INFORMATION Overview Context: You want to reward good performance - - PowerPoint PPT Presentation

INFORMATION

Overview

• Context: You want to reward good performance by a subordinate,

but he has a better idea of what that performance is than you do. What should you do?

• Concepts: principals and agents, incentives, asymmetric

information, adverse selection, moral hazard, signalling, reputation.

• Economic principle: when people have superior information,

expect them to use it to their advantage

Games with uncertainty

• Consider an additional, non-strategic player: Nature
• If a certain variable can take several values, let Nature “decide”

which value it will be (according to underlying probabilities)

• Asymmetric information: a player who moves before Nature does

not know the value. A player who moves after Nature and

• bserves Nature’s move, knows the value

The E.T. “chocolate wars”

In the movie E.T., a trail of Reese’s Pieces, one of Hershey’s chocolate brands, is used to lure the little alien into the house (Video link on book’s website) As a result of the publicity created by this scene, sales of Reese’s Pieces tripled, allowing Hershey to catch up with rival Mars

Chocolate wars

• Universal Studio’s original plan was to use a trail of Mars’s M&Ms
• Mars turned down the offer
• The producers of E.T. then turned to Hershey, who accepted the

deal (for $1m), which turned out to be very favorable to them (and unfavorable to Mars)

Chocolate wars

• Publicity from the product placement increases Mars’ profits by

$800,000, decreases Hershey’s by $100,000

• Hershey’s increase in market share costs Mars $500,000
• Benefit to Hershey from having its brand featured is given by b
• Hershey knows the value of b. Mars knows only that

b = $1, 200, 000 or b = $700, 000 with equal probability

• No product placement by any of the two implies “business as

usual”

Chocolate wars

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

not buy

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buy M

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

b = 1200 (50%)

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

b = 700 (50%) N

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

buy

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not buy H

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buy

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not buy H 0, 0

• 500, -300

0, 0

• 500, 200
• 200, -100

Chocolate wars

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

not buy

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buy M

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

b = 1200 (50%)

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

b = 700 (50%) N

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buy

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not buy H

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buy

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not buy H 0, 0

• 500, -300

0, 0

• 500, 200
• 200, -100
• 500

Chocolate wars

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not buy

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buy M

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b = 1200 (50%)

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

b = 700 (50%) N

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buy

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not buy H

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buy

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not buy H 0, 0

• 500, -300

0, 0

• 500, 200
• 200, -100
• 500

−500 × 50% + 0 × 50% = = −250

Typical scenarios

• Agency problem: a principal (e.g., employer) wants to contract

with an agent, but the former cannot observe the latter’s actions (moral hazard)

• Lemons problem (or adverse selection): one party (e.g., car

seller) has better information than the other

• Signalling problem. A player chooses its actions strategically so

as to influence others’ beliefs (e.g., reputation)

Typical scenarios

• Agency problem: a principal (e.g., employer) wants to contract

with an agent, but the former cannot observe the latter’s actions (moral hazard)

• Lemons problem (or adverse selection): one party (e.g., car

seller) has better information than the other

• Signalling problem. A player chooses its actions strategically so

as to influence others’ beliefs (e.g., reputation)

Agency and incentives

• Terminology: We refer to the payer as the principal, the payee as

the agent, and the analysis as principal-agent or agency theory.

• S. Kerr, “On the folly or rewarding A, while hoping for B.”

Performance is hard to measure. Any measurement system can be gamed; incentives work; expect to get exactly what you pay for

• Relation to psychology theories of motivation (e.g., intrinsic v

extrinsic)

Incentives matter

• Medicare’s reimbursement’s policy: fees cover
• verhead, not just marginal cost; doctor’s time vs

medical equipment

• Patent office: contrast US and EU
• Auditing firms are paid by the firms they audit;

moreover, they often make far more from consulting relationships than auditing

Agency: rewarding employees

• Outcome depends on effort by employee (agent) and on other

factors beyond his control

• Employer (principal) cannot distinguish between different factors

causing observable outcome

• Incentive scheme: a system determining agent’s compensation as

a function of outcome

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Agent’s effort

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Outcome Agent’s reward Other factors

Agency: power incentives

• Types of incentive scheme:

− High-powered: compensation depends a great deal on

• utcome

− Low-powered: compensation is fairly flat

• Suppose principal is risk neutral, agent risk averse.

Then high-powered incentives trade-off:

− More effort (good from the principal’s perspective) − Greater risk on employee (compensation depends on effort and on random events)

Agency: examples

• Salesperson compensation
• CEO compensation
• Utility regulation

Typical scenarios

• Agency problem: a principal (e.g., employer) wants to contract

with an agent, but the former cannot observe the latter’s actions (moral hazard)

• Lemons problem (or adverse selection): one party (e.g., car

seller) has better information than the other

• Signalling problem. A player chooses its actions strategically so

as to influence others’ beliefs (e.g., reputation)

The lemons problem

• When the uninformed player moves first, she must

think about how informed players will use their information:

− Examples: product quality, insurance, credit

• General result: Tendency for low-quality products (or

high-risk customers) to flood the market

• Solutions: warranties, reputation and branding, credit

rationing, verification (medical examinations)

