Managerial Economics: Applying the Tools Topic 10, Part 2

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Managerial Economics Applying the ToolsTopic
10, Part 2

• Goods with different quality Adverse selection
• Signaling equilibria
• Pooling equilibria
• Paul Kerin Sam WylieMBS Term 3, 2004

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Mass markets with quality problems
Were considering mass markets for apparently
homogenous goods everyone produces goods that
look the same BUT are not necessarily of the same
quality

COMPETITORS
COMPANY
MASS MARKET CUSTOMERS
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Goods that differ in quality

• In Strategy class Competing firms will offer
  products differentiated by quality (Ferraris
  versus Corollas), just to reach different
  customer groups
• In Man Ec We look at products differentiated by
  quality, to talk about information problems
• Low quality goods and high quality goods in the
  market, but customers cant tell them apart!
• Low quality goods have a cost advantage
• Producers of high-quality goods want to signal
  their quality

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Example The market for lemons

• You want to buy a used car
• Apart from imperfect information, its a
  perfectly competitive market there are lots of
  buyers and lots of sellers
• To simplify, there is only one kind of used car
  on the market three-year-old Holden Barinas
• There is just one going price in the market no
  one will pay more or sell for less than the going
  price
• Buyers and sellers see the going price, and
  decide if they want to participate in the market
• Unfortunately, there are really 2 qualities of
  cars on the market good cars and lemons

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Who knows what?
The seller knows what type of car she is selling.
(This is a generalisation.) What happens in the
market depends on whether buyers can also tell
the type of car
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The market for lemons case 1 symmetric and
perfect information buyers know what type the
car is
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The market for lemons case 2 asymmetric
information buyers dont know what type the car
is
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The market for lemons case 2 asymmetric
information Pgt8K?

• Suppose the buyer cannot tell a good car from a
  lemon before they buy
• Will you buy if the price is at least 8,000?
• NO!
• At this price, every seller will want to sell.
  But this means that if you buy a car it has a 60
  chance of being a lemon (worth 6,000 to you) and
  a 40 chance of being good (worth 10,000 to the
  buyer). So the expected value of a car to the
  buyer is 7,600. So you will not pay more than
  8,000 for a car with an expected value of 7,600!

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The market for lemons case 2 asymmetric
information 6KltPlt8K?

• Suppose the buyer cannot tell a good car from a
  lemon before they buy
• Will you buy if the price is between 6,000 and
  8,000?
• NO!
• At this price, only the sellers of lemons will
  want to sell. Every car being offered is a lemon
  and you will not pay more than 6000
• So we expect that the market will have a price of
  between 3,000 and 6,000, with only lemons sold

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The market for lemons case 2 asymmetric
information outcomes
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Adverse selection a lower price means a lower
quality of cars in the market

• The problem of adverse selection can lead to the
  complete collapse of the market for good cars
• Any evidence of such problems in the used car
  market? (Dutta, Strategies and Games)
• The average car depreciated 37 in the first
  year. By the end of the second year it had
  depreciated 50. (If you tried to sell your 1994
  car in 1996, you would get only half the price
  that you had paid for it a mere two years
  before.)
• Only about 1 of new (1 or 2 year old) cars are
  lemons, so most sales should be from people with
  changed circumstances.
• ? Suppose you would pay 80 of new if there
  were no adverse selection
• But if the price is only 80 of new, some people
  with changed circumstances decide to keep the car
  (give it to kids, drive it to their new home,)
  ? now cars for sale only worth 70.
• But if the price is only 70,

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The Asian Fire sale and the market for lemons
Khanna and Palepu, Harvard Business Review
July-August 1999, 125-134

• Asian crisis led to a serious liquidity crisis
  for many Asian firms
• Created the need to sell off assets
• large market for assets arose at the time of the
  crisis
• However, in many of the countries experiencing
  crisis (especially Thailand and Indonesia) there
  is insufficient reliable public information on
  the value of an asset.
• (Inadequate accounting practices, inadequate
  government supervision, lack of transparency in
  record-keeping.)
• buyer cannot know the true value of the asset,
  only the average value in market
• certain assets that are worth more than average
  are pulled off the market, and average value
  keeps falling market breakdown
• The few companies that have been buying in Asia,
  such as GE Capital in Thailand, are the ones that
  chose to build a direct understanding of the
  local markets in the years before the crisis.

