Why is asymmetric information causing market failure?

Vahlens Handbooks Fritsch - Market Failure and Economic Policy (9th edition) Production: Ms. Deuringer Date of change: 02/19/2014 Status: Imprimatur Page 245 10. Market failure due to lack of information In the model of complete competition it is assumed that all actors are fully, timely and free of charge . In real markets, however, many actors make decisions without having even remotely complete information. The subject of the market failure category “information deficiencies” are those cases in which market players are so uninformed that the market is significantly impaired in its functioning and “fails”. First, Section 10.1 gives an overview of various types of information deficiencies. Section 10.2 then deals with the manifestations of the problem of asymmetrical information, whereby corresponding market-endogenous possible solutions are also discussed. The two following sections are devoted to two special types of information deficiencies, namely ignorance of utility (Section 10.3) and ignorance of prices (Section 10.4). Section 10.5 deals with the possible consequences of uncertainty for the market process. Section 10.6 then gives an overview of the basic policy options for dealing with market failures due to a lack of information. Finally, the main results are summarized (Section 10.7). 10.1 Types of information deficiencies In the following, two types of information deficiencies are distinguished, namely ignorance and uncertainty. Ignorance exists when market players are insufficiently informed, but it would in principle be possible to eliminate this gap by obtaining appropriate information. Uncertainty relates to future developments, which, even with the greatest effort, cannot be forecast with complete certainty. I am talking about "ignorance" and not "imperfect information", because •• the term ignorance better takes into account the fact that a market failure is not only due to a lack of information (in the quantitative sense) but also as a result of qualitative deficiencies in information ( false or misleading information) can occur; and •• the designation “imperfect” information suggests that perfect in the sense of complete information is a condition to be striven for. However, since the acquisition of information is usually associated with costs, not complete, but only “optimal” information can represent a meaningful goal. A distinction can be made between several forms of lack of information in the sense of ignorance, which can lead to market failure. Starting point for Part II: Market failure: causes and therapeutic options 246 Vahlens Handbooks Fritsch - Market Failure and Economic Policy (9th edition) Production: Ms. Deuringer Date of change: 02/19/2014 Status: Imprimatur Page 246 Consideration are exchange relationships in which one market partner is better informed than the relevant actor on the opposite side of the market (asymmetrical information distribution; Section 10.2). One can differentiate between several forms or perspectives of problems of asymmetrical information distribution. On the one hand, there is the phenomenon of ignorance of quality, which occurs when actors can only assess the quality of a good relatively poorly (problem of hidden information or properties). Lack of quality may lead to malfunctions in the market in the form of adverse selection (Section 10.2.1). Second, the asymmetrical distribution of information can impair the market allocation because the actions of actors cannot be observed or assessed with sufficient accuracy (problem of hidden actions or moral risk; Section 10.2.2). A third form of asymmetrical information presents the risk of an opportunistic hold-up that a contractual partner interprets an agreement unilaterally for its own benefit and withholds part of the service or demands a greater consideration. The information asymmetry here consists in the fact that the probability of such hold-up behavior cannot be precisely estimated when the contract is concluded (problem of hidden intentions; Section 10.2.3). And fourthly, phenomena of asymmetrical information distribution are the subject of the principal-agent approach, which can be understood as a general theory of asymmetrical information distribution (Section 10.2.4). Another form of lack of information in the sense of ignorance is the lack of knowledge of benefits; In this case, the consumers are adequately informed about the quality of a certain good or offer, but incorrectly assess the usefulness of the good and therefore consume too little or too much of this good (see Section 10.3). Finally, ignorance of prices is characterized by the fact that the market players have problems in determining the market-clearing price, so that significant demand or Supply surpluses arise (see Section 10.4). The term of uncertainty (= risk) describes those constellations in which the future development cannot be forecast with complete certainty, even with great effort. As a rule, there are various options for adaptive reactions that can be used to reduce the uncertainty (Section 10.5.1). In connection with the question of whether there is a market failure that requires government intervention, it is important to distinguish between entrepreneurial and non-entrepreneurial uncertainty. One exposes oneself to entrepreneurial uncertainty voluntarily. The motive for assuming uncertainty is the prospect of making a profit if successful (Section 10.5.2). Non-entrepreneurial uncertainty is a risk that is a normal ‘side effect of life and is not linked to the possibility of generating corresponding profits. One is usually exposed to this form of uncertainty involuntarily. 