The market for lemons

• Sellers knows quality of his or her car
• Buyer only knows distribution of qualities
• For a given price, only worse cars will be offered for sale
• Buyers update beliefs and willingness to pay
• This process may unravel to the point there is no market

Adverse selection in health markets

po pe qe qo

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

p q A D

MC AC

Adverse selection

• Consumer type: θ ∼ U[0, 1]
• Willingness to pay: θ
• Cost of serving type θ: C = c0 + c1 θ
• Price p implies q = 1 − p (types with θ > p)
• Cost of marginal type: c0 + c1 θ, where θ = p and p = 1 − q

MC = c0 + c1 (1 − q)

• Cost of average type served: average between types θ = p, θ = 1

AC = c0 + c1

• 1 − 1

2 q

• Note that AC > MC

Adverse selection

• Equilibrium level of q (p = AC):

qe = 1 − c0 − c1 1 − c1

2

• Optimal level of q (p = MC):

qo = 1 − c0 − c1 1 − c1

• Hence qe < qo

Adverse selection in health markets

po pe qe qo

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p q A D

MC AC

Please accept my resignation. I don’t care to belong to any club that will have me as a member. — Groucho Marx.

Winner’s curse

• Common value auction: the object is worth the same for every

bidder, each bidder gets an unbiased signal of value

• Examples: oil field, penny jar
• Expected valuation given signal: unconditional and conditional on

being the highest bid

• Optimal strategy is to bid much less than signal estimate;

discount should be greater the greater the number of bidders or the closer to common value is the auction

Typical scenarios

• Agency problem: a principal (e.g., employer) wants to contract

with an agent, but the former cannot observe the latter’s actions (moral hazard)

• Lemons problem (or adverse selection): one party (e.g., car

seller) has better information than the other

• Signalling problem. A player chooses its actions strategically so

as to influence others’ beliefs (e.g., reputation)

Signalling

• When the informed player moves first, she must think about the

information conveyed by her actions to uninformed players (the signal):

− Does a low price suggest low quality? − Advertising as a signal − Job market signaling − Incumbent firm’s reaction to entry

Price as a signal of quality

• One seller of stereo equipment, many buyers. Seller sets price,

buyers decide whether or not to buy (at most one unit each). Seller knows quality of stereo, buyers do not.

• Demand:

− 80% of customers willing to pay at most $200 regardless of quality − 20% of customers willing to pay $400 for high-quality product, only $200 for low quality one

• High quality product costs $300; Low quality product costs $100

Price as a signal of quality

• Claim: It is an equilibrium for seller to set p = 400 if quality is

high and p = 200 if quality is low.

• In this equilibrium, price conveys information about quality:

consumers know that a high price implies high quality.

• Why wouldn’t a low-quality seller want to “masquerade” as a

high-quality seller by setting a high price? Because it loses too much of the market. (Numbers are profit per customer.) p = 400 ⇒ Profit = (400 − 100) × 20% = 60 p = 200 ⇒ Profit = (200 − 100) × 100% = 100

Signalling equilibria

• In the previous game, we have a separating equilibrium: different

types of seller choose different strategies.

• High quality seller chooses different strategy so as to ensure buyer

knows she’s buying from a high quality seller. In order for this to work, it must be the case that imitation is costly.

• If imitation costs are not very high, we have a pooling equilibrium.

In this case, the “bad” type imitates the “good” type so as to acquire a reputation for being good.

• In a multi-period situation, pooling may become attractive: the

cost of imitating early on pays off in terms of future payoffs: reputation building.

Reputation for toughness

What is the equilibrium of the following one shot entry game?

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stay out

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enter E

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fight entry

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accommodate entry I 1, 1

• 1, -1

0, 4

Reputation for toughness

• What if Monopolist faces a potential entrant in each of a series of

local markets? (Cf American Tobacco example)

• By “teaching entrant a lesson” in first markets, Monopolist might

be able to discourage entrants in other markets

• Key: Assume that there is some chance monopolist is a “Rambo,”

a monopolist whose payoff to cooperation is less than −1

Reputation for toughness

• Entrants believe Monopolist is “tough” with probability α
• Suppose Monopolist fights entry even if it is not “tough”
• A second entrant still believes Monopolist is tough with

probability α; expected value from entry is α × (1) + (1 − α) × 1

• If α > 1/2, then entrant stays out
• For a normal Monopolist, fighting the first entrant is an

investment in reputation

• (Advanced note: in this case, equilibrium would require mixed

strategies, similar to rock-paper-scissors)

Reputation for toughness

• Watch video clips from The Maltese Falcon, Casino.
• What game is being played?
• Why may it be rational to appear to be irrational?

Repetition, trust and product quality

• Previously, we saw how repetition improves cooperation between

firms

• Same is true for relation between seller and buyer when there is

asmmetric information

• Examples:

− Restaurants − Auto repairs

Takeaways

• Think about how your rival will:

− use its information advantage − react to your information advantage

• You will get what you reward
• Beware of the Groucho Marx problem: low-quality products or

customers flood the market (or: If this is such a good deal, why are you offering it to me?)

• Your actions convey information and create reputations