1 Business Economics I Coordination through Contracts II.

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Business Economics I

Coordination through Contracts II

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Adverse selection I

Problems of adverse selection arise when one or both parties are able to use an information advantage (they know something the other one does not know) to offer transactions that are hurting the interest of the other party.

Example: Car Insurance: Imagine that there are just two types of drivers:

cautious and reckless in equal proportions. The estimated costs of accidents of the cautious driver is € 1 000 and for the reckless driver – € 5 000. The insurance company does not know who is a cautious driver and who is reckless driver, so it offers a policy at a price the average of both: € 3 000 + a margin of € 500 = € 3500. Who is going to buy the insurance? What does this mean for the company?

Health Insurance

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Adverse Selection II

The presence of adverse selection means that (if parties respond rationally) some exchanges will not happen.

In order to make them viable, we have to design and introduce safeguard mechanisms that prevent opportunism.

Do you think that there could be a problem if adverse selection in eBay? Why?

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Solutions to Adverse Selection I

How can we alleviate the adverse selection problem? The source of the problem is in the combination

asymmetric information + the self-interest. What can we modify? – The information

That’s why we develop information mechanisms that aim at mitigating the effect of asymmetric information

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Solutions to Adverse Selection II

Screening: we find out the information about each individual.

How? – by “Self Selection; that is offering a menu of contracts, which are designed in a way that makes it better for the individuals to choose the contract that reflects their true characteristics.

Example: Insurance: deductible, partial coverage Labour contracts: salary increases with tenure/short

term performance

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Solutions to Adverse Selection III

Signalling: the individuals themselves signal in an unmistakable way their characteristics. In this way the insurer can offer them a contract + price corresponding to their true characteristics. Implications: signalling implies that it is no longer

profitable/beneficial or possible for the poor risk individuals to signal that they are good risk ones.

Examples: Risky drivers, have more fines for excess speed. Higher education as a signal Sun tan in the winter in Europe; clothes + make up & jewelry

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Solutions to Adverse Selection IV

Grouping: offering the contract to a group of individuals ‘en bloc’, so that the risk of adverse selection is eliminated from the outset Implication: the insurance/contract will be offered at a

price representing the average cost of all the individuals. In this way, we don’t need to know the characteristics of each individual.

Example: Health insurance bought by the company for all the

employees

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Moral Hazard

We speak of moral hazard problem, when we have opportunistic behaviour due to asymmetric information after contracting.

Example: Comprehensive car insurance; fire insurance in

California; Employees’ effort levels Buy backs of shares Lord Black

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Solutions to Moral Hazard

The most common solution is linking compensation to performance indicator

Example: Pay for performance - piece rate; commission based on

sales; stock option schemes

Implications: The indicator should be observable and measurable. Risk allocation

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Problems related to this MH solution

We can measure how many calls a call operator has answered but cannot measure whether (s)he was kind to the customers and whether helped them resolve their problems.

Result: The operator has incentive to answer as many calls as possible and no incentive to actually help the customers.

Bonus as a function of company profits: too much risk for the employee; inefficient risk allocation

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Agency Relations

Principal – the person/the party who contracts someone (the agent) to perform a task for him/them

Agent: the person/the party who is contracted to perform a task for the principal.

Example: La Caixa (P) hires you (A) to work in the credit

department You (P) contract a plumber (A) to repair the sink at

your home.

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Agency Problems

Agency problems arise when the behaviour of the Agent diverges from the one that is good for interests of the Principal.

Assumption: the Agent must act in good faith to best achieve the objectives set by the Principal.

Agency problems: opportunism on behalf of the Agent. Why do they exist? – diverging interests (self interested

actors) Asymmetric Information makes it costly to resolve the

agency problems.

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Agency Costs I

Agency costs: all the costs incurred in order to control agency problems on behalf of both the Principal and the Agent as well as the loss due to realized opportunistic behaviour

Examples: The time you spend supervising the plumber at home +

the time he spends to demonstrate to you that all the parts he uses cost as much as he says + the faster leaking of the sink because he uses a material that is not adequate for fixing the parts together.

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Types of Agency Costs

Agency Costs

Safeguard costs

Residual Loss (Opportunity

Cost)

Monitoring Costs (Principal)

Bonding Costs (Agent)

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Agency Costs II

Monitoring Costs: The expenses of the Principal both before and after the contract to make sure that the Agent complies with the terms of the contract.

Example: The inspection the bank carries out before lending you

money The cost of software tracking the Internet activities of

the employees when using the company computers.

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Agency Costs III

Bonding Costs: The expenses of the Agent to guarantee the Principal that Agent’s behaviour will not deviate from the one agreed upon.

Examples: The expenses associated with showing solvency and

faithful representation of the financial situation of the company (voluntary auditing even if it is not required)

The resources spent on building reputation.

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Agency Costs IV – Residual Loss

Total Cost

Safeguard Costs

Residual Loss

Costs

Intensity of SupervisionOptimal Safeguard

Costs

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Agency Costs – Residual Loss

Residual Loss: the difference between what would have been the hypothetical benefit for the P if there were no agency problems and the actual benefit when agency problems are present.

In theory we could bring the residual loss to 0, but the cost of doing so are too high.

We want to minimize the total cost. That’s why we choose a level of safeguard costs at which there will be some residual loss. The goal is that the sum of both is minimum.

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Reputation as Safeguard I

Reputation – what is it? The knowledge the others have with respect to what

you do in certain situations Example: He is a reliable client – he always pays his

bills on time; Donnie Brasko How do we build reputation?

We build our reputation via repeatedly not defaulting in our contractual relations.

This means that Reputation is costly

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Reputation as Safeguard II

What does reputation do? Signals to the principal that the agent will not deviate. This means that reputation can decrease safeguard

costs. For example, you don’t run a detailed check on a person who has been recommended to you by a reputable friend of yours.

Is this important: The good will of the companies Services and experience goods

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Reputation as Safeguard II

What are the costs of building and maintaining reputation? Time to build it Missing the gains from opportunistic behaviour Examples: Tylenol;

The importance of Repetition: Can you built a reputation if you trade only once with a

person? Is it costly to do it?

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Reputation as Safeguard IV

The Cost Benefit Analysis: When would you like to build and maintain your reputation? When the benefits are higher than the costs

Benefits>Costs means that There is little to gain from being opportunistic (you

won’t cheat for € 100; what about € 100 mln?) It is easier/ more likely that the opportunism will be

detected. The punishment for cheating are significant (compared

to the gains) Repetition makes it more likely that benefits>costs

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Implicit Contracts

Implicit contracts – many contracts in the firm are not formalized/written.

Examples: Promotion or salary raise for good performance Life long employment in big Japanese companies Josef Ackermann