Economics of Information Asymmetry

Tarun Jain

Economics Area
Indian Institute of Management Ahmedabad
Risk and Insurance

Firms pay large premiums to insure assets against fire, flood

or “acts of God”
Risk and Insurance

Firms pay large premiums to insure assets against fire, flood

or “acts of God”

Senior investors prefer fixed deposits to equities, even when

the returns to equity investments are much higher in the long
run
Risk and Insurance

Firms pay large premiums to insure assets against fire, flood

or “acts of God”

Senior investors prefer fixed deposits to equities, even when

the returns to equity investments are much higher in the long
run

Borrowers with perfect repayment pay higher interest rates

than their records suggest
Risk and Insurance

Firms pay large premiums to insure assets against fire, flood

or “acts of God”

Senior investors prefer fixed deposits to equities, even when

the returns to equity investments are much higher in the long
run

Borrowers with perfect repayment pay higher interest rates

than their records suggest
Risk and Insurance

Firms pay large premiums to insure assets against fire, flood

or “acts of God”

Senior investors prefer fixed deposits to equities, even when

the returns to equity investments are much higher in the long
run

Borrowers with perfect repayment pay higher interest rates

than their records suggest

This session will examine the origins of risk, how firms use
insurance to mitigate risk, why insurance markets fail and how
to fix them with signals
Diminishing Marginal Utility
Lottery

Definition
A lottery is any event with an uncertain outcome.

Example
I Payoff from a equity share for an investor
I Outcome of a roulette wheel for a gambler
I Amount of rainfall for a farmer
Review of Probability
Definition with rules

An event’s limit of frequency in a large number of trials is the

probability associated with the event.
I Probability of event A
r
P(A) = R

where
R: Large number of trials
r: Number of times event A occurs in those trials

I Probabilities cannot be less than zero nor greater than one

I Given a list of mutually exclusive, collectively exhaustive events, the
sum of the probabilities of the events must be equal to one
Risk Averse Preferences

Definition
A risk averse individual prefers a lottery with a more certain outcome to
one with a less certain outcome, given that each lottery offers equal
expected wealth.
Expected value = pA ∗ payoff(A) + pB ∗ payoff(B)
Expected utility = pA ∗ U(payoff(A)) + pB ∗ U(payoff(B))
For a risk averse individual,

U(Expected value) > Expected utility

Risk Averse Preferences
Risk Neutral Preferences

Definition
A risk neutral individual is indifferent between a lottery with a more
certain outcome and one with a less certain outcome, as long as each
lottery offers equal expected wealth.
Expected value = pA ∗ payoff(A) + pB ∗ payoff(B)
Expected utility = pA ∗ U(payoff(A)) + pB ∗ U(payoff(B))
For a risk neutral individual,

U(Expected value) = Expected utility

Risk Neutral Preferences
Risk Loving Preferences

Definition
A risk loving individual prefers a lottery with a less certain outcome to
one with a more certain outcome, given that each lottery offers equal
expected wealth.
Expected value = pA ∗ payoff(A) + pB ∗ payoff(B)
Expected utility = pA ∗ U(payoff(A)) + pB ∗ U(payoff(B))
For a risk loving individual,

U(Expected value) < Expected utility

Risk Loving Preferences
Price of risk

Example
I Suppose Sanjay Student holds a bond which can be either Rs. 400
or Rs. 900 next year
I Probability that the bond will be worth Rs. 400 is 50%
I Probability that the bond will be worth Rs. 900 is 50%
⇒ Expected value of the bond is (0.50 ∗ 400) + (0.50 ∗ 900) = Rs. 650
Price of risk

Example
I Sanjay is risk averse, draws utility from wealth
√
I U = W gives the relationship between his utility (in “utils”)
and wealth (in rupees)
⇒ Expected
√ utility from the
√ bond is
(0.50 ∗ 400) + (0.50 ∗ 900) = 25
Certainty Equivalence and the Market for Insurance

Definition
The certainty equivalent is the guaranteed payoff at which a person is
indifferent between certain wealth and a higher but uncertain wealth.
Certainty Equivalence and the Market for Insurance

