Lecture Managerial economics - Chapter 9: Risk analysis and Moral Hazard

So far, we assumed there’s no uncertainty in the world. But, in reality, these payoffs are uncertain, most business outcomes are uncertain as well. In this chapter, we will learn: Risk analysis, Moral Hazard/Principal-Agent Problem. Inviting you to refer.

Week 9

Risk Analysis and Moral Hazard

Today’s Agenda

1 Risk Analysis

2 Moral Hazard / Principal-Agent Problem

So far, we assumed there’s no uncertainty in the world

• In the OPEC game, if Kuwait and Saudi share the market, they will both earn $180,000

But, in reality, these payoffs are uncertain

• In economics, it’s called “risky payoff.”

• In statistics, it’s called “probability distribution”

Most business outcomes are uncertain as well

• In order to make good business decisions, it’s very

important to understand this uncertainty and to measure the risk properly

Attitudes toward Risk

Suppose there are two salary options

1 Fixed salary of $100,000

2 Uncertain salary depending on coin toss outcome

– $0 if Heads and $200K if Tails

The preference between these 2 options will reveal the attitude toward risk.

Attitudes toward Risk (cont)

• If you prefer options #2, the uncertain payoff

Almost all people are risk-averse

• But the degrees of risk-aversion differ among people

• Some people are more risk tolerant than others.

Moral Hazard

Let’s consider an auto insurance

• By design, insurance pays for costs if certain events

occur

Insured people may have distorted incentives

• Insurance company wants you to drive safely

• But the insured may drive less carefully

Moral hazard

• What the insurance industry calls this distorted

incentive

The Principal-Agent Model

Moral hazard

• Economists use “principal-agent models” to

analyze moral hazard

The Principal-Agent Model

• agents work on behalf of the principals

• the problem of different incentives between agent and principal

• occurs because of asymmetric information

Principal-Agent Problem (cont)

Asymmetric Information

• One party has more private information than the other

• The party with private information is called “Agent”

• The other party without private information is called

“Principal”

There are many applications of principal-agent problem

• Shareholders vs Managers (in corporate finance)

• Employer vs Employee (managerial accounting)

• Politicians vs Public (in political science)

• unemployment, life, & auto insurance (in economics)

Solving principal-agent model

Several methods depending on the case

1 Monitor agents more carefully

• have health insurance customers come in for regular exams

• monitor employees at work

– Monitoring can be too costly

2 Use appropriate incentives

• co-payments in insurance

• performance based salary pay

3 New idea: give ownership to the agent

• independent contracting instead of employment

• outsourcing

• franchising

Adverse Selection

Suppose you purchase a new car for $20,000

• drive it for 1 day & then sell it the next day

–what would a buyer think about your car?

–what price will you get for your car? Why?

Asymmetric information:

• sellers know the true quality, but buyers do not

• this leads to adverse selection, often known as the

“lemons problem”

–George Akerlof (2001 Nobel prize)

Lemons Problem in Used Car Market

Adverse selection problem

• Suppose there’s an average fair price for used cars

• If the seller has good quality car with higher value than this price, he will not sell it

• Only the “lemons” (cars with defects) will remain in the

market.

–Adverse selection arises.

→ Bad cars drive out the good cars from the used car market

• This will further drive down the used car price.

Q: If you are a good car seller, what can you do?

How to Fix Adverse Selection?

Create a market for information

• Reveal information

– Carfax

– Better Business Bureau (BBB)

– quality data, product analysis, product

inspection, credit ratings, etc

• hire a mechanic to check the used car

• build seller reputation: brand names

Signaling

• Warranties & other guarantees

Self-Selection

high quality types to signal their quality

• Usually, signaling occurs when the seller has private

inspection records

Conditions for Credible Signaling

1 Signaling should reveal true quality

• Low quality types will have less incentive to

follow the high quality types.

2 Low signaling cost

• should be low enough for the high quality type to invest

Implications for Used Cars

If you are a potential buyer,

• Check whether the seller offers extended warranty

–if he doesn’t, the car is likely to be a lemon

• Ask for all the previous repair/maintenance works

• Anything strategy to avoid the lemons?

If you are a seller with a good quality car,

• disclose all the information such as maintenance

services

–By signaling, buyers will find it’s a good quality car

–You will have a better chance to charge more

» Sometimes, it pays to disclose private information

Auto Insurance

• Insurance company knows that there are high risk

drivers and low risk drivers But it can’t tell one

from the other.

• Drivers themselves know whether they are good

or bad drivers.

– Buyers have private information

→ Contrary to the used car case

If the insurance company offers just one type of

auto insurance policy, what will happen?

Adverse Selection in Auto Insurance

Adverse Selection in Auto Insurance

• Only the bad drivers will get the insurance

• Insurance companies will lose money

How to solve this adverse selection?

• Self-Selection

–Rothschild and Stiglitz’s idea

–Stiglitz won the 2001 Nobel prize

Idea: Design multiple policies such that

• One for the good drivers

• Another for the bad drivers

A Possible Self-Selection Solution

Moral Hazard vs Adverse Selection

These two are both caused by asymmetric information.

