CLASS 7: Asymmetry of Information

Oren Sussman

Saïd Business School, University of Oxford

Oxford, Michaelmas term, 2021

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Oren Sussman Class 7: Asymmetry of Information

Asymmetry of information

Prime suspect of market failures in financial markets

see
class-3 trade in test results
class-6 costly state verification
class-6 absent insurance market ⇒ liquidity shortages

Notice
the problem is the asymmetry, not the shortage of information
if both parties are equally ignorant, Chapter-5 analysis

Warning
market failures do not follow automatically from information
asymmetries
more so: the right sort of regulation is not an immediate
implication
a detailed analysis is required
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Oren Sussman Class 7: Asymmetry of Information

Taxonomy of the problem

adverse-selection moral-hazard
(hidden type) (hidden action)

1 e1
1
informed party
nature

uninformed party uninformed party

2

2 e2

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Oren Sussman Class 7: Asymmetry of Information

Simplest hidden type problem: Akerlof’s lemons (I)

Consider a second-hand car market with a multitude of

qualities, θi
θ1 < θ2 < ... < θI
with matching incidence in the population
hence, the probability of picking type i, at random: π i
quality is known to the vendor only

Common practice: derive a full-information benchmark

remove information asymmetry
there will be I (complete) markets

pi = θ i

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Oren Sussman Class 7: Asymmetry of Information

Akerlof (II)

With unobservable quality, one might think

 
p = E θe

However, since  
E θe < θI

θI drops out, so the next candidate is

 
e i < θI
p = E θ|θ

Repeated elimination ⇒ market shutdown

Question: how can the better types signal quality

e.g. indemnify the buyer
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Oren Sussman Class 7: Asymmetry of Information

Spence signaling model
Consider a labor market, with two types of workers,
differentiated by productivity, θi , i = H, L

θH > θL > 0

incidence of the H type: π

unit employer, cannot observe productivity
not even ex post

Workers can go to university, zero effect on prouctivity

at a subjective cost
cL > cH > 0

Labor market is competitive

labor in short supply

All players are risk neutral . . . . . . . . . . . . . . . . . . . .

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Oren Sussman Class 7: Asymmetry of Information

Full-information benchmark (I)

Two labor markets, with different wage rates, wi

Labor demand

 1 if θ i ≥ wi
firm’s labor demand =

0 if θ i < wi

Demand for university education

eH = eL = 0

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Oren Sussman Class 7: Asymmetry of Information

Full information benchmark (II)

w w
S S

wH   H D

wL   L D

 1   
type H type L

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Oren Sussman Class 7: Asymmetry of Information

A separating equilibrium

A a separating equilibrium may or may not exist

If it exists, it has to satisfy the following conditions:

two separate markets with wages wH and wL
education reveals H type


prob θ = θH | e = 1 = 1, → wH = θH

no education reveals L type

prob θ = θL | e = 0 = 1, → wL = θL

market clearing

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Oren Sussman Class 7: Asymmetry of Information

Revelation conditions (I)
Type H signals productivity by getting education

wH − c H > wL

Type L does not disguise as type H

wH − cL < wL

Solve out for wi and rearrange

θ H − θ L > cH θH − θL < cL

Express in terms of productivity-adjusted cost of signaling

(PACS)
cL cH
> 1 >
θH − θL θH − θL . . . . . . . . . . . . . . . . . . . .
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Oren Sussman Class 7: Asymmetry of Information

Detour: parameter space

So far, we presented equilibria with graphs that had the

endogenous variables, prices and quantities on the axes, being
“shifted” around by the exogenous variables (income,
technology ...)

In some cases, a more interesting question is:

for what combination of structural parameters would an
equilibrium exist
or the equilibrium would satisfy certain properties

In our case, there are four structural parameters, θH , θL , cH , cL

but they can be combined to two economically meaningful ones
the PACS

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Oren Sussman Class 7: Asymmetry of Information

Revelation conditions (II)

cL
θ H −θ L

separating
1

irrelevant

cH
450
1 θ −θ L
H

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Oren Sussman Class 7: Asymmetry of Information

Pooling equilibrium (I)
If it exists, it has to satisfy the following conditions
e = 0 for both types ⇒ pooled labor market

wp = πθH + (1 − π) θL

type H must form beliefs on

λ = prob θ = θH | e = 1

with implied wage rate

wb = λθH + (1 − λ) θL

type H does not attempt to signal (given beliefs)

wb − cH < wp

type L does not attempt tp signal (given beliefs)

wb − cL < wp
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Oren Sussman Class 7: Asymmetry of Information

Pooling equilibrium (II)

Substitute in
 
wb − wp = (λ − π) θH − θL

Express in terms of PACS

cL cH
> >λ−π
θH − θL θH − θL

Not clear how to nail down these beliefs

If λ = π, a pooling equilibrium exists all over the parameter
space

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Oren Sussman Class 7: Asymmetry of Information

