1、Chapter 7 Hidden characteristics problemGeorge HendrikseEconomics and Management of Organisations:Co-ordination,Motivation and Strategy Figure III:Positioning of Part III behavioural hypothesisopportunisticselfishidealisticcompleterationalityHiddencharacteristicsdegree ofrationalitylimitedrationalit
2、yproceduralrationalityWelfare theorem Anonymity Law of demand and supply Complete set of markets Law of one priceKeywords Ex ante information asymmetry Adverse selection Self-selection Signaling ScreeningIncentivesHidden characteristics problems are due to asymmetric information and diverging intere
3、sts.Agent has superior information(about preferences or costs)before a contract is determined by the principal in a hidden characteristics problem,i.e.there is an ex ante information asymmetry.Two hidden characteristics problems Adverse selection MisrepresentationExample:Dental insuranceSuppose that
4、 an insurance company has done research regarding the average family dental outlays.Each family knows the quality of the teeth of the various family members,while the insurance company is less informed.There are 5 types of familiesOutlays(in euros)Percentage of population20020400206002080020100020Av
5、erage annual dental outlays for families is 600 euros.A naive insurance company asks an insurance premium of 700.Average profit per family:700-600=100.Behaviour of families Families with dental outlays of 600 or less will not buy insurance.Families with dental outlays of 800 or more will buy insuran
6、ce.Implications1.Average dental outlays of the families buying insurance is(800+1000)/2=900.2.The naive insurance company runs a deficit.Observation The insurance company has to adopt a different premium policy in order to make a profit.Nash equilibriumChoice of policy by a rational insurance compan
7、y:Offer insurance at a price of 1000.Only the families with the highest dental outlays will buy insurance.Pareto inefficiency:adverse selectionThe adverse selection model consists of three stages:1.Nature chooses the type(ability)of the agent.2.Principal chooses contract,without knowing the type of
8、the agent.3.Agent accepts or rejects contract.Figure 7.1:The order of decisions in the hidden characteristics problemChoice of characteristicRRAARARADFDFLHNaturePrincipalChoice of contractAgentDecision to acceptExample:InsuranceX:Expected benefit or claim payment to buyerV:Value from risk reduction
9、of insuranceP:Insurance premiumBuyer with characteristics X will buy insurancewhen:P X+VX P-VSuppose V=1 andX=Xg=3,50%population is type G Xb=7,50%population is type BHow does the insurance premium P in equilibrium depend on the structure of information?Figure 7.2:Decision order and payoffs in the i
10、nsurance with complete informationAR ARAR ARARARARAR1481114811.5.5 37NatureChoice of characteristicInsurance companyChoice a,bClientDecision to accept-201 580-60 010 4000-3 300-4-70 70 000-30004Payoff principalPayoff agentComplete contingent contractA contract can and will specify a price for each s
11、tate/type.A contract consists therefore of two variables,i.e.p3,p7.Figure 7.3:Equilibrium in the insurance market with complete information Choice of characteristicAR ARAR ARARARARAR1481114811.5.5 37NatureInsurance companyChoice a,bClientDecision to accept-201 580-60 010 4000-3 300-4-70 70 000-30004
12、Payoff principalPayoff agentNash equilibriumPrincipal:4,8Agent of type 3:YesAgent of type 7:YesNotice that both types buy insuranceFigure 7.4:Asymmetric information/hidden characteristic in the insurance problemChoice of characteristicAR AR AR ARARARARAR1481114811.5.5 37NatureInsurance companyChoice
13、 PClientDecision to accept-201 580-60 010 4000-3 300-4-70 70 000-30004Payoff principalPayoff agentComplete contractInsurance company can not make price dependent on type because the characteristic is not observable(i.e.hidden).A contract will specify only one price!The contract is P.Figure 7.5:Accep
14、tance decisions and payoffs in the insurance problem Price P Surplus buyer Buy?Expected profit insurance company 3.5L:4-3.5 0H:8-3.5 0YesYes.5(3.5-3)+.5(3.5-7)=-1.54L:4-4=0H:8-4 0YesYes.5(4-3)+.5(4-7)=-16.5L:4-6.5 0NoYes.5(6.5-7)=-.258L:4-8 0H:8-8=0NoYes.5(8-7)=.59L:4-9 0H:8-9 0NoNo 0 The profit max
15、imising complete contract of the principal is therefore 8.Nash equilibriumPrincipal:8Agent of type 3:NoAgent of type 7:YesObservationOnly(bad quality/high cost)buyers get insurance.General tendencies in markets with hidden characteristics Less exchange than in a market with complete information (Los
16、s of CS+PS)One price in equilibrium (because price can not be made dependent on quality).Adverse selectionMain questionWhich organisation/institution/rules minimise the loss of surplus in the principal-agent problem?Solutions for the hidden characteristics problem are geared towards the ingredients