10. Market failure due to lack of information 247 Vahlens Handbooks Fritsch - Market failure and economic policy (9th edition) Production: Ms. Deuringer Date of change: 02/19/2014 Status: Imprimatur Page 247 10.2 Asymmetrically distributed information 10.2.1 Quality ignorance (hidden information, hidden properties) and adverse Auslese There is a lack of quality when the customer cannot fully assess the quality of a good before the contract is concluded. As a rule, it can be assumed that the supplier is better informed than the customer about the quality of the goods in question (for example because he produced it himself), that is, the information about the quality is distributed asymmetrically. Section deals with the case of information asymmetry at the expense of the consumer. Lack of quality can also consist in the fact that the customer is better informed than the provider about certain facts relevant to the respective transaction. For example, a policyholder should be able to assess the risk of a loss occurring better than the insurer (Section A major cause of the information asymmetry is that the better informed side of the market does not have sufficient incentive to reveal its knowledge to the other side of the market. Therefore, essential properties of the transaction object or the transaction partner remain hidden for the exchange. This is why this constellation is also identified as a problem of hidden information or hidden characteristics (see Section Regardless of which side of the market is affected by the lack of quality, the competitive process with asymmetrical information distribution can lead to only relatively poor quality being traded and the market for good quality collapsing. The extent to which problems of lack of quality are to be expected also depends essentially on the properties of the goods in question; Section shows that a correspondingly restricted functioning of the market is to be expected, especially in the case of experience and trust goods. Information asymmetry to the detriment of the customer Assume that a certain good is offered in different qualities. If a customer is able to precisely recognize the quality offered in each case, he can align his willingness to pay to the quality; he would accordingly be prepared to pay a reasonably high price for good quality and correspondingly little for relatively poor quality. Figure 10.1 illustrates this relationship. If, on the other hand, a customer can only correctly assess the true quality of a good after the contract has been concluded, there is a kind of screen between him and the quality of a particular offer (see Figure 10.2). How will the customer behave in this case? A plausible assumption in this context would be, for example, that he or she aligns his willingness to pay with the average expected quality and offers a price that is reasonable for this average quality. What quality it actually receives, however, depends on chance. Figure 10.2 illustrates this constellation. Part II: Market Failure: Causes and Therapy Options 248 Vahlens Handbooks Fritsch - Market Failure and Economic Policy (9th edition) Production: Ms. Deuringer Date of change: 02/19/2014 Status: Imprimatur Page 248 If the customer bases his willingness to pay on the expected average quality, then follows from the fact that an offer of above-average high quality, which can only be provided at correspondingly higher costs, is associated with comparatively low profits or even losses. Even if a supplier is interested in selling relatively high quality, the behavior of the customer due to the information asymmetry forces him to provide goods of inferior quality. If the inquirers notice that the average quality of the offer is declining, then their figure decreases. Figure 10.1: Demand behavior without asymmetrical information distribution The inquirers can safely assess the quality of an item on offer. For a high quality copy, the willingness to pay is relatively high; The willingness to pay is correspondingly lower for poor quality. Demander Demand side expressed willingness to pay Supply side Goods of the highest quality at high prices Goods of lowest quality at low prices Figure 10.2: Demand behavior with asymmetrical information distribution When the contract is signed, the demanders only know the average quality of the goods offered. As a result, they're only willing to pay the price for an average-quality specimen. Demand side potential willingness to pay Screen supply side goods of the highest quality goods of the lowest quality random allocation expressed willingness to pay Demander 10. Market failure due to lack of information 249 Vahlens Handbooks Fritsch - Market Failure and Economic Policy (9th edition) Production: Ms. Deuringer Date of change: 02/19/2014 Status: Imprimatur Page 249 Willingness to pay accordingly. The decreasing willingness to pay, in turn, leads to a decline in the supply of higher quality products, with the consequence that the willingness to pay on the part of the customer decreases. This process continues until only the worst possible quality is offered: The market for higher qualities collapses. The poor quality displaces the good quality, and the price levels off at a correspondingly low