate their coworkers in team. Also team incentivies suffer from free rider effects.

Question 83

According to Compensation and incentives in the workplace - Edward P. Lazear ( 2018). What are career incentives? and how do they limit moral hazard?

Answer 83

Consider a middle aged man who has been in same position for many years with little hope moving up the hierachy. So his motivation is low, so experience-earnings relationship ( which is negaitvely sloped) can serve a way to motivate workers. efficiency is enhanced by underpaying them and overpaying old, so the 'young workers keep chasing that bag' It can solve moral hazard issues too, as if you have been in the same job for a long time, you most likely face low incentives to exert a lot of effort, if you cannot get promoted. They earn rents on their job relative to what they get if they would be forced to leave job.

Question 84

According to Compensation and incentives in the workplace - Edward P. Lazear ( 2018). When is intrinstic motivation used rather than monetary incentives?

Answer 84

Intrinstic motivation is used in voluntary work. monetary incentivies crowd out intrinstic motivation, where people take acitons because those actions are personally fufiling ( e.g. blood donations declined when the collecting agency moved from voluntary to paid contributions).

Question 85

According to Compensation and incentives in the workplace - Edward P. Lazear ( 2018). Should LSE make greater use of incentive pay for lecturers, class teach- ers and students? How would you design a scheme that worked?

Answer 85

Incentive pay based upon career incentives possibly But could be argues that teaching is intrinstically motivated. Rewarding them might make them feel less social responsibility.

Question 86

So we have established all these types of piecewire pay rate systems are great for incentives but what situations are they best suitied for? Compensation and incentives in the workplace - Edward P. Lazear ( 2018).

Answer 86

They are best suited for situtations in which output and quality are easily observed.

Question 87

What are 3 things that determine a moral hazard problem?

Answer 87

1) Effort is costly 2) its unobservable 3) the benefits of effort accrue to the principal and not the agent