17、of the model.Three kinds of solutions to adverse selection problems1.Eliminate the problem(by reducing choice)Organisational change replacing market2.Menu of contracts/Self-selection(market solution by increasing choice)Repeal of the law of one price3.Generate additional information(market solution)
18、-screening-signalling1.Eliminate the problemPrevent adverse selection to occur by eliminating certain choices.Replace the market by an organisational/institutional change.Example:mandatory insurance2.Self selectionContracts consisted of one variable(price,insurance premium,interest rate,wage,).Ranki
19、ng of contracts across types is therefore the same.If contracts consist of two variables,then the choice of a particular contract may reveal something about the hidden characteristics of this person.Suppose that there is a contract variable which the agent does not like,i.e.bad 1,and a good contract
20、 variable for the agent,i.e.good 2.Preferences regarding these two contract variables are depicted with indifference curves.There are two types of individuals:low quality(l)and high quality(h).Indifference curves of both types of agentsLBAH1Bad 1Good 2The indifference curve of a person with bad char
21、acteristic is the steepest,because this person requires a larger compensation(A+B)for an additional unit of the bad in order to stay on the same indifference curve.(One additional unit of the bad requires less compensation for an H-type in order to stay on the same indifference curve.)Menu of contra
22、ctsLBHBad 1Good 2HighLowHighLowIncreasing utilityANotice that the above figure represents a good and a bad from the perspective of the agent(informed player).A person of type L prefers contract A above contract B.A person of type H prefers contract B above contract ANotice that the type of the agent
23、 is not observable by the principal,but that the agents reveal their type(hidden characteristic)by their choice behaviour.Example:Wages and seniorityHidden characteristic:probability of early departure.Seniority wagesWage at retirement ageSeniority part in wageBA0highlowlowhighLHEquilibriumJob candi
24、dates with a low probability of early departure will choose contract B.Companies offering these contracts are willing to invest substantially in schooling because this investment will pay itself back over time.Two types of equilibria Pooling equilibrium:Different types choose the same contract.Separ
25、ating equilibrium:Different types choose different contracts.It depends on the preferences of the agents(IC-constraints),their outside opportunities(PC-constraints)and the population whether a separating equilibrium(i.e.agents with different characteristics choose different contracts)or pooling equi
26、librium(agents with different characteristics choose the same contract)occurs.Figure 7.15:Hidden characteristics and separating equilibrium/self-selectionHLABABARARARARNatureChoice of typePrincipalChoice of contractAgentDecision to acceptFigure 7.16:Hidden characteristics and pooling equilibriumHLAB
27、ABARARARARNatureChoice of characteristicPrincipalChoice of menu of contractsAgentDecision to acceptComposition of populationSelf-selection conditionsParticipation constraintsRemarks about the self-selection solution Efficiency(CS+PS)increases due to the introduction of a second variable into contrac
28、ts,but the high quality types still suffer.Self-selection in equilibrium depends on the preferences,reservation wages and the distribution of types.Repeal of the law of one price Certain organisational practices(seniority wages,piece rate wages,dividends)are understood as a second variable in contra
29、cts in order to mitigate adverse selection effects.3.Generate extra information1.Screening2.Signalling1.ScreeningPrincipal(uninformed player)collects additional information.Figure 7.21:Hidden information and screeningLHGBGBABABABABNatureChoice typePrincipalChoice screenPrincipalChoice contractARARAR
30、ARARARARARAgentAcceptance decisionExample:Banks collect information about pay back history of customersExample:Entrance examinationsScreening might work,but not perfectly.2.SignallingAgent(informed party,i.e.person with superior information)transmits additional informationFigure 7.19:Hidden informat
31、ion and signallingLHGBGBABABABABNatureChoice typeAgentChoice signalPrincipalChoice contractARARARARARAR ARARAgentAcceptance decisionExample:The unravelling principle of Grossman If only the average quality of a group of people is known,then every person will announce his/her level of quality.Suppose
32、 there are three students who received the grades 7,8,and 9.It is not known who has received which grade.If it is only announced that the average grade is 8,then the person with a 9 has a strong incentive to announce that(s)he has a grade above the average.The average of the remaining two people drops to 7.5.The person with the 8 now has a strong incentive to announce that his grade is higher than a 7.5.