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Information and market failure

• Why do health insurance companies worry about
  healthy young married women?
• What is the outcome, if insurance companies
  raise the price of insurance to that group?
• Why do insurance companies make you pay the first
  part of any claim (the deductible)?
• Why is car insurance sometimes unavailable for
  younger drivers?
• Are higher interest rates better for banks?
• Adverse selection can also lead to statistical
  discrimination and rationing

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Greshams Law

• Imagine an economy in which the currency consists
  of gold coins. The holder of a coin is able to
  shave a bit of gold from it in a way that is
  undetectable without careful measurement the
  gold so obtained can then be used to produce new
  coins. Imagine that some of the coins have been
  shaved in this fashion, while others have not.
  Then someone taking a coin in trade for goods
  will assess positive probability that the coin
  being given her has been shaved, and thus less
  will be given for it than if it was certain not
  to be shaved. The holder of an unshaved coin
  will therefore withhold the coin from trade only
  shaved coins will circulate.
• Bad Money Drives Out the Good

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Bad staplers drive out good

• Suppose that there are firms producing good
  staplers and firms producing bad staplers
• Customers cant tell the two types of staplers
  apart ? staplers are all sold for the same price
• But producers of bad staplers have lower costs
  than producers of good staplers
• If its a competitive market, firms keep entering
  so long as positive profits are being earned, and
  enter until profits are driven to zero
• Bad stapler producers keep entering until their
  profits are nearly zero
• But that means that producers of good staplers
  are losing money!
• Firms producing good staplers exit the market (or
  switch to producing bad staplers)

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Responses to adverse selection

• Note that the problem of adverse selection harms
  the uninformed parties and some of the informed
  parties
• In the lemons example, it meant that buyers could
  not buy good cars
• But also sellers of good cars could not get a
  reasonable price for their cars (even if the
  price is still above their WTS, the presence of
  lemons means they earn less)
• Uninformed buyers may try to overcome the
  information asymmetry by search
• Informed sellers may try to overcome the problem
  by
• Offering warranties
• Other signaling strategies

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Warranties and the market for lemons
Lets go back to our used car market, and suppose
that there are lots more buyers than sellers ?
the price rises to buyers WTP Sellers of good
cars want to offer a warrantybut what kind of
warranty? Ex Lets say the warranty is a 2000
payment in the event of a breakdown But if that
warranty makes buyers willing to pay close to
10,000 instead of 6,000, sellers of lemons will
want to offer the warranty, too ? Customers
shouldnt assume the warranty means its a good
car
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Warranties
Lets return to our car market example Suppose
that good cars never break down. However, a lemon
has a high probability of breaking down (that is
why it is a lemon). Say lemons break down with an
80 probability. (But cars only break down once)
Fixing a broken down car is expensive about
5,000. Suppose now that a car seller offers
you the following deal Buy the car for 9,000.
If it breaks down, the seller will fix your car
for free. Should you buy the car?
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Warranties good seller
So if the buyer knew that it was a good car, she
would accept the deal
Dont buy
(0,0)
Buyer
Offer deal
Breakdown (zero chance)
Good seller
(-4,000 ?)
Buy
Dontoffer deal
No breakdown (100)
(0, 0)
(1000,1000)
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Warranties lemon seller
But the buyer can infer sellers offering the deal
are good, the seller of a lemon would not offer
the deal
Dont buy
(3000 0)
Buyer
Offer deal
Breakdown (80)
Lemon seller
(1,000 ?)
Buy
No breakdown (20)
Dontoffer deal
(3000 0)
(6,000 ?)
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Warranties lemon seller (cont)
Dont buy
(3000 0)
Buyer
Offer deal
Breakdown (80)
Lemon seller
Expected payoff for lemon seller if buyer
accepts offer is 2000. So if the lemon
seller thinks that you will accept the deal,
they will not offer it!
Buy
No breakdown (20)
Dontoffer deal
(3000 0)
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Warranties conclusion

• So the warranty works
• Only the good sellers will offer the warranty
• Buyers can buy the car with the warranty, sure
  that they are buying a good car (and will never
  need to use the warranty)
• But it is not worth while for the sellers of
  lemons to copy the warranty their cars break
  down and the warranty costs more than the
  increased price that they receive for their cars
• The dog that didnt bark
• If good firms are offering a warranty
• Then if a firm doesnt offer a warranty,
  customers correctly infer that its a bad firm.
  Silence is informative!