level. This process is known as "adverse selection". Example: Suppose two groups of used car owners want to sell their car. While the vehicles of one group have significant defects ("lemons"), the used vehicles offered by the other group are in excellent condition ("plums"). Every owner of a “plum” wants to get at least 2,000 for his good piece, whereas the owner of a “lemon” is satisfied with 1,000. In principle, buyers would be willing to pay a maximum of 1,200 for a “lemon” and 2,400 for a “plum”. If there is no asymmetrical information, i. H. If the buyer can reliably identify good and bad quality before the conclusion of the contract, the “lemons” in the range between 1,000 and 1,200 are sold; Owners of “plums” get a price between 2,000 and 2,400. If there is a lack of quality, the buyers know how high the proportion of relatively good or relatively bad vehicles is, but - unlike the seller - they cannot determine whether a particular vehicle is a "plum" or "plum" vehicle before it is used. is a "lemon". As a result, risk-neutral customers are maximally prepared to pay the expected value. If the same number of “plums” and “lemons” are offered, the expected value results as follows: Expected value = 0.5 · 1,200 + 0.5 · 2,400 = 1,800. Since 1,800 is below the minimum price for “plums”, no “plum” owner is willing to sell their vehicle. If the buyers realize that there are only "lemons" on offer, they reduce their willingness to pay to a maximum of 1,200. Although trading in “plums” would be advantageous for both sides of the market, the offer now consists exclusively of “lemons”; there is no market for “plums”. Information asymmetry to the detriment of the provider Adverse selection can also occur in the presence of an information asymmetry to the detriment of the provider, namely if the latter cannot assess certain transaction-relevant conditions in the sphere of influence of the customer with sufficient accuracy. For example, those asking for credit or insurance represent a relatively poor quality if they tend to behave particularly carelessly, i. H. Represent 'bad risks'. If a risk-neutral provider of such contracts does not know ex ante whether a particular customer is a good or a bad risk, he will calculate his price in such a way that he does not suffer any loss on average: he estimates the proportion of good and bad risks Risks and calculates on this basis the applicable, cost-covering insurance tariff or interest rate. Since this price is relatively high for the good risks, the consumers concerned will tend to forego insurance. As a result of this self-selection of the customers, the proportion of bad risks in the contract portfolio is higher than in the population of all potential policyholders. The higher proportion of bad risks forces a price increase. Due to the rising prices, other good risks then refrain from signing a contract. As a result, the provider has to increase his price again because the average quality of his inventory continues to increase Part II: Market failure: causes and treatment options 250 Vahlens Handbooks Fritsch - Market Failure and Economic Policy (9th edition) Production: Ms. Deuringer Date of change: 02/19/2014 Status: Imprimatur Page 250 has deteriorated. In extreme cases, further price adjustments are necessary until the contract portfolio only includes the very worst risks that have to pay a correspondingly high price. Although the good risks would conclude contracts at a reasonable price, these do not come about because the providers are not able to recognize the risk that a certain customer represents before the contract is concluded. Even with information asymmetry to the detriment of the provider, the good quality is displaced by the poor quality; In contrast to the information asymmetry to the detriment of the consumer, the price levels off here at a relatively high level. Example: If a private accident insurance company cannot assess whether a potential customer represents a good or a bad risk, it must calculate a uniform and cost-covering tariff for all risks. With such a single premium, the bad risks are relatively better off, since the premium commensurate with their risk would have to be higher. With this pricing, the good risks pay a relatively high premium and are accordingly worse off; m. a. W .: To a certain extent, the good risks subsidize the bad risks. In this respect, one can expect that the good risks will forego the insurance due to the relatively high price and that the insurers will lose their subsidy payers. As a result, the premiums required to cover costs must increase for the rest of the insured.Even in the reduced inventory there will in turn be risks for which the premium is relatively high in view of the low probability of damage. If they refrain from insurance cover because of the price-performance ratio that is unfavorable for them, the insurer must further increase the standard premium. The process continues until the group of insured only consists of relatively bad risks that have to pay an appropriate (“actuarially fair”) but very high premium. At the end of this development, a significant proportion of the players do not have any accident insurance, although they would like to be insured at a reasonable price. The degree of lack of quality for different types of goods It is not to be expected for all goods to the same extent that the supplier can assess the quality better than the customer before the conclusion of the