• But they are not identical problems.

What is the difference between these two problems?

Adverse Selection:

• If there’s private information to one party, bad guys will drive out the good guys from the market.

– which leads to inefficiency or worst outcome

• Used car market

– Seller has private information

• Insurance market

– Buyers have private information

How to solve the adverse selection problem?

• Signaling

1 Auction Types

2 Class experiment

• dollar auction

3 Keys to eBay’s success

4 Types of Bidding strategies in eBay

5 Winner’s Curse

Online Auction

Revenues from online auctions

• $6.5 billion in 2000

• $30 billion in 2003

• Expected growth rate of 68% through 2006

Up to the third-quarter of 2012, Net revenue of

$10.079 billion, up to 21.8% from $8.272

billion in the same period of 2011.

Normal Auction vs Reverse Auction

Normal Auction

• A service or product is made available by the seller

• Buyers bid for the ownership rights

Reverse Auction

• Buyer announces the need for a product or service

• Sellers bid for the right to sell the buyer

Types of Auction Mechanisms

– The price decreases until a buyer bids

• In eBay, used for large quantity auctions

– All winners pay the lowest winning bid

Sealed-Bid Auction

• Mainly used for reverse auctions

Second-Price, Sealed-Bid Auction

• Vickrey, 1996 Nobel Price

Keys to Ebay’s Success?

Network Externality

• eBay: customer to customer (C2C) internet business

• Needs to get critical mass

–First movers advantage

–Many other auction sites failed

» Onsale.com, ubid.com (?)

Customer Service

• Feedback Ratings

–biggest fear among online customers = Fraud, Scam

–Ratings provide a safety check to the customers

• Easing the transaction between buyer and seller

–purchasing paypal

• Colluding, bid rigging by sellers

– Sellers try to hike up the price by bidding under aliases

» Email address is all needed to open up Ebay account

• Very hard to detect

• Known indicators

– Same shill appears frequently in seller’s auctions

→ Check the bidding history of completed items

→ Bids are significantly higher than current bid (unmasking

Ebay Auction Specifics

Various Formats:

• Standard English Auction

• Dutch Auction

• Buy It Now

Fixed End Time

• different from standard English auction

Minimum Bid Increment

Proxy mechanism:

• Customers set the maximum willingness to pay and computer

automatically increases their bidding up to the maximum

• Winning bid depends on the 2nd highest bidder.

– Winners usually pay less than their maximum bid

(Consumer surplus)

Bidding Strategies

Late Bidding

• 58% of biddings were placed in the last day

• Sniping: bidding at the very last seconds

Evaluator

• Have a clear idea of his valuation (willingness to pay)

• Bid early at significantly higher price than the current bid

Skeptic

• Always bid current bid + minimum increment

• Multiple bids, if outbid

• Skeptical on proxy bidding

Unmasking

• Bid at current bid plus variable increments

• Tries to expose winner’s maximum bid

• Usually early in the auction (not at the last minute)

Winner’s Curse

Winner’s Curse: Paying more for item than its value

• Winner realizes that his bid is the highest among all

Consider a standard Sealed-bid Auction

• For fear of winner’s curse, most bidders bid less than

their value of the item

• Standard sealed-bid auction does not guarantee the

maximum profit to the seller

Vickrey Auction

Second-Price, Sealed-Bid Auction

• Winner will not pay his bid (the highest bid)

• But pays the second highest bid

Bidders

• Adjust their bids upward because they will not pay too high a price

• In other words, people don’t fear winner’s curse

Vickrey shows

• The optimal bidding strategy is to reveal their assessed value.

– In the standard auction, they bid less than the assessed value.

• Hence, this will generate the highest profit to the seller.

Applications

• Not common

• Can be found in stamp collection auctions

• eBay’s proxy bidding is similar but it’s not sealed bid.

2 Types of Bidding strategies in eBay

3 Winner’s Curse and Vickrey auction

• Vickrey auction will reveal the bidder’s true

value.

Organization Design How are profit-maximizing firms organized?

What is the optimal size firm?

How does a firm decide which activities to conduct within the firm (internal production) versus using the external market (outsourcing)?

How should the firm organize to maximize profits?

These questions come under the topic of “The

Nature of the Firm.”

The Nature of the Firm

“The Nature of the Firm,” written by economist Ronald Coase

in 1937

It involves weighing the tradeoffs, costs and benefits,

advantages and disadvantages, of various types of

organizational structure and design, which brings up such

issues as:

1> The boundaries of the firm, optimal size of the firm, issues

of internal production vs external production

2> Centralization vs decentralization of decisions and

information within the firm

3> Monitoring and rewarding performance (separation of

ownership and control in most large firms)

4> General compensation rules

MECHANISMS TO MINIMIZE POTENTIAL

Principle-Agent PROBLEMS OF

CORPORATIONS

1> Shareholder Empowerment

2> Corporate Governance Reforms

3> The Market for Corporate control