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Evidence on warranties

• From Dutta, Strategies and Games
• Of all used cars purchased, 20 are sold through
  new car dealerships and another 15 are sold
  through used car dealerships. Dealerships
  typically offer warranties on the used cars they
  sell
• The average price of a used car in 1994 was about
  11,500. The average private-party sale price on
  a used car was about 2,000 less than the average
  sale price at dealers

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Signaling

• The warranty is an example of a signal that the
  good seller can send to the buyer
• In our example here the signal had no cost to the
  good seller. This is not generally the case
• For a signal to work it requires three features
• The cost to the bad type must be high enough so
  that they do not want to pretend to be a good
  type
• It must be less costly to the good type than to
  the bad type.
• Even given the cost, it must be better for the
  good type to distinguish themselves than be
  mistaken for a bad type

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Bargaining revisited!

• Signaling is not just a mass-market concept
• It applies whenever you need to distinguish
  yourself from another type of person/firm/group
• Example Back to bargaining.
• We assumed complete information all parties to
  an agreement know the WTP or WTS of each player
• Observation If there is incomplete information,
  your trading partner knows his WTP/WTS, but you
  dont know it for sure
• Why does that lead to delay?
• Why might that rule out agreement, in some
  instances?

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Other examples the early career rat race

• Suppose there are ordinary and talented workers
• Your boss can observe the quality of your work
  but not how difficult you found the task
• If everyone spends the same time, the talented
  workers will be recognised and gain promotion
• So the ordinary workers work harder to try and
  appear to be talented
• So to distinguish themselves, the talented
  workers also have to work hard

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The early career rat race potential outcomes

• Separating equilibrium. This is where the signal
  works. The talented workers work too hard but
  are recognised. The ordinary workers just give
  upor
• Pooling equilibrium. In this situation, the
  ordinary workers work hard and talented workers
  work normally. The boss interprets ordinary
  performance as a sure sign of lack of talent. But
  the boss cannot infer anything from exceptional
  work because everyone is doing it!

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Signaling lifting the fog

• Signaling can overcome information problems
• But its costly to the good type who is trying
  to distinguish herself from the bad type
• Choosing the wrong signal just means the bad
  type will copy you. Despite the cost of the
  signal, there is no gain in information
• So it is important to carefully choose your
  signaling strategy. It needs to be low cost to
  you and high cost to others, so that it will be
  believed and cannot be jammed by the bad types

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Pooling Equilibria preserving the fog

• If youre a bad type (or you might be) you want
  the bad types and the good types to look the same
• You mimic the good type
• Follow the herd Forecasters try and keep their
  forecast in line with the others its more
  costly to make a mistake, if youre the only one
  who makes it.
• You make it harder to get clear information about
  your quality signal jamming
• Create variability and complexity in performance
  measures
• Bury information where possible
• If you refused a project, bury it so that no one
  finds out you might have been wrong (e.g. ET)
• Refuse to collect more information (e.g.
  Continental Corporation refusing an extensive due
  diligence by a buyer)

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How to find a credible signaling strategy

• If the good types send a credible signal, what
  does that say about the equilibrium?
• Customers (or business partners) believe youre
  the good type when you send the signal ? you get
  the good deal
• Customers assume that if you didnt send the
  signal, youre the bad type ? you get treated
  like a bad type
• ? Spell out exactly what this will mean, in this
  situation.
• What makes the signal credible?
• Bad types dont want to send it. (That is, they
  know they could fool customers by sending the
  signal, but its not worth it.)
• Draw a decision tree, to find a signal that bad
  dont want to send.
• Last check that good types are better off than
  in the pooling equilibrium (where customers cant
  distinguish them from bad)

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Signaling warranties and the market for lemons

• Back to our used car market, but suppose that now
  there are only 30 lemons
• There are lots more buyers than sellers ? the
  price rises to buyers WTP.
• What is the pooling equilibrium?
• If good cars break down with a 5 probability and
  lemons break down with a 50 probability, what is
  the signaling equilibrium?
• (Firms can offer warranties of the following
  form If your car breaks down, I pay you X)
• Which equilibrium do the good sellers prefer?