contract. There are big differences in this respect, depending on the type of good in question, whereby a distinction is usually made between: •• neoclassical-homogeneous goods, •• search or inspection goods, •• experience goods and •• trustworthy goods or beliefs. In the case of neoclassical homogeneous goods, both sides of the market are fully informed about the properties of the goods in question. Goods of standardized quality traded on the stock exchange, such as mineral oils, ores, types of grain and coffee are examples of this. The quality of search and inspection goods can be recorded completely and at relatively low cost before the conclusion of a contract. This applies, for example, to pieces of furniture such as tables and chairs, for which one can obtain sufficient clarity about many aspects of quality by looking closely or simply trying them out. Information asymmetries only play a minor role in this type of goods. Experienced goods, on the other hand, are characterized by the fact that an assessment of their qualitative properties is only possible after they have been purchased. A quality assessment before the 10th market failure as a result of information deficiencies would be conceivable here, but it mostly fails to a large extent disproportionately high cost. This means that consumers run the risk of receiving relatively poor quality against their will. For example, a consumer is normally not able to determine the wholesomeness of canned tuna in advance, because appropriate analyzes (e.g. determination of the mercury concentration) would require both special knowledge and equipment. The quality of the food offered in a restaurant can ultimately only be reliably assessed after it has been consumed. Experienced goods are characterized by a medium level of lack of quality. In the case of goods of faith or trust, one can only recognize poor quality if one has already consumed a certain amount of the good in question; In certain cases, the quality of the goods can never be reliably determined at all. For example, after certain forms of medical treatment or taking a medication, one often does not know for sure whether a cure occurred due to or despite the therapy. The quality of goods of belief or trust may not be clearly determinable after the consumption of the good because it depends on a number of variables that cannot be observed or are difficult to control. For example, the healing effects of a particular drug are, among other things, evaluated. influenced by the diagnostic and therapeutic skills of the attending physician. The problem of lack of quality is particularly pronounced in the case of goods of belief or trust, since the causes of poor quality can hardly be determined even after the goods have been consumed. Overview 10.1 summarizes the characteristics of the various types of goods with regard to potential information asymmetries. Overview 10.1: Goods types and information asymmetries Part II: Market failure: causes and therapeutic options 252 Vahlens Handbooks Fritsch - Market failure and economic policy (9th edition) Manufacture: Ms. Deuringer Date of change: 02/19/2014 Status: Imprimatur Page 252 As a result, it can be stated that with asymmetrical distributed information there is a risk of adverse selection. Adverse selection has the consequence that •• in the case of asymmetry at the expense of the customer, the price and the quality offered decrease until, in the end, only poor quality is traded. The market for good quality is collapsing. •• in the case of asymmetry at the expense of the provider, the price rises until it is only appropriate for those customers who represent a relatively low quality. •• there is an interest in transactions in the area of ​​relatively high quality, but these transactions do not materialize. These problems with regard to the functionality of the market are particularly relevant for goods based on experience and trust. Section 10.2.5 investigates the extent to which adverse selection is to be expected in reality and which market-endogenous solutions exist for the problems caused by asymmetrical information distribution. 10.2.2 Hidden actions and moral risk Moral risk means that one side of the market can change facts relevant to the transaction to the detriment of the transaction partner after the conclusion of the contract, without this being apparent to the other side of the market. This constellation is also characterized as a problem of hidden actions ("hidden action"; cf. Section In particular, if performance and consideration extend over a longer period of time and the performance of a party is linked to the occurrence of certain circumstances, there is a risk of behavior contrary to the contract or moral risk. The classic example of this is the insurance contract: In many cases, it cannot be ruled out that a policyholder will cause the damage through careless behavior and the insurer will have to take responsibility for damage that could have been prevented by the policyholder. An essential prerequisite for the occurrence of moral risk is that the party obliged to perform is not able to recognize behavior by the transaction partner that is contrary to the contract; in this respect, there is an information asymmetry to the detriment of the obliged entity. Without this information asymmetry, the person obliged to perform could refuse any performance with reference to the behavior of the other in violation of the contract. Example 