6 pages 48 hours (A0109)

Information and

Organisational Design LUBS5002

Lecture 3

The Economics of Information: Information Problems for

Markets and Organisations

Introduction

KEY ISSUES

Solutions to adverse selection and

moral hazard

Market functioning under

asymmetric information.

Moral Hazard/

Hidden Action

Adverse Selection /

Hidden Information

Co-ordination and Information

KEY TERMS

Informational Asymmetry

Paradox of Information

Opportunistic Behaviour

Hidden Information

Adverse Selection

Hidden Action

Moral Hazard

Market for lemons

Collapse of market

Signalling

Screening

Sheepskin effect

Pooling and separating

equilibrium

Contracting

Incentives

In this session we develop the central importance of information to issues of co-ordination and business in

general. Issues of information pervade most, if not all, areas of work, negotiating, contracting, bargaining,

bidding and strategic decision-making being but a few.

In this session we look at how information can be seen as an economic good, deriving value from its

scarcity. Specifically, we look at the problems the uneven distribution of information can cause. Apart

from markets which may be characterised as perfectly competitive, very few business transactions are

characterised as being fulfilled under conditions of perfect information.

The existence of informational asymmetries takes two general forms; moral hazard and adverse selection.

Much of the literature in these areas stems from the study of the insurance market, although the concepts

that will be developed in this unit have a much wider application.

For this session you will need to read chapter 4 of the textbook.

OBJECTIVES

After completing this unit you should be able to:

1. Understand how information influences the form of co-ordination mechanism.

2. Be able to distinguish between different forms of informational asymmetries.

3. Relate the economics of information to the business world and particularly in situations which

involve bargaining, negotiations, contracting and so on.

4. Use the economic concepts to improve strategic decision making particularly under conditions of

uncertainty and imperfect information.

Module Design The division of labour

Specialisation

Co-ordination

Market Information Organisation

∙ Economic Approaches to Organisations

- Agency Theory - Transaction Cost Economics

- Strategy - Evolutionary Approaches

Objectives

 Understand how information influences the form of co- ordination mechanism.

 Be able to distinguish between different forms of informational asymmetries.

 Relate the economics of information to the business world and particularly in situations which involve bargaining, negotiations, contracting and so on.

 Use the economic concepts to improve strategic decision making particularly under conditions of uncertainty and imperfect information.

Introduction

‘In the field of economics, perhaps the most important break with the past lies in the economics of information. It is now recognised that information is imperfect, obtaining information can be costly, there are important asymmetries of information, and the extent of information asymmetries is affected by the actions of firms and individuals. This recognition deeply affects the understanding of wisdom inherited from the past, such as some of the basic characterisation of a market economy, and provides explanations of economic and social phenomena that otherwise would be hard to understand’

Joseph E. Stiglitz 2000, p1441.

Markets and Information

The price mechanism will only be a sufficient co-ordination mechanism where the economic entities involved have quite limited informational requirement.

Key question:

‘In what instances is the price mechanism not sufficient to communicate all necessary information?’

 When the price cannot reflect all dimensions of the good/service;

 Uncertainty is present;

 Imperfect information.

Markets and Uncertainty

Can markets deal with uncertainty?

Consider:

Contracts between local councils and road construction firms are extremely long with terms spelled out in minute detail. Others, such as between consulting firms and their clients, are short and fairly vague about the division of responsibilities.

What factors might determine such differences in contract length and detail?

Imperfect Information

Imperfect information = important violations of assumptions.

Imperfect information can be:

- symmetrically distributed

- asymmetrically distributed

Asymmetric information:

- give rise to opportunistic behaviour

- affects the functioning of markets

- influences the choice between market or organisational

co-ordination.

Asymmetric Information

Private information creates two problems:

 Adverse selection (Hidden information)

 ex ante informational problem

 what is if concern are characteristics of the items being transacted.

 Moral hazard (Hidden Action).

 ex post informational problem

 focus is on behaviour and incentive problems

Hidden Action or Hidden

Information?

A radio report recently reported a study on the makes and models of cars that were observed going through road junctions in a major city without stopping at the stop signs. According to the study, Volvos were heavily over-represented. This is initially surprising because Volvo has built a reputation as an especially safe car that appeals to sensible, safety conscious drivers. Volvos are bought by middle-class couples with children.

Using your understanding of moral hazard and adverse selection how can this observation be explained?

The Market for ‘Lemons’: A More Formal Analysis

Assume fixed number of cars for sale

- 50% ‘plums’ 50% ‘lemons’

- only sellers know which is which - buyers assume 50% risk of ‘lemon’

‘Plums’ are worth £6000 to buyers and sellers

‘Lemons’ are worth £2000

A buyer will offer the expected (average) value of the car

EV = 0.5*£6000 + 0.5*£2000 = £4000

The Market for ‘Lemons’

 Owners of ‘lemons’ will sell (£4000>£2000)

 Owners of ‘good’ cars will not sell (£6000<£4000)

 Consumers realise that only ‘lemons’ are being traded and price collapses to £2000.

Questions:

1 Is there are market failure?

2 Who benefits from the informational asymmetry? Who is harmed?

3 What happens if the ‘lemons’ problem is less severe?

Hidden

characteristics

buyer

buyer seller

seller

P=0.5

P=0.5

Offer

p

Offer

p

(0,0)

(0,0)

(2000 -p,

p-2000)

(6000 -p,

p-6000)

Payoffs to (buyer,seller)

The Market for Lemons: A Sequential Game.

supply demand

2000 4000 6000

6000

Offer

price (£)

Average

quality

value (£)

A Continuum of Quality: The Market Collapses

Solving the ‘Lemons’ Problem:

Credible Signals

 Uniformed buyers have incentive to learn more about the product

 High quality sellers have to attempt to communicate quality - i.e. send a credible signal about quality.

 Provision of credible signals can help markets operating with asymmetric information to perform better.

 In practice such signals may be hard to design and transmit.

Signalling in the Labour Market

Why do graduate earn more than non-graduate?

 Human capital theory:

 invest in human capital in expectation of higher productivity/increased future income stream.

 Education as signal

 a degree is a credible signal to employers of high ability/potential productivity

Sheep-skin effect:

income differences > probable productivity difference

Asymmetry of Information

pooling equilibrium versus separating equilibrium

Moral Hazard: An Overview

The term ‘moral hazard’ originated in the insurance industry

Moral hazard is useful for analysing firm organisation, team

production, shareholder activism and certain financial characteristics of firms.

Moral hazard is a principal-agent problem

Solutions to the problem of moral hazard:

- better monitoring

- incentives

- reputation effects

Conclusion

‘the most important advances in the economics of information will be in an area in which only limited progress has been made so far: organisations, on how well organisations absorb new information, learn, adapt their behaviour, and even their structures; and how different economic and organisational designs affect the ability to create, transmit, absorb, and use knowledge and information’

Joseph Stiglitz, 2000, p1471.