Example
I Certainty equivalent price of the bond
I W ∗ = U 2 = (25)2 = Rs. 625

⇒ At the certainty equivalent price, Rs. 625, Sanjay is just indifferent

between holding the bond and selling it
Certainty Equivalence and the Market for Insurance

Example
I Quess Insurance Company is risk neutral and willing to buy the
bond, i.e., take on Sanjay’s risk
I What is the maximum Quess will pay for the bond?
I What is the minimum Sanjay will accept for the bond?
I The difference is the risk premium
Robust insurance markets

I Life insurance (risk of dying)

I Including annuities (risk of living too long)

I Health insurance

I Property insurance

I Financial insurance

But missing markets for many risks in life (low education, earnings)
Recap ideas so far

I Analysis of individual choice and decisions

I Uncertainty and lack of information complicate
decision-making
I Most people in most situations are risk averse and try to
reduce uncertainty
Recap ideas so far

I Analysis of individual choice and decisions

I Uncertainty and lack of information complicate
decision-making
I Most people in most situations are risk averse and try to
reduce uncertainty

I Insurance can mitigate uncertainty

I Pricing risk is key to make insurance markets work
Information Asymmetry

Manufacturers who claim their products are superior quality

compete to provide longer warranties
Information Asymmetry

Manufacturers who claim their products are superior quality

compete to provide longer warranties

New car owners must purchase insurance before driving on

public roads

Firms offer a combination of fixed and variable pay to new

employees to motivate maximum performance

This session examines why insurance markets might not work,

and remedies to overcome these challenges
Adverse Selection

Market breakdown
I Akerlof (1970) showed that it is possible there is no trade in the
market, even though
1. Sellers willing to sell goods at a given price
2. Buyers willing to purchase goods at the same price
Adverse Selection

Market breakdown
I Akerlof (1970) showed that it is possible there is no trade in the
market, even though
1. Sellers willing to sell goods at a given price
2. Buyers willing to purchase goods at the same price

The reason is hidden information.

Adverse Selection

Market breakdown
I Akerlof (1970) showed that it is possible there is no trade in the
market, even though
1. Sellers willing to sell goods at a given price
2. Buyers willing to purchase goods at the same price

The reason is hidden information.

The mechanism is adverse selection.

Lemon’s Problem
In new car market

I Two types of cars: Peaches and lemons

1. Look the same, but peaches work (Good) and lemons don’t
(Bad)
2. Good cars are fraction 0.6
3. Lemons are fraction 0.4
Lemon’s Problem
In new car market

I Two types of cars: Peaches and lemons

1. Look the same, but peaches work (Good) and lemons don’t
(Bad)
2. Good cars are fraction 0.6
3. Lemons are fraction 0.4

I If dealers cannot distinguish between the two, both sold at same

price
1. Good cars are worth Rs. 2 lakh to buyers
2. Lemons are worth Rs. 1 lakh to buyers
Lemon’s Problem
In new car market

I Two types of cars: Peaches and lemons

1. Look the same, but peaches work (Good) and lemons don’t
(Bad)
2. Good cars are fraction 0.6
3. Lemons are fraction 0.4

I If dealers cannot distinguish between the two, both sold at same

price
1. Good cars are worth Rs. 2 lakh to buyers
2. Lemons are worth Rs. 1 lakh to buyers
⇒ Market clearing price for new cars should be

(0.6 × 2) + (0.4 × 1) = Rs. 1.6 lakh

Lemon’s Problem
In used car market

I Two types of cars: Peaches and lemons

1. Peaches are fraction 0.6
2. Lemons are fraction 0.4
⇒ The average price for used cars should be Rs. 1.6 lakh
Lemon’s Problem
In used car market

I Two types of cars: Peaches and lemons

1. Peaches are fraction 0.6
2. Lemons are fraction 0.4
⇒ The average price for used cars should be Rs. 1.6 lakh

But the market will not clear at this price!