1: Various complex protective measures are possible against bicycle theft. The optimal level of security results from weighing security costs and the corresponding benefits of security measures. A person insured against bicycle theft pays a premium for the insurance to replace the value of the bicycle in the event of damage. This reduces the benefit of theft-preventing measures, so that certain security measures no longer prove to be worthwhile and the probability of loss increases. If the insurance company is in a position to precisely check the level of protection actually achieved, it can set the premium individually: Careful policyholders then pay relatively little and carefree a lot. Problems arise only when insurers cannot see the true level of loss prevention. The non-observability of the damage prevention measures creates a moral risk in the form that stolen bicycle owners 10. Market failure as a result of lack of information 253 Vahlens Handbooks Fritsch - Market failure and economic policy (9th edition) Production: Ms. Deuringer Date of change: 19.02.2014 Status: Imprimatur Page 253, cautious to have been, but actually behaved carelessly. The insurer cannot determine the level of care actually exercised and must therefore replace the stolen bike. Example 2: Two pawns meet. If one farmer says to the other: “I have insured myself against fire and hail.” After a short pause, the other asks: “I understand the fire, but how do you do hail?” moral risk with regard to the behavior of the respective contractual partner, he will take this risk into account when calculating the price he is asking: In order not to suffer a loss in the event of moral risks occurring, the price is set relatively high. The assumed information asymmetry prevents prices that are differentiated according to the individual moral risk. With a uniform, relatively high price for all contractual partners, however, the contractually loyal actors are also burdened and may therefore refrain from concluding a contract. An adjustment process is set in motion, at the end of which only contracts are concluded at relatively high prices and only those individuals will ask for contracts where behavior contrary to the contract is very likely. Moral risk can also lead to adverse selection. Example: A bicycle insurer finds that a large proportion of those insured behave relatively carelessly and only implement a low level of protective measures. If the insurer cannot identify who is observing a high level of care and who is not, he must set the same premium for everyone - including the really cautious. With a relatively high premium, however, the good risks will forego bicycle insurance and instead secure their vehicle well. The insurance, which is now offered at relatively high premiums, is particularly worthwhile for the bad risks that require a low level of care. Problems of moral risk can also arise if two contracting parties involve an expert third party who, based on his specialist knowledge, provides the service and determines the extent of the service. Such a constellation is shown in Figure 10.3. Parties A and B conclude a contract, according to which B (e.g. patient) of A (e.g. health insurance) Figure 10.3: External moral risk Contracting party A instructs specialist C to provide a service for the contracting party B. If neither A nor B are able to assess the quality of C's performance, there is an “external moral risk.” Part II: Market failure: causes and treatment options 254 Vahlens Handbooks Fritsch - Market failure and economic policy (9. Edition) Production: Ms. Deuringer Date of change: 02/19/2014 Status: Imprimatur Page 254 assurance) services should receive; B must make payments to A for this. A does not undertake the provision of the service himself, but instead instructs specialist C (e.g. a doctor) as his vicarious agent. If neither A nor B are able to control the behavior of C, then there is a double information asymmetry. These information asymmetries create the danger of moral risk in the form that the service provider C, due to his higher level of expertise, provides unnecessary services and charges these services to A. Moral risk becomes even more likely when B has no incentive to control C. In particular, if B's ​​payments are independent of the way in which the service is provided by C, B will not control person C. One speaks here of a 'supplier-induced' demand or an external moral risk. Example: Most patients are unable to assess the need for certain medical services. Since the doctor is paid for by the health insurance in Germany, the patient - provided he does not have to pay his own contribution to the costs - has little interest in inexpensive care, because the costs of his treatment are passed on to all insured persons. In addition, the patient usually lacks the medical knowledge to be able to control the treatment by the doctor. The health insurance companies are also hardly able to check the necessity of the services provided by the doctor in individual cases. The inability and the lack of incentives to control tend to mean that doctors, as providers, are able to determine the scope of the service they provide (within certain limits) themselves. There is therefore a risk that doctors will prescribe more than the required service so that their income increases accordingly. 