Signaling and economic efficiency

Across separating and pooling equilibria

same level of employment
same level of productivity per worker

Revelation of type does not contribute to a better allocation

does consume resources

Separation is, in fact,

a transfer fro L to H type

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Oren Sussman Class 7: Asymmetry of Information

Myers & Majluf

There companies of (hidden) types i = H, L

incidence of H type: π
all players are risk neutral
a company is just an owner-manager

Both types have assets in place, that would generate income

y, with certainty
but no cash

Companies have a project that requires a unit investment,

generating income yH > yL
yi is observable
rf = 0
yH > 1, H is NPV positive

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Oren Sussman Class 7: Asymmetry of Information

Myers & Majluf: debt finance

The value of the company is

vi = y + yi

we assume that even vL > 1

so that any company can borrow at the riskless rate

A company would borrow and invest if only

y + yi − 1 > y

that is if yi − 1 > 0
i.e. project is NPV positive

Suppose L is NPV negative

(but not too negative)
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Oren Sussman Class 7: Asymmetry of Information

Myers & Majluf: equity-market shut down (I)
By way of contradiction, companies fund by selling a share α
of the company
h i
α πvH + (1 − π) vL = 1

1
α=
πvH + (1 − π) vL

The cost of funding to the issuer: αvi

Since
vH > πvH + (1 − π) vL > vL
it follows that
vH vL
αvH = > 1 > = αvL
πvH + (1 − π) vL πvH + (1 − π) vL
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Oren Sussman Class 7: Asymmetry of Information

Myers & Majluf: equity-market shut down (II)

L’s equity is over priced

cost of funding is low, possily

yL − αvL > 0

But L’s over-priced equity is at the expense of H

αvH > 1

So H pulls out of the equity market

signals in the information insensitive market – debt

L follows, market shuts down

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Oren Sussman Class 7: Asymmetry of Information

Mikkelson and Partch
Sample: 1972 to 1982, 360 listed companies
more than three thousand company years
595 funding events
44% did not report any funding event

(1) (2) (3)

type of security number of events amount/value (%) price impact (%)
common stock issuance 80 15.1 −3.6∗
straight debt issuance 172 30.0 −0.2
convertible debt 33 22.4 −2.0∗
preferred stock 14 25.6 −0.3
privatly-placed debt 80 − −0.6
term loans 61 − 0.2
credit agreements 155 − 0.9∗

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Oren Sussman Class 7: Asymmetry of Information

My own calculations
1988-1998, investment spikes, US listed companies, flow of
funds

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Oren Sussman Class 7: Asymmetry of Information

Theories of debt: a note

Chapter 2: security interests

debt restructuring

Chapter 6: costly-state verification

monitoring, banking, relationships

Chapter 7: debt signals quality

in public markets

Not covered

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Oren Sussman Class 7: Asymmetry of Information

Hidden action

An entrepreneur has an exclusive access to a project

investment required: one unit
wealth: w < 1
cash flow: (0, y), either failure or sucess
all players are risk neutral

Probability of success depends on hidden effort

i = H, L, π H > π L
eH = e, e = 0,

Entrepreneurs are in shor supply, investor breaks even

Project is NPV positive even under L effort

y × π H − e − (1 + r) > y × π L − (1 + r) > 0
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Oren Sussman Class 7: Asymmetry of Information

Comment on assumtions

Effort affects the probability of success

not the cash flow
so that even ex post, effort is not revealed

Entrepreneurship is in short supply

investor breaks even
not an essential assumption

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Oren Sussman Class 7: Asymmetry of Information

Full information benchmark (I)

Investor and entrepreneur negotiate a contract

Investor breaks even: participation constraint

RH π H = (1 − w) (1 + r) , RL π L = (1 − w) (1 + r)

Entrepreneur: find Ri , ei that delivers the highest:


H π H − eH

 y − R




y − RL π L





w (1 + r)

(objective function) s.t. the PC

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Oren Sussman Class 7: Asymmetry of Information

Full information benchmark (II)

Substitute the PC into the objective

   
y − RH π H − e = π H y − e − (1 + r) + w (1 + r)
 
y − RL π L = π L y − (1 + r) + w (1 + r)

H, the highest NPV option, is selected

first Welfare Theorem
through Ri , the entrepreneur internalizes the social cost of her
effort choice

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Oren Sussman Class 7: Asymmetry of Information

Full information benchmark (III)

The Modiglian-Miller Theorem holds

 
π H y − RH − e + π H RH = π H y − e

Proposition
Contract negotiation is a maximization problem: to find a
combination of contractible variables that deliver the highest value
to the informed player subject to delivering enough to the
uninformed player so that she is willing to participate in the
contract.

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Oren Sussman Class 7: Asymmetry of Information

Hidden effort: the incentive constraint

Effort is hidden: ei is not observable

but all the parameters are common knowledge

If so, ei is known, and can be made part of the contract

s.t. the incentive consytraint (IC)

Contracted effort maximizes


 (y − R) π H − eH

(y − R) π L

given R
not Ri

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Oren Sussman Class 7: Asymmetry of Information

The IC (II)

(y – R)πi – ei

y H  e

y L

R
R y
H L
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Oren Sussman Class 7: Asymmetry of Information

Contract problem: three types of solution

Rπi

R H

R L
L
R y
H

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Oren Sussman Class 7: Asymmetry of Information

The IC (IV)

In standard mathematical notation

i = argmaxi (y − R) π i − ei

Proposition
There is no “cheating” in a moral-hazard relationship. The
uninformed player knows, with confidence, what decision the
informed player makes. However, deprived of the ability to directly
observe and enforce the action of the informed player, the
unformed player must verify that the action that is agreed in the
contract is compatible with the incentives of the informed player.

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Oren Sussman Class 7: Asymmetry of Information

The contract problem

Same as full information + IC

Maxi,R (y − R) π i − ei

s.t.
PC : Rπ i = (1 − w) (1 + r)
IC : i = argmaxi (y − R) π i − ei
plus
(y − R) π i − ei ≥ w (1 + r)

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Oren Sussman Class 7: Asymmetry of Information

IC investor expected payoff

Rπi
A
(1 – w’’)(1 + r)

(1 – w’)(1 + r)

R
R* R’

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Oren Sussman Class 7: Asymmetry of Information

Contract problem: implications (I)

Proposition
The Modigliani-Miller Theorem no longer holds as the composition
of funding, internal and external, may affect the choice of effort
and, hence, the value of the firm. For example, when high effort is
not incentive compatible, and the entrepreneur operates the
project at a low level of effort, which is reflected in a low valuation
for the firm.

Proposition
When firm value is diminished, the entire loss of value falls on the
informed player, the entrepreneur. Whether the project is operated
at the H or L level of effort, the investor breaks even due to the
PC; since the risk adjusted cost of capital is always 1 + r, the loss
must fall on the entrepreneur.
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Oren Sussman Class 7: Asymmetry of Information

Contract problem: implications (II)
Proposition
It follows that being better informed operates to the determent of
the informed player. If only he could, he would opt to make the
result of the project observable to the uninformed player. That
would allow him to commit himself to a high level of effort, get
cheaper funding in return, and collect the entire extra surplus that
effort generates.

Proposition
Notwithstanding, the contract is Constrained Pareto efficient.
That is, subject to the constraints imposed on the problem by
information asymmetry, no Pareto improvements exist. The reason
is that, by construction, the contract maximizes the expected
payoff to the entrepreneur given a fixed expected payoff to the
investor (at the break even level) . . . . . . . . . . . . . . . . . . . .
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Oren Sussman Class 7: Asymmetry of Information

Contract problem: implications (III)

Proposition
The previous proposition does not exclude the possibility of
bailouts, namely gifting low-w, low-effort firms with cash,
decreasing their dependence on external funding, thereby enabling
high-effort contracts. However, such transfers are not Pareto
improvements as the tax payers that fund the gifts are worse off

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Oren Sussman Class 7: Asymmetry of Information

Alternative interpretation

Let b be hidden “private benefits of conrol”

perks of the job
executive jets, royal suits ...
indulging in these, undermines effective management

yπ H − (1 + r) > (y + b) π L − (1 + r)

Can also be interpreted as diverted cash

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Oren Sussman Class 7: Asymmetry of Information

Cutler and Summers (I)

Time line
2 January 1984, Pennzoil contract to buy a substantial
minority stake in Getty
Within a week, Texaco, acquirs Getty
so Getty is in breach of contract to Penzoil
Texaco takes all of getty liabilities
Penzoil sued Texaco
19 November 1985 a Texas jury awarded Pennzoil damages of
$12B
joint value of both is just $10.5B
a series of legal battles ensues
12 April 1987 Texaco files for bankruptcy
18 December 18 1987 they settle for $3B

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Oren Sussman Class 7: Asymmetry of Information

Deriving the supply of absorption (II)

Null hypothesis: (under M&M), wealth transfers have no

affect on joint value

Date Event Texaco Penzoil joint

19 Nov. 1985 Texas jury rules for Penzoil -646 296 -351
18 Dec. 1985 Texaco obtains temporary restraining order 446 -127 319
12 Feb. 1987 Court of Appeals upholds judgment -819 379 -440
6 Apr. 1987 Supreme Court vacates bond ruling -1000 276 -733

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Oren Sussman Class 7: Asymmetry of Information

Jensen and Meckling (1976)

The firm is a nexus of contracts

a web of agency relationships
managing conflicts: managers, workers, owners, external
investors, regulators, tax authorities
Contract: whatever affect the relationship
including charters, article of association, legal precedents
including banks, suppliers, buyers ...
no corporate personality
no social responsibilty

Differs, somewhat, from assets under joint ownership

as in class 3

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Oren Sussman Class 7: Asymmetry of Information

Stiglitz Weiss: credit rationing

full-information equilibrium
r*

credit rationing equilibrium

funds

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Oren Sussman Class 7: Asymmetry of Information