Question 1012 moral hazard, principal agent problem, asymmetric information
When does the ‘principal-agent problem’ occur? Is it when:
I. The principal has conflicting incentives (moral hazard);
II. The agent has conflicting incentives (moral hazard);
III. The principal has incomplete information about the agent (asymmetric information); or
IV. The agent has incomplete information about the principal (asymmetric information)?
The principal-agent problem occurs when the following statements are true:
The principal-agent problem occurs when the the agent has conflicting incentives and the principal has incomplete information about the agent.
For example, a lone worker (agent) in a retail shop is remotely managed by their boss (principal). The boss cannot easily monitor their employee without being on-site, next to them in the shop. This might be because there's only enough work for one person or because the opportunity cost of the boss's time is very high.
The boss wants the worker to achieve their sales targets every month, be friendly to customers, up-sell, keep the shop clean and organised and take short lunch and toilet breaks.
However, a worker who is secretly slothful, unknown to the boss, may be tempted to take long breaks, evade customers and not bother keeping the shop clean and organised. Since the boss can't easily observe the worker, it's hard to know whether the worker is under-achieving sales targets due to low foot traffic (not the worker's fault) or laziness. It's difficult to tell if the shop is dirty and disorganised due to messy customers (not the worker's fault) or worker indolence. This is the principal-agent problem.
Question 1009 lemons problem, asymmetric information, adverse selection
Akerlof’s 1970 paper ‘The Market for "Lemons": Quality Uncertainty and the Market Mechanism’ provides a famous example of asymmetric information leading to market failure. This example is commonly known as the ‘Lemons Problem’. Imagine that half of all second hand cars are:
- Lemons worth $5,000 each. Lemons are bad second-hand cars with hidden faults that only the seller knows about; and the other half are
- Plums worth $10,000 each. Plums are good second-hand cars without faults.
Car buyers can’t tell the difference between lemon and plum cars.
Car sellers know whether their car is a lemon or a plum since they’ve driven the car for a long time. However, plum car owners cannot prove their cars’ higher quality to buyers. Also, lemon car owners are known to dis-honestly claim that their cars are plums.
What will be the market price of second hand cars?
It might first appear that the buyer, who can't tell the difference between plums and lemons, will pay the probability-weighted expected value: $7,500 (=0.5*10,000+0.5*5,000).
However, the sellers with plum cars worth $10,000 won't be happy to sell their good cars for only $7,500, so only lemon cars worth $5,000 will be put up for sale. The buyer knows this, so the buyer should expect to only see lemons supplied, and therefore only bid the $5,000 lemon price. The lemon car sellers are 'adversely selected'.
This is known as market failure.
Akerlof (1970) compares the situation with Gresham's Law:
Gresham's law has made a modified reappearance. For most cars traded will be the "lemons," and good cars may not be traded at all. The "bad" cars tend to drive out the good (in much the same way that bad money drives out the good). But the analogy with Gresham's law is not quite complete: bad cars drive out the good because they sell at the same price as good can; similarly, bad money drives out good because the exchange rate is even. But the bad cars sell at the same price as good cars since it is impossible for a buyer to tell the difference between a good and a bad car; only the seller knows. In Gresham's law, however, presumably both buyer and seller can tell the difference between good and bad money. So the analogy is instructive, but not complete (Akerloff 1970, page 489)
Question 1010 lemons problem, asymmetric information, adverse selection, fungible
The ‘Lemons Problem’ is likely to more adversely affect the desirability of which type of investment?
Residential real estate is not fungible, which means that each property is different and unique. Even for near-identical apartments, one might have quieter neighbours than the other which is not apparent to a buyer after a brief inspection. Due to the buyer having less information about the property than the seller, there is an asymmetric information or 'lemons problem'.
'Lemon' properties, with hidden problems that only the seller is aware of, are more likely to be sold than plum or peach properties with no problems.
Fungible assets that are all identical such as listed stock in the one company or bank bills issued by the one bank and maturing at the same time with the same face value don't suffer from this problem, so long as no insider trading occurs. This is because all fungible assets are identical, so the buyer and seller have symmetric information.
There are lots of potential hidden problems with real estate, such as rising damp causing odours after rain, loose-fill and sheet asbestos, structural building problems, old peeling paint causing lead poisoning, unpleasant neighbours, new planned highways causing noise and air pollution or towering apartments that block sunlight, cause congestion, peer through your windows and throw rubbish into your yard.
Question 1011 winners curse
A teacher fills up a large jar with coins. The jar is auctioned among a large class of wealthy accounting students who have never studied economics or finance.
The auction is conducted in the English style, which is as an open-outcry ascending auction. This means that the winning bidder is able to bid, win and pay slightly more than the second highest bidder's private valuation, but less than their own private valuation.
The jar of coins is not allowed to be weighed by students and is filled with different-valued coins so it’s difficult to value. Therefore there is a wide distribution of bidders’ fair value estimates. Students’ bids are purely profit-driven, there is no fame to be gained by being the winner or loser.
Assume that each bidder bids up to their personal estimate of the fair value of the jar of coins without observing the number of other bidders during the auction. The winning bidder is likely to:
'Winner's Curse' is likely to occur here due to the large number of potential bidders and the large variation in their estimates of the mean value of the coin jar. All of the students will have a random estimate of the fair value of the coin jar. The mean of median estimate will be the closest to the fair value. But the student with the highest random valuation is likely to win the auction, and they would have paid more than the mean valuation, which is too much.