10.2.3 Risks of opportunism: Hold up or hidden intentions The problem of hold up (literally translated: “robbery”) can occur in long-term contractual relationships. It consists in a contracting party interpreting the agreement unilaterally for its own benefit and withholding part of the service or demanding greater consideration. Here, the information asymmetry refers to the fact that the probability of such hold-up behavior cannot be precisely estimated when the contract is concluded; the true intentions of the contractual partner remain hidden ("hidden intention"; see section 10.2.3). Hold-up behavior aimed at one's own advantage, which can also include cunning (deception, fraud), is called opportunistic. There is always a risk of a hold up if: •• the concluded contract is incomplete in that there is leeway with regard to the interpretation of contractual rules, and •• at least one of the parties to the contract has made specific irreversible investments for the relationship which, when the relationship was terminated sink in. Due to the sunk costs that arise when the relationship is broken off, actors who have made relationship-specific irreversible expenses are dependent on the contractual partner and can therefore be exploited. Such a dependency due to irreversible investments is also referred to as a lock-in effect. 10. Market failure due to lack of information 255 Vahlens Handbooks Fritsch - Market failure and economic policy (9th edition) Production: Ms. Deuringer Date of change: 02/19/2014 Status: Imprimatur Page 255 Examples of relationship-specific irreversible expenses and corresponding hold-up problems: • Long-term supply relationship: Trusting in a long-term business relationship, a supplier purchases an expensive special machine that can only be used for the orders of a specific customer and allows considerable cost savings compared to conventional technology. The buyer could exploit the dependency created by this specific investment of his supplier by threatening to break the supply relationship in the event of an upcoming contract extension (hold up) and in this way forcing the supplier to make price concessions. If the supplier expects such extortion, he will not get involved in the relationship-specific investments in special machines; consequently, the corresponding cost-saving potentials remain unused. •• Employment contract: In the course of his activity in a company, an employee acquires not only his professional qualification but also a company-specific qualification, i.e. knowledge that he can only apply in the company. If the employee has (co-) financed this company-specific qualification himself, for example by accepting wages below the market level, then he is dependent insofar as the employer can demand the 'surrender' of this additional productivity at every wage negotiation by paying the wages pushes until the employee only gets his professional qualifications, but not his company-specific qualifications. Because more would not be rewarded in another employment relationship. If, on the other hand, the employer fully pays for the company-specific qualification, he becomes dependent: The employee could demand a wage that is above the market price for his professional qualification. Without clear regulations for remuneration for company-specific qualifications, there is a risk that too little will be invested in this area. •• Rental agreement: In rental agreements, corresponding exploitation becomes possible because the tenant incurs costs for the move, adapts his furniture to the circumstances of the apartment, carries out interior work and, last but not least, establishes social ties at the place of residence. These are all specific investments that may be lost if you move out. The landlord can skim off this bond - provided there are no restrictions in this regard - with a rent increase above the market level or refrain from necessary maintenance investments to the extent that he does not have to fear moving out of the tenant or rent reductions. Unlike in the case of moral risk, the undesirable behavior is clearly recognizable. However, there are no sanction options to induce the contractual partner to behave loyally.In principle, the risk of an opportunistic hold-up could be avoided by considering all eventualities in the contract from the outset. However, it is often impossible or inexpedient to conclude a long-term contract that does not allow for any uncertainty. Because mostly not all eventualities can be foreseen and it is extremely time-consuming to regulate all possible future constellations ex ante in a reasonably exhaustive manner. The consequence of such hold-up problems is that specific investments that actually make sense are not made or that the relevant contractual relationship is not even entered into. If, as a reaction to hold-up problems, the relevant production steps are carried out internally, this means that the fundamentally available possibilities of division of labor and market coordination are not exhausted. The market then fails insofar as it does not offer an adequate opportunity for certain transactions. There is a loss of welfare. Part II: Market Failure: Causes and Therapy Options 256 Vahlens Handbooks Fritsch - Market Failure and Economic Policy (9th edition) Produced by: Ms. Deuringer Date of change: 02/19/2014 Status: Imprimatur Page 256 10.2.4 Principal-agent theory The principal-agent theory provides a general analytical framework for the problems associated with asymmetrically distributed information (adverse selection, moral risk and hold up). Fundamental