Chapter 15
Challenge To Market Effectiveness 5:
Incomplete Information
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Learning Objectives
• How does incomplete information affect customers?
• How can brand names, money-back guarantee and
eBay ratings reduce the effects of incomplete
information?
• What is adverse selection?
• How does adverse selection manifest itself in the used
car market?
• What is agency cost?
• How do consumers face agency costs?
• How does incomplete information about potential
employees affect firms?
• How does incomplete information affect health insurance
firms?
2
15-2
Incomplete Information
• If customers have incomplete information about
products’ qualities, customers don’t always get
what they want.
• Businesses sometimes use uncertainty to cheat
customers.
• Product uncertainty harms firms as well as
consumers.
• Consumers pay less for a product the less sure
they are of the product’s safety and reliability.
3
15-3
Brand Names
• Firms that can earn consumers’ trust increase the
demand for their products.
• Brand name greatly reduces the uncertainty facing
consumers.
• A well-known brand name is an asset only if customers
have positive experiences with the products.
• A brand name makes it easy for customers to associate
their negative experiences with the company.
• Not-for-profit groups sometimes use brand names to
promote their causes.
4
15-4
Value of Brands
• The value of a brand
is how much extra
profit over the long
term a company
receives because of
the brand.
Company
Value of Brand
Coco-Cola
Microsoft
$67.5 billion
$59.9 billion
IBM
GE
Intel
$53.4 billion
$47.0 billion
$35.6 billion
Nokia
Disney
$26.5 billion
$26.4 billion
McDonald’s
$26.0 billion
5
15-5
Money-Back Guarantees
• Firms use money-back guarantees as a
means of winning customers’ trust.
• Money-back guarantees allow consumers
to recover most of the cost of buying a
product if the product proves defective.
6
15-6
eBay Ratings
• eBay is an online auction website that allows anyone to
buy and sell goods.
• Both the buyer and seller have the ability to harm each
other.
• eBay has succeeded only because it has created a
buyer and seller rating system under which buyers and
sellers mostly trust each other.
• eBay’s rating system not only provides buyers and
sellers with information about each other, but also gives
eBay users an incentive to behave honestly.
• eBay represents a triumph of markets over uncertainty.
7
15-7
Hidden Information
• Firms sometimes attempt to deliberately
increase consumer uncertainty by hiding
information.
• “Sound of silence” has strong applications to
consumer product markets.
• Silence signals that the situation is very bad
because if it wasn’t, the firm would have an
incentive to say something.
• Consumers may not benefit from mandatory
disclosure laws.
8
15-8
Adverse Selection
• Distrust created by uncertainty is
sometimes magnified by adverse
selection.
• Adverse Selection occurs when one
attracts those with whom one least wants
to interact.
9
15-9
Used Cars and Adverse Selection
• When buying a used car,
buyers most want to
attract sellers of high
quality cars.
• Sellers would most want
to part with vehicles of
low quality.
• Current owners know
their car’s quality, but
prospective buyers don’t.
As adverse selection
lowers the price of used
cars, fewer used cars of
high quality are sold.
Car’s quality Car’s value
to buyer
High
$10,000
Low
$3,000
• The price of used cars
will be far below
$10,000 because of
adverse selections.
• This low price for used
cars means that
owners of excellent
cars will be even less
willing to sell them.
10
15-10
Countering Adverse Selection
in Used Car Markets
• The cure for adverse selection is additional
information.
• An independent mechanic can verify the car’s
quality.
• A warranty by the seller can reduce hidden
information.
• An association with brand names can reduce
adverse selection, e.g. “certified pre-owned
BMW.”
11
15-11
Incomplete Information
About Employee Activities
• When employees make decisions for their employers,
they act as agents.
• These agents have an interest in maximizing their own
welfare, not the welfare of their employer.
• Agency Costs = The harm suffered by employers when
employees makes decisions that help themselves but
harm their employers.
• Agency costs arise because firms have incomplete
information about their employees’ activities, e.g. bribes
and gifts to managers, frequent flyer miles for business
travelers.
12
15-12
Agency Costs and Consumers
Agency costs also affect consumers:
• Stockbrokers have an incentive to recommend
that their customers engage in an excess
amount of stock trading.
• Real estate agents serve their own self-interests
by pushing their clients to make quick
purchasing decisions.
• Doctors can serve their own self-interests while
determining prescription drugs for their patients.
13
15-13
Incomplete Information
About Potential Employees
• Firms don’t have complete information about potential
employees and hence must guess based upon signals.
• Resume omission can damage job applicants.
• On average, job candidates who would be the happiest
with the salary offered are the candidates of the lowest
quality since the marketplace values them the least.
• Incomplete information can result in firms engaging in
statistical discrimination in hiring decisions.
• Statistical discrimination occurs when someone is
discriminated against for being in a group whose
members have some undesirable quality.
14
15-14
Incomplete Information
About Politicians
• Adverse selection contaminates most
revolutions because the only types of people
capable of acquiring power in revolutionary
environments are those skilled at murder and
betrayal.
• The unique success of the American Revolution
is due to its escaping adverse selection.
• Voters always have incomplete information
about presidential candidates.
15
15-15
Incomplete Information
About Insurance Customers
• Adverse selection creates potential problems for health insurance
companies.
• The people who most want to buy health insurance are the people
whom the health insurance companies least want to insure.
• Health insurance companies escape adverse selection by not
providing coverage for preexisting conditions.
• Unchecked adverse selection will drive healthy customers out of the
market, resulting in only sickly people buying insurance.
• Governments sometimes prevent insurance companies from fighting
adverse selection.
• Genetic testing would create tremendous adverse selection
problems for the health insurance industry.
16
15-16
Incomplete Information
About Romantic Dates
• You want to date someone with high qualities.
Unfortunately, the higher someone’s qualities,
the better they will do in the dating market and
the less interest they will have in you.
• Uncertainty makes dating markets difficult to
navigate.
• Dating market participants are willing to pay
money to reduce uncertainty resulting in many
Internet dating services.
• Silence can also send signals in online dating.
17
15-17
Do You Know?
• How do brand names reduce uncertainty?
By building reputation for quality and consistency, brand
names reduce uncertainty for customers.
• Why is it difficult for firms to hide information if they are
forbidden to lie but have the option of not releasing
information?
Even silence speaks for itself. Silence signals that the
situation is very bad because if it wasn’t, the firm would
have an incentive to say something.
18
15-18
Do You Know?
• Why would unfettered adverse selection cause almost all
used cars for sale to be of low quality?
Since prospective buyers don’t know the quality of used
cars, they are willing to pay only a low price. As adverse
selection lowers the price of used cars, fewer used cars
of high quality are sold.
• How do agency costs harm firms?
Agency costs arise because firms have incomplete
information about their employees’ activities. Firms’
employees have an interest in maximizing their own
welfare and not the welfare of their employer.
19
15-19
Summary
• Incomplete information about product harms firms as
well as consumers.
• Brand name greatly reduces the uncertainty facing
consumers.
• Firms use money-back guarantees as a means of
winning customers’ trust.
• Through its rating system, eBay represents a triumph of
markets over uncertainty.
• “Sound of silence” has strong applications to consumer
product markets.
• Adverse Selection occurs when one attracts those with
whom one least wants to interact.
• As adverse selection lowers the price of used cars,
fewer used cars of high quality are sold.
20
15-20
Summary
• When firms have incomplete information about their
employees, these employees have an interest in
maximizing only their own welfare.
• Consumers also face agency costs in dealing with
stockbrokers, real estate agents and doctