Asymmetric Information Problems

Lecture 10

On some markets, asymmetric information leads to high transaction costs.

Asymmetric Information: when one party to an exchange has differentoften more completeinformation than the other party involved.

When are asymmetric information problems especially important?

The quality of goods being exchanged is difficult to ascertain.

When are asymmetric information problems especially important?

The quality of goods being exchanged is difficult to ascertain.

The delivery of goods takes place over time.

When are asymmetric information problems especially important?

The quality of goods being exchanged is difficult to ascertain.

The delivery of goods takes place over time.

The payment for goods takes place over time.

Asymmetric information is particularly problematic on financial markets.

Financial Markets: markets in which funds are exchanged between lenders and borrowers.

Asymmetric information is particularly problematic on financial markets.

Financial Markets: markets in which funds are exchanged between lenders and borrowers.

Because financial transactions occur over time, asymmetric information can make those transactions especially costly.

What do lenders have incomplete information about?

The expected profitability of a borrower’s stated project.

What do lenders have incomplete information about?

The expected profitability of a borrower’s stated project.

What project the borrower actually pursues.

What do lenders have incomplete information about?

The expected profitability of a borrower’s stated project.

What project the borrower actually pursues.

Whether or not the project actually proves profitable.

Two broad categories of asymmetric information problems

Adverse selection

When market mechanisms select individuals who it is not beneficial to trade with.
On financial markets: bad credit risks are the ones who most actively seek out loans.

Two broad categories of asymmetric information problems

Adverse selection

When market mechanisms select individuals who it is not beneficial to trade with.
On financial markets: bad credit risks are the ones who most actively seek out loans.

Agency (principal–agent) problems

When an individual contracts to act in the interests of another but lacks the incentives to do so.
On financial markets: borrowers’ incentives are not aligned with those of lenders.

Why does adverse selection arise in financial markets?

Some borrowers do not intend to repay the loan.

A borrower who never plans to repay will agree to an arbitrarily high interest rate.

Why does adverse selection arise in financial markets?

Some borrowers do not intend to repay the loan.

A borrower who never plans to repay will agree to an arbitrarily high interest rate.

Some borrowers do not understand the repayment burden.

Unsophisticated borrowers may not grasp how burdensome a high rate truly isand so agree to it anyway.

Why does adverse selection arise in financial markets?

Some borrowers do not intend to repay the loan.

A borrower who never plans to repay will agree to an arbitrarily high interest rate.

Some borrowers do not understand the repayment burden.

Unsophisticated borrowers may not grasp how burdensome a high rate truly isand so agree to it anyway.

All borrowers have an incentive to understate risk.

To secure a loan, borrowers emphasize best-case outcomes and minimize discussion of downside risk.

Bad credit risks are interest-rate inelastic.

Distinguishing between bad and good credit risks is costly.

Bad credit risks are interest-rate inelastic.

Distinguishing between bad and good credit risks is costly.

Price rationing does not necessarily lead to an efficient outcome.

When lenders raise interest rates, they increase the probability they are dealing with a bad credit risk.

Adverse Selection: Credit Market Diagram

Good credit risks, interest-rate elastic

Bad credit risks, interest-rate inelastic

Adverse Selection: Credit Market Diagram

D‑good (elastic)

D‑bad (inelastic)

Supply of loanable funds

Adverse selection can lead to “credit rationing.”

At the market interest rate i*, bad credit risks still demand more loans than supplied. Raising i further worsens the pool. Lenders ration credit instead.

The “Lemons Problem”

Adverse selection is not unique to financial markets.

It arises in any market where one side knows more about quality than the other.
Classic case: the used-car market, where sellers know more about vehicle quality than buyers.

George Akerlof formalized this as the “Market for Lemons” (1970).

Nobel Memorial Prize in Economic Sciences, 2001.
Buyers, unable to distinguish good cars from “lemons,” offer only a pooled average price.
Good-car owners withdraw, only lemons remain, markets can unravel entirely.

Agency problems arise when an individual contracts to act in the interests of another but lacks the incentives to do so.

They are particularly important when transactions are carried out or completed over time.

Agency problems arise when an individual contracts to act in the interests of another but lacks the incentives to do so.

They are particularly important when transactions are carried out or completed over time.

Hence their special relevance in financial markets.

Agency problems arise when an individual contracts to act in the interests of another but lacks the incentives to do so.

They are particularly important when transactions are carried out or completed over time.

Hence their special relevance in financial markets.

The incentives of a principal and an agent can be misaligned.

Agency problems arise when an individual contracts to act in the interests of another but lacks the incentives to do so.

They are particularly important when transactions are carried out or completed over time.

Hence their special relevance in financial markets.

The incentives of a principal and an agent can be misaligned.

Monitoring an agent over time is costly.

On financial markets, misaligned incentives and costly monitoring create moral hazard.