to the principal-agent theory is the distinction between a principal, the client, and the agent who is hired. perform certain actions or provide services. Can the agent be expected to act exactly as the principal expects him to do? If the action desired by the principal involves effort for the agent, this question cannot simply be answered in the affirmative. A disregard of the interests of the principal is particularly to be feared if the principal is incompletely informed about the properties or actions of the agent, i.e. there is an asymmetrical distribution of information at the expense of the principal. Within the framework of the principal-agent theory, three aspects of the problem of unevenly distributed information are discussed, which are dealt with in more detail below: Hidden actions or information ("hidden action" or "hidden information"; Section, hidden properties ("Hidden characteristics"; Section as well as hidden intentions ("hidden intentions"; Section Hidden actions or hidden information If the principal can only incompletely observe the action of his agent, there is a risk that the agent will omit contractually guaranteed actions unnoticed or actions to be omitted according to the agreement that violates the interests of the principal. Such behavior is to be expected in particular if the agent can increase his benefit through his 'wrongdoing'. In this respect, the term “hidden actions” describes similar facts as that of “moral risk”. These are problems due to information asymmetries that occur after the conclusion of the contract (ex post). Hidden actions do not cause problems if the result of the action depends solely on the agent's behavior, e.g. B. his effort and exertion (s), is dependent. In this case, the effort made can be derived from the result (E): A bad result must be based on a correspondingly poor performance by the agent; a good result results from a good performance or contract-abiding behavior of the agent. In the event of poor performance by the agent, the principal has the option of reducing the agent's remuneration or withholding it entirely or making claims for damages. In this regard, the principal-agent theory assumes that neither the agent's action is observable, nor can the effect be fully traced back to the agent's effort. Consequently, the result is determined not only by the agent's efforts (e), but also by an unobservable random variable (θ) (stochastic component). If, under these conditions, the agent's remuneration were to be reduced in the event of an unfavorable result, there is a risk that the agent will be 'punished' as a result, 10. Market failure due to lack of information 257 Vahlens Handbooks Fritsch - Market failure and economic policy (9th edition) Production: Ms. Deuringer Date of change: 02/19/2014 Status: Imprimatur Page 257 although he may not be responsible for the bad result. Information that is unevenly distributed is therefore only relevant within the scope of the principal-agent approach if the result is also influenced by an unobservable random variable. Examples of constellations in which hidden actions can occur: •• Patient-doctor relationship. The principal here is the patient; the doctor acts as its agent. Treatment by the doctor affects the patient's well-being. Due to a lack of medical knowledge, however, it is usually impossible for the patient to check the accuracy of the medical diagnosis or the necessity of the proposed therapy. •• Shareholder manager in public companies. As an agent of a public company with only small shareholders, the manager does not have to fear that his principals, the shareholders, control him in the exercise of his business, because the individual control costs are too high compared to the individually expected income or the shareholders have the necessary skills to Lack of control. •• Employers and employees. The employment relationship is almost a classic principal-agent relationship: In many cases, the principal “employer” has great difficulty checking the workload of his employees (agents). •• Politicians and bureaucrats. Politicians promise voters that public services will be provided. Bureaucrats are entrusted with the provision of services. In this respect, the politician takes on the role of the principal, the bureaucrat represents an agent. Information asymmetries can arise in this relationship, for example, when the bureaucrats can assess the costs of the provision of services much better than the politicians. Hidden actions can occur on either side of the market. For example, in the patient-doctor relationship, the provider “doctor” may hide an action; In the insurance contract, it can be the inquirer, the insured, who uses an asymmetrical distribution of information to his advantage. The problem of hidden actions can be illustrated using Figure 10.4. The principal P gives the agent A an order. The result of the agent's action (E) depends on the effort of the agent (e) and on random influences (Θ). The agent receives a fixed fee H); the residual R falls to the principal P as the difference between E - H). In the case of such an agreement, the agent does not have the incentive to make an effort or to refrain from concealed actions that are advantageous for him: the level (s) of effort selected by the agent cannot be checked by the principal, poor results do not entitle the principal to refuse payment H. . One possibility to motivate the agent more to perform would be to reward him