Adverse selection Flashcards
Search goods
the quality of a good is known
beforehand.
• Examples: Flour, Petrol, a Big Mac, etc.
• The only problem for the consumer is
searching for the cheapest price, or the best
price/quality tradeoff
Experience goods
the quality of a product only
becomes apparent some time after the purchase.
• Think of a restaurant meal (although you could
refuse to pay if it’s really bad), or a used car.
• So, it may be difficult to know the quality
beforehand, but sometime after the purchase it
becomes apparent what the quality was.
• So, in principle it is possible to write a contract on
the actual quality realization or ”Not satisfied,
money back” policies, etc
Credence goods
difficult to determine quality
even after the fact.
Example of credence good
Buying a stock is an example of a credence good:
difficult to tell if management did badly, or was just
dealing with difficult market circumstances, or took
some risky investment that didn’t pay off
Pooling equilibrium is not a problem as long as
demand and supply is fixed,
Suppose buyers know the average quality of all
sellers, but not the quality of any particular seller.
• Then buyers are willing the pay for the average
quality of the pool, and all transactions happen at
a single pooling price.
• So low quality sellers benefit (get a higher price
than under symmetric information), and high
quality sellers lose out (get a lower price than
under symmetric information)
When does pooling eq becomes a problem
• The real problem starts when seller can choose
whether to enter the market or not
Adverse Selection
General Assumptions:
• products are of variable quality: ‘lemons’ or ‘peaches’;
• individual quality is only known to sellers;
• buyers only know average quality.
The consequence:
• ‘good’ and ‘bad’ products fetch the same ‘pool’ price;
• forcing high cost/high quality goods out.
Akerlof shows that it is possible for a downward
spiral in price and quality to drive
the market out of existence. • i.e., there is no buyer willing to pay the asking price for the average car on the market.
Fin services
• Fund Management: Mutual funds, Hedge Funds, Pension Funds etc. • Financial advice/agencies: from corporate finance to insurance brokers • Market making & broking transactions
The retail financial services industry is similar
to
retail banking in that it deals with small
retail customers.
• But it is very different in other respects.
• This industry largely manages funds on behalf
of (or advises) clients who retain full
ownership and legal title.
Main problem with retail investment services is
asymmetric information and consequent adverse selection. • Lack of expertise on part of buyers means they find it hard to assess quality. • Poor quality of asset management can be reflected in: • lack of necessary skills, investments • lack of effort • negligence • incompetence • dishonesty • either separately or in combination.
Minimum standards
• This raises the average performance and hence the price
clients are willing to pay, keeping the high quality managers
in the market
Implications with minimum standards
- Efficiency.
• We establish a market but there is still market
breakdown in the important sense that this is not a
Pareto optimal situation
• Compare this with the full information situation.
• Most obvious, the low quality suppliers (and
customers that like low quality product) are
forced out of the market.
• Arguably much better to have an exam (like the
‘knowledge’ test for taxi drivers) and then let a
two-tier market develop. - Competition
• These rules are clearly anticompetitive: by
excluding suppliers they reduce the total supply
and drive up the price.
• In the example of the previous section with the
minimum standard set at c=1, this is enough
to cause a sellers market to emerge, with
positive profits.
• Minimum standards often raise entry costs,
and so make markets less contestable.
• Reasonable minimum standards vs curtailing
market power is an important trade-off for
regulators
Who sets the min standards
The government or the industry itself
the US the financial sector practiced complete self-regulation up to
the Securities and Exchange Act of
1934
In the Netherlands the financial sector was only
formally regulated with the
Wet toezicht kredietwezen
(Wtk) in 1952
Self regulation of min standards
• The industry forms a self-policing group with
barriers to membership based on some measure of
quality.
• e.g., have to pass to bar exam if you wish to be a
lawyer.
• The industry group then self-organizes mutual
monitoring and audit.
• These groups can become government sanctioned (the Financial Accounting Standards Board (FASB),
a group funded by industry that sets accounting
standards (Generally Accepted Accounting Principles,
GAAP) which are enforced by the SEC.)
The risk with self-regulating
risk of too tight standards in
order to discourage competition.
• The problem with industry self-regulation is that
any time industry people get together the result is
usually collusion and anti-competitive agreements.
what is the problem with government agency setting the minimum standards
government may have less expertise
to set the right standard, monitor behavior,
etc
Legal system
At a minimum there is always criminal
law for deterring fraud and other forms of theft.
• But high standard of proof and the technical
nature of financial crime makes prosecution rate
low.
Regulatory capture
Regulators
start seeing it as their job to protect the industry
from the public, rather than the public from the
industry.
• Civil servants working at regulator came from
industry.
• …See it as their job to ’help’ the industry rather
than police them.
• …Are looking for future jobs in industry.
• (although also some evidence that tough but
effective regulators nevertheless are highly
sought after by private industry)
Another way of dealing with asymmetric info is
Reputation
• If customers know from your track record that
you are high quality, you don’t have to settle
for a pooling price.
• However in finance often the track record is too short
and too little informative (although naïve investors
will extrapolate too much anyway).
• In general it’s hard to establish reputation in
the case of a credence good
Signaling
Suppliers undertake associated activity, which signals
high quality and is uneconomic for low quality suppliers to
provide.
• EXAMPLE: 3 year car warranty
• Signaling theory generally useful in finance.
• EXAMPLE: high dividend signals quality
management since poor managers can’t sustain
this.
• Debt signalling: signaling that you have high
expected future cash flow by taking on more debt.
• But not very useful in retail investment services, because any costly signal will come at the cost of returns
Certification
• Similarly, good suppliers ask an agency to certify
their status (e.g. ”APK keuring”) Example: Moody’s AAA bond rating.
• In principle credit rating agencies should be able to
distinguish good and bad risks, but they failed to do
that in the case of the sub-prime mortgage bonds that
lead to the financial crisis.
• Also: can have perverse incentives. (e.g. the rating
agencies were paid by their clients, tried to
increase sales by putting out lenient ratings).