Moral hazard: when an agent takes on more risk than the principal desires because the principal bears the costs of that risk.

Where do principal–agent problems arise?

Borrowers and lenders

The lender funds the project, the borrower carries it out.

Where do principal–agent problems arise?

Borrowers and lenders

Stock brokers and their clients

The client wants portfolio growth, the broker earns commissions on trades.

Where do principal–agent problems arise?

Borrowers and lenders

Stock brokers and their clients

Investment bankers and firms whose IPOs they underwrite

The issuing firm wants maximum proceeds, the banker may undervalue shares to ease the sale.

Where do principal–agent problems arise?

Borrowers and lenders

Stock brokers and their clients

Investment bankers and firms whose IPOs they underwrite

Corporate executives and the corporation’s stockholders

Stockholders (principals) want firm value maximized.
Executives (agents) are hired to do thisbut can act in their own interests instead.

Corporate executives and stockholders

Stockholders are the owners, executives are hired to maximize firm value.

Executives can act in their own interests instead.

Stockholders face large costs to act collectively.
Stockholders face large costs to monitor executives.
Executives can spread costs across stockholders while concentrating benefits on themselves.

Principal–agent problem in practice: the Tyco Roman Orgy

“[Former Tyco CEO Dennis] Kozlowski [was] convicted in 2005 of stealing $150 million from Tyco and illicitly making $430 million more by artificially inflating the value of company stock. […] The most glaring example of this extravagance was a $2 million week-long birthday party for his wife, Karen, which became known as ‘The Tyco Roman Orgy.’ Tyco picked up half the bill for the Roman-Empire-themed 40th birthday party on the island of Sardinia, attracting the attention of federal prosecutors in Manhattan.” “These Images of a ‘Tyco Roman Orgy’ Helped Put a CEO in Prison,” Business Insider, January 6, 2014

The economic lesson: Stockholders bore the cost of Kozlowski’s self-dealing. When monitoring is costly and ownership is dispersed, executives can extract enormous private benefits with little direct accountability.

“Stakeholderism” can worsen principal–agent problems.

When executives are told to maximize value for all stakeholdersemployees, communities, suppliers, and the environmentrather than shareholders alone, accountability becomes diffuse.

With no single measurable objective, an executive can justify almost any expenditure as serving some stakeholder. The result may be less discipline on self-dealing, not more.

From an economic perspective, a clear residual claimant (the stockholder) provides the sharpest monitoring incentive.

A creative monitoring solution: the Van Halen brown M&Ms clause

“Buried amongst dozens of points in Van Halen’s rider was an odd stipulation that there were to be no brown M&M’s candies in the backstage area. If any brown M&M’s were found backstage, the band could cancel the entire concert. […] To ensure the promoter had read every single word in the contract, the band created the ‘no brown M&M’s’ clause. […] Whenever the band found brown M&M’s candies backstage, they immediately did a complete line check, inspecting every aspect of the sound, lighting and stage setup to make sure it was perfect.” “The Truth About Van Halen and Those Brown M&Ms,” Entrepreneur, March 24, 2014

The economic lesson: Van Halen embedded a low-cost signal into their contract. A missed M&M clause revealed that the agent (the promoter) had not read the contract carefullyand likely had not met the technical requirements either. Cheap screening devices can substitute for expensive direct monitoring.

How do markets respond to asymmetric information problems?

Collateral requirements

A pledge of assets reduces the lender’s risk and screens out the most reckless borrowers.

Restrictive debt covenants

Contractual limits on what borrowers can do with funds reduce moral hazard.

Stock options for executives

Aligning executive compensation with share price reduces the principal–agent gap.

Reputation requirements and “Lemon Laws”

Reputation is a costly-to-build asset that provides ongoing incentives for honest dealing.
Legal guarantees reduce the information disadvantage of buyers of complex goods.

Asymmetric information helps to explain many features of financial and corporate markets.

Financial markets are among the most regulated of all markets.

Smaller and less established firms rely on banks rather than public debt or equity marketsbecause reputation has not yet been established.

Firms typically must build size and reputation before raising funds by issuing marketable debt or equity.

Asymmetric information: a summary

Adverse selection

Bad types are attracted to a market precisely because their type is hidden.
Result: credit rationing, market unraveling (the Lemons Problem).

Principal–agent / moral hazard

Agents take excessive risk when principals bear the downside.
Monitoring is costly, so contract design (collateral, options, signal clauses) partially substitutes.

The economic approach

Focus on incentives: who bears the cost? Who has the information?
Institutional features of financial markets (regulation, covenants, reputation) are endogenous responses to these information problems.

What institutional features of financial markets can you now explain using asymmetric information?

Discussion: Can you explain these features?

Why do banks require collateral for loans?

Why are executives paid partly in stock options?

Why are financial markets so heavily regulated?

Why do new firms rely on bank debt rather than public markets?

Key Terms

Practice Questions

Question 1 of 5

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