with the residual (R) while the principal has a constant figure. The principal's income depends on the result. The agent receives a fixed fee. The principal alone bears the risk. Part II: Market Failure: Causes and Treatment Options 258 Vahlens Handbooks Fritsch - Market Failure and Economic Policy (9th edition) Produced by: Ms. Deuringer Date of change: 02/19/2014 Status: Imprimatur Page 258 Amount B receives (see Figure 10.5). Insufficient efforts on the part of the agent are at the expense of the agent with this success-related fee regulation; the agent's behavior is irrelevant to the income of the principal. With this form of contract, however, the agent also bears the risk of a randomly bad result. Consequently, the agent will only enter into such an arrangement if he is in some way compensated for taking this risk. The higher the risk, the greater the compensation required by the agent, which is at the expense of the fixed amount due to the principal. The problem described here can also occur when there is hidden information. A situation characterized by hidden information is when the principal can observe the agent's actions after the conclusion of the contract, but remains in the dark about the appropriateness of the action due to a lack of expertise. For example, in his role as a principal, the patient can observe on his own body how the doctor, as his agent, arrives at the diagnosis and which therapies are carried out. As a rule, he cannot judge whether diagnosis and therapy are appropriate. After the treatment, he only knows whether the symptoms have been resolved or not. The quality of the medical service ultimately remains hidden from him. So what is the difference between hidden actions and hidden information? Hidden actions exist when the principal can neither assess the efforts of his agent (s) nor the influence of random influencing factors (Θ). As a result, if the outcome is poor, the principal has no way of knowing whether the poor outcome is due to poor agent engagement or other factors beyond the agent's control. The term “hidden actions” thus refers to the agent's unobservable level of effort. “Hidden information”, on the other hand, emphasizes the agent's undetectable abilities and qualities. From the point of view of the principal, this distinction is ultimately irrelevant: In both cases, he does not know to what extent the reason for a certain result is to be found in the person or the actions of the agent or whether this result is mainly due to chance influences. In this respect, both terms describe the same economic problem. Figure 10.5: Hidden actions with variable remuneration for the agent The principal receives a fixed income. The agent is rewarded based on success and bears the risk. 10. Market failure due to lack of information 259 Vahlens Handbooks Fritsch - Market failure and economic policy (9th edition) Production: Ms. Deuringer Date of change: 02/19/2014 Status: Imprimatur Page 259 Hidden characteristics ("hidden characteristics") Contractual relationships can be characterized by that the principal cannot assess the properties of his potential agent before the contract is concluded (ex ante), but the result depends largely on these properties, generally the performance or productivity of the agent. The principal has an interest in using agents that are characterized by relatively high performance. Examples of hidden characteristics: •• Chief bureaucrat and subordinates. The head of administration (chief bureaucrat), as principal, has an interest in knowing the actual performance of his employees. The subordinates, the agents, can, however, assess their capabilities better than the chief bureaucrat. In this respect, the performance indicators on the performance of the employees represent hidden characteristics for the administrative manager. The subordinates have little incentive to reveal their true possibilities, as they have to fear that correspondingly higher performance will then be demanded of them. •• Insurer and insured. In many cases, the insurer must expect that there are considerable differences in risk among the persons to be insured; Some policyholders are unlikely to suffer damage, others have a high probability of occurrence. As a rule, it can be assumed that the policyholders are much better able than the insurer to assess their risk. The problem of the hidden properties can be illustrated with the help of Figure 10.6. The principal P intends to place an order with an agent A. The agent receives a result-independent fee H, the principal is entitled to the residual R, which results from the difference between the ex ante unknown (but of course subsequently becoming known) result E and the fixed fee H. Due to the information asymmetry, from the point of view of the principal, all potential agents are equivalent in terms of their performance (A1 = A2 =... = An). Since the principal is not able to differentiate the agent's remuneration according to his performance, he sets the same, result-independent fee H for all agents. Again, a 'screen' (see Figure 10.2) prevents complete information. In fact, however, the agents differ: Agent A1 is characterized by a relatively high level of performance (L1); its use leads to a relatively high yield E1. In the case of the agent An, the productivity level is significantly lower, which leads to a correspondingly low yield En. With regard to the performance of the agents, the order of precedence is L1> L2>. . . >