I Recall that
I Buyers cannot distinguish between lemons and peaches
I Sellers know which car is which

I At Rs. 1.6 lakh, sellers will gladly sell lemons, but not peaches

I Buyers know that the only cars offered are lemons

I Market clearing price will be Rs. 1 lakh
I Only lemons are sold, all peaches are unsold
Adverse selection in car insurance

I Two types of individuals: High risk and Low risk

I Equal fraction (50%) of each type
I Both types start with W = 125. Loss reduces W to 25
I High-risk individuals have loss probability 0.75
I Low-risk individuals have loss probability 0.25
I Expected loss (H) is (0.75 ∗ 100) = 75
I Expected loss (L) is (0.25 ∗ 100) = 25
Actuarially Fair Insurance

I In an actuarially fair insurance policy, the premium is equal to

the expected loss and the insurance company breaks even.

In this case:
⇒ High risk drivers will pay premium = 75
⇒ Low risk drivers will pay premium = 25
Car Insurance
Perfect information case

√
Assume U = W (Risk averse preferences)
I High risk without insurance
√ √
U = (0.25) 125 + (0.75) 25 = 6.55
√
I High risk with insurance U = 125 − 75 = 7.07
I Low risk without insurance
√ √
U = (0.75) 125 + (0.25) 25 = 9.64
√
I Low risk with insurance U = 125 − 25 = 10
⇒ Both High risk and Low risk drivers will purchase insurance
Car Insurance
Asymmetric information case

Insurer cannot distinguish between High and Low risk drivers

⇒ Average premium should be 50
⇒ High risk drivers will buy insurance at this price, but Low risk
drivers will not
⇒ Since only High risk drivers will buy insurance, insurance premium
increases to 75

⇒ Asymmetric information implies no insurance for Low risk drivers

Signaling
Overcoming Adverse Selection

I Potential market breakdown due to adverse selection

I Sellers take a credible, costly action, i.e., a signal, that shows they
are high quality providers

I Action too costly to be replicated by low quality providers

I Important: Potential buyers of goods know that only high quality

providers can undertake the signal
Job Market Signalling

I Employees can be either lazy (L) or hard working (H)

I Hiring, testing and firing workers is very costly
I Firms would like to hire only hard workers
Job Market Signalling

I Employees can be either lazy (L) or hard working (H)

I Hiring, testing and firing workers is very costly
I Firms would like to hire only hard workers

I Lazy workers look like hard workers

I Is there a way firms can distinguish between two types of workers?
Job Market Signalling

I Employees can be either lazy (L) or hard working (H)

I Hiring, testing and firing workers is very costly
I Firms would like to hire only hard workers

I Lazy workers look like hard workers

I Is there a way firms can distinguish between two types of workers?

I Answer
I Hard workers will send a signal that is too costly for lazy
workers to mimic
I Investing in education is one such signal
I Hard workers complete courses at lower cost than lazy workers
I Credible signal of worker quality
Lazy workers
Hard workers
Water-proof watch sales

Source: www.lightbox.com
Business school signals
Watch at home

I HBS students can signal their interest in two employers, increasing

chances of getting an offer

http://www.youtube.com/watch?v=wSYkYrnsfKg
Dating signals

I Singles on Cupid.com have two virtual ‘roses’ they can send to

potential suitors
I Increases probability of getting a reply by 35 percent

Cupid.com "virtual rose"? - An exclusive Cupid.com virtual rose

is added to a message that says "I think you're special." It's
a special touch that only Gold Members can give. A limited number
are given to each Gold Member. Roses are replenished monthly, when
the Gold Member's subscription renews.
Warranties as Signals
Adverse selection in the product market

I Notation
PH : Consumers’ reservation price for high quality good
PL : Consumers’ reservation price for low quality good
Assume PH > PL

CH : Cost of producing high quality good

CL : Cost of producing low quality good
Assume CH > CL

X Number of years under warranty

XWH : Warranty cost of high quality good where
XWL : Warranty cost of low quality good
Assume WL > WH
Warranties as Signals
Case 1: Any good with a warranty is a high-quality good

I Profit from high quality good with warranty

PH − CH − XWH

I Profit from high quality good without warranty

PL − CH

⇒ High quality producer will issue a warranty if

PH − CH − XWH > PL − CH
Warranties as Signals
Case 1: Any good with a warranty is a high-quality good (contd.)

I Profit from low quality good with warranty

PH − CL − XWL

I Profit from low quality good without warranty

PL − CL

I Low quality producer will not issue warranty if

PH − CL − XWL < PL − CL

⇒ Credible warranty
PH −PL PH −PL
WH >X > WL
Warranties as Signals
Case 2: Good with longer warranties is a high quality good

I Longest warranty low quality producer can afford to offer

PH −PL
X = YL where YL = WL
Warranties as Signals
Case 2: Good with longer warranties is a high quality good

I Longest warranty low quality producer can afford to offer

PH −PL
X = YL where YL = WL

I Longest warranty high quality producer can afford to offer

PH −PL
X = YH where YH = WH
Warranties as Signals
Case 2: Good with longer warranties is a high quality good

I Longest warranty low quality producer can afford to offer

PH −PL
X = YL where YL = WL

I Longest warranty high quality producer can afford to offer

PH −PL
X = YH where YH = WH

I Since WL > WH and YH > YL

⇒ High quality product will have warranty YH = YL + 1
⇒ Low quality product will not have warranty
Counter signaling
Too cool for school?

I Nouveau riche consume conspicuously while those with old money

are understated

I Neighborhood gangsters often resort to violence and threats, but

truly powerful leaders rarely use violence

I Professors in local colleges insist on being called “Dr.”, but

Nobel-laureates often go by their first name
Counter signaling

I Not signaling is a signal too!

I By not signaling, person shows they are so confident of their

abilities that signal is not required

I While signaling helps to distinguish between low and mid quality

goods, counter-signaling distinguishes between mid and high quality
Signaling in Seinfeld

http://www.yadayadayadaecon.com/clip/16/
Principals, Agents and Incentives within Organizations

CEOs and senior executives who own significant shares of a

firm work harder to maximize stock returns than those who
do not
Principals, Agents and Incentives within Organizations

CEOs and senior executives who own significant shares of a

firm work harder to maximize stock returns than those who
do not

Employees on fixed wages who are difficult to fire often arrive

late, take long lunch breaks and leave early
Principals, Agents and Incentives within Organizations

CEOs and senior executives who own significant shares of a

firm work harder to maximize stock returns than those who
do not

Employees on fixed wages who are difficult to fire often arrive

late, take long lunch breaks and leave early

Hiring managers design contracts to maximize employee

performance
The Principal-Agent Relationship

I The Principal owns resources

I The Agent is hired by the principal and given stewardship over
resources
I Contract imperfectly describes future contingencies
I Post-contractual behaviour of the agent must be either monitored
or properly motivated
Moral Hazard

Market breakdown
I The principal cannot observe, verify or enforce all actions of the
agent
1. Agents change actions to suit their own welfare, rather than
principal’s welfare
2. Impossible to write contracts
Moral Hazard

Market breakdown
I The principal cannot observe, verify or enforce all actions of the
agent
1. Agents change actions to suit their own welfare, rather than
principal’s welfare
2. Impossible to write contracts

The reason is hidden action.

Moral Hazard

Market breakdown
I The principal cannot observe, verify or enforce all actions of the
agent
1. Agents change actions to suit their own welfare, rather than
principal’s welfare
2. Impossible to write contracts

The reason is hidden action.

The mechanism is moral hazard.

Incentive Schemes

I Pay for performance

I Start-ups: Stock options
I Sales: Commissions
I Factory workers: Piece rates
I Lawyers: Fixed fee, hourly rate or contingency
I Doctors: Fee for service

I Promotion tournaments
I CEOs and senior executives

I Intrinsic motivation
I Selection into profession (nuns, soldiers)
I Public recognition and rewards (“Employee of the month”,
galantry awards)
I Socialization (“unit’s honor”)
Teacher Absence Rates by Country

Teacher
absence (%)

Peru 11
Ecuador 14
Papua New Guinea 15
Bangladesh 16
Zambia 17
Indonesia 19
India 25
Uganda 27

Source: Chaudhary et al (2004) for most countries; Habyarimana et al (2004) for Zambia; World Bank (2004) for

Papaua New Guinea.

