Chapter 17, 2006 Thomson Learning/South-Western,Asymmetric Information,2,Asymmetric Information,In a game with uncertainty, asymmetric information refers to the information that one player has but the other does not.,3,Principal-Agent Model,Principal: offers contract in a principal-agent model. Agent: performs under terms of the contract in the model. Moral-hazard problem: when agents actions benefit the principal but the principal does not directly observe the actions.,4,Table 17-1: Applications of the Principal-Agent Model,Principal,Hidden action,shareholders,manager,patient,student,effort, executive decisions,effort,effort, unnecessary procedures,preparation, patience,monopoly,health insurer,parent,Agent,manager,employee,doctor,tutor,customers,Insurance purchaser,child,quality of fabrication,risky activity,delinquency,managerial skill,job skill,medical knowledge, severity of condition,subject knowledge,valuation for good,preexisting condition,moral fiber,Hidden type,Agents private information,5,Effort Choice Under Full Information,In Figure 17-1, if shareholders could specify the managers effort in a contract, they would choose the level e* producing the highest joint surplus. In upper panel, e* corresponds to the greatest distance between gross profit and manager effort cost.,6,Gross profit, cost,Gross profit (45-degree line),Manager effort,0,MP,MC,0,FIGURE 17-1: Effort Choice Under Full Information,Manager effort cost,Manager effort,Marginal gross profit, marginal cost,e*,7,Incentive Schemes,Lines S1, S2, and S3 correspond to various incentive contracts in Figure 17-2. The slope of the incentive scheme is also called its “power”. It measures how closely linked the managers pay is with firm performance.,8,S3 (high power, 45-degree line),FIGURE 17-2: Incentive Contracts,Gross profit,Manager pay,S1 (constant wage),S2 (moderate power),9,Manager Equilibrium Effort Choice,The managers effort choice is given by the intersection of marginal pay and marginal effort cost in Figure 17-3. The marginal pay associated with constant wage scheme S1 leads to no effort. Effort increases in the power of the incentive scheme.,10,MC,FIGURE 17-3: Manager Equilibrium Effort Choice,Manager effort,Marginal pay, marginal cost,S3,S3,S3,e0,e1,e1 = e*,Marginal pay schemes,11,Managers Participation Decision,By fixing the slope of the incentive scheme in Figure 17-4, the intercept of the scheme determines the managers participation decision. Shareholders will choose the lowest intercept subject to having the manager participate.,12,S3,FIGURE 17-4: Managers Participation Decision,Gross profit,Manager pay,S1,S2,13,Profit-Maximizing Bundle with One Consumer Type,In Figure 17-5, a monopolist chooses the bundle q* maximizing the consumers and monopolists combined surplus. This can be found in the upper panel as the greatest distance between gross consumer surplus and the total cost curves. Or, in the lower panel by the intersection of the marginal surplus and marginal cost curves.,14,Surplus, cost,Gross consumer surplus of representative consumer GCS,MS,MC,FIGURE 17-5: Profit-Maximizing Bundle with One Consumer Type,Monopolists total cost,Quantity in bundle/quality of unit,Marginal surplus, marginal cost,q*,Quantity in bundle/ quality of unit,A,B,15,d,FIGURE 17-6: Comparing Gross and Ordinary Consumer Surplus,Quantity (shirts),Price ($/shirt),A,B,20,7,15,E,16,Two Consumer Types, Full Information,Facing a high-value and low-value consumer in Figure 17-7, the monopolist chooses bundles given by the intersection between each types marginal consumer surplus and marginal cost. The high type receives a larger bundle qH than the low type, qL,17,MCSH,MC,FIGURE 17-7: Profit-Maximizing Bundles with Full Information About Two Consumer Types,qL,A,B,MCSL,qH,C,D,Marginal consumer surplus, marginal cost,Quantity in bundle/ quality of unit,18,Two Consumer Types, Asymmetric Information,The menu of bundles from Figure 17-7 reproduced in Figure 17-8, would not be incentive compatible. The high-value consumer would gain surplus equal to the area of region C by purchasing the qL-unit bundle meant for low-value consumers rather than the qH-unit bundle.,19,MCSH,MC,FIGURE 17-8: Full Information Solution is Not Incentive Compatible,qL,A,B,MCSL,qH,C”,D,Marginal consumer surplus, marginal cost,Quantity in bundle/ quality of unit,C,20,MCSH,MC,FIGURE 17-9: Profit-Maximizing Bundles Under Asymmetric Full Information,qL,A,B,MCSL,qH,D,Marginal consumer surplus, marginal cost,Quantity in bundle/ quality of unit,qL,21,Table 17-2: Bidding Valuation 50 is Player 1s Dominant Strategy in a Second-Price Auction,22,Figure 17-10: Spence Signaling Game in Extensive Form,.,.,.,Education,High talent Probability ,None,(Worker payoff = competitive wage c, Firm Payoff zero expected profit),Firm,Worker,.,.,.,.,Firm,Firm,Firm,None,Education,Worker,Low talent Probability ,(Worker pa