Teacher Absence in Government Schools in India

State Absence (%) State Absence (%)

Maharashtra 14.6 West Bengal 24.7

Gujarat 17.0 Andhra Pradesh 25.3
Madhya Pradesh 17.6 Uttar Pradesh 26.3
Kerela 21.2 Chhattisgarh 30.6
Himachal Pradesh 21.2 Uttaranchal 32.8
Tamil Nadu 21.3 Assam 33.8
Haryana 21.7 Punjab 34.4
Karnataka 21.7 Bihar 37.8
Orissa 23.4 Jharkhand 41.9
Rajasthan 23.7

Weighted Average 24.8

Teachers in Public Schools

The problem
I Poor performance of public schools in developing countries
(including India)
I Many reasons, including low teacher quality, attendance and
motivation

What is the solution?

Teacher Pay for Performance

Image course: Business Today Kenya.

Teacher Pay for Performance
An experiment in Kenya

I Primary school teachers in Kenya

I Poor performance of public schools in Kenya
I Teacher absenteeism is 20%; chronically late
I Hiring, promotion and increments based on education and
seniority
I Strong civil service and union protection
I Gifts from parents if students perform well
I Transfers to undesirable districts if students perform poorly
(rare)

Can teacher compensation based on student performance improve

learning?
Teacher Pay for Performance
An experiment in Kenya

I 50 incentive schools with up to 24 schools eligible for prizes, 50

no-incentive (control) schools
I Prizes for all teachers in school based on (i) Absolute student
performance and (ii) Improvements in teacher performance
I First prize suits ($51 - 43% of monthly salary)
I Second prize cutlery ($43)
I Third prize tea set ($34)
I Fourth prize linen ($26 - 21% of monthly salary)
I Outcomes measured on national primary school-leaving exam

What is the impact of the incentives?

Teacher Pay for Performance
Official test scores increase, but not broad learning

Year 0 Year 1 Year 2 Year 3

(Pre-program) (Post-program)

A. Score on formula used to reward teachers

Incentive school 0.036 0.131* 0.215*** 0.026
(0.083) (0.079) (0.075) (0.060)
Observations 63,812 76,509 73,789 57,674

B. Take government exam?

Incentive school 0.002 0.064* 0.070** -0.005
(0.029) (0.038) (0.029) (0.028)
Observations 14,945 9,731 11,651 8,964

C. Take NGO exam?

Incentive school 0.010 0.019** 0.010 0.032
(0.012) (0.008) (0.028) (0.036)
Observations 14,921 13,085 12,982 2,277

D. Drop out?
Incentive school 0.004 -0.008 -0.008 0.002
(0.017) (0.012) (0.011) (0.009)
Observations 13,841 13,347 12,007 9,479

Source: Glewwe, Ilias and Kremer (2010) “Teacher Incentives” American Economic Journal: Applied Economics.
Teacher Pay for Performance
Increase in test prep sessions

Year 0 Year1 Year 2 Year 1 minus

Year 0

Number of test preparations sessions

Incentive school -0.011 0.042 0.074** 0.053
(0.044) (0.037) (0.034) (0.042)
Observations 3,000 3,000 3,000 3,000

Source: Glewwe, Ilias and Kremer (2010) “Teacher Incentives” American Economic Journal: Applied Economics.
Teacher Pay for Performance
Increase in test taking skills

Any of last four Correctly Correctly answers

MCQs correct? answers MCQ fill-in-blank ques. Diff.

Indicators of correctly answering different types of questions (year 2 English test)

Incentive school 0.243** 0.036* 0.022 0.015**
(0.105) (0.020) (0.019) (0.007)
Observations 8573 9395 9395 9395

Source: Glewwe, Ilias and Kremer (2010) “Teacher Incentives” American Economic Journal: Applied Economics.
Teacher Pay for Performance
No change in teacher attendance or teaching pedagogy

Year 0 Year 1 Year 2 Year 1 minus Year 2 minus

Year 0 Year 0

A. Teacher attendance (percent of visits teacher is present)

Incentive school 0.041 -0.014 0.002 -0.066 -0.036
(0.038) (0.021) (0.027) (0.047) (0.056)

B. Teacher present in the classroom

Incentive school -0.020 -0.008 0.044 0.009 0.081
(0.050) (0.042) (0.058) (0.065) (0.082)

C. Use of blackboard
Incentive school 0.018 -0.028 0.047 -0.048 0.069
(0.024) (0.022) (0.040) (0.031) (0.063)

D. Use of teaching aid

Incentive school -0.028 -0.004 0.015 0.027 0.050
(0.028) (0.030) (0.040) (0.57) (0.070)

E. Teacher energy (1 to 5 where 1 is energetic)

Incentive school 0.010 0.031 -0.129 -0.026 -0.048
(0.094) (0.069) (0.106) (0.143) (0.181)

F. Homework assignment
Incentive school 0.054 -0.045 -0.008 -0.079 -0.020
(0.036) (0.045) (0.045) (0.057) (0.058)

Source: Glewwe, Ilias and Kremer (2010) “Teacher Incentives” American Economic Journal: Applied Economics.
Pay for Performance

I Other experiments in India and the US find similar results

I Performance pay for public sector workers is promising, BUT

I Multiple dimensions to public missions (Multitasking)
I Organizational inequality and conflict
I Hit ceilings to effort
I Fiscally expensive
I Selection into profession
Session Recap

I Analysis of individual choice and decisions

I Insurance can mitigate uncertainty
I BUT, insurance markets break down due to adverse selection
Session Recap

I Analysis of individual choice and decisions

I Insurance can mitigate uncertainty
I BUT, insurance markets break down due to adverse selection

I Government mandates are one way to overcome adverse selection

I Signaling is how markets overcome adverse selection
Session Recap

I Analysis of individual choice and decisions

I Insurance can mitigate uncertainty
I BUT, insurance markets break down due to adverse selection

I Government mandates are one way to overcome adverse selection

I Signaling is how markets overcome adverse selection

I Moral hazard threat to insured contracts

I Pay-for-performance explicitly motivates employee effort
I Implicit incentives effective in many settings
Practice Problem 1

I Arnab is a √
risk-averse decision maker whose utility function is given
by U(I ) = I , where I denotes Arnab’s monetary payoff from an
investment. Arnab is considering an investment in machine tools
factory with a payoff of Rs. 10,00,000 with probability 0.6, and Rs.
250,000 with probability 0.4. If the cost of the investment is Rs.
6,00,000, should Arnab invest in this factory?
Practice Problem 2
Consider two types of farmers and two pieces of land. An ‘independent farmer’
works his own piece of land versus ‘collective farmers’ who cooperate and jointly
working on two pieces of land. Each farmer (whether independent or collective)
can decide how much time to spend farming. Let farmer i’s weekly time spent
on farming be hi (in hours per week; so h1 for farmer 1 and h2 for farmer 2).
The farmer’s productivity (expressed in bushels of grain) is directly proportional
to the time he spends on farming. In particular, an independent farmer produces
(80 ∗ hi ) bushels of grain if he works hi hours per week. Farmers in a collective
are more productive since they can specialize: a collective farmer produces
(90 ∗ hi ) bushels of grain if he works hi hours per week. Collective farmers share
the output of their farm equally. Let bi be the bushels of grain that farmer i can
take home at the end of the year, then bi = 80hi for an independent farmer,
while bi = (90h1 + 90h2 )/2 for a collective farmer. Farmers dislike working and
more so as they work more. In particular, farmer i’s utility is Ui = bi − (hi2 /2).
Assume that a farmer i will choose hi to maximize his utility Ui .
a. Write out the utility functions of an independent farmer and the collective
farmers completely in terms of h1 and h2 .
b. How many hours will an independent farmer work (assuming that farmers
choose hi to maximize their utility)? What is his utility?
c. How many hours will a collective farmer work? What is his utility?
d. What is the problem with a collective farm? What would happen
(qualitatively) if 100 farmers worked jointly in a collective farm? How
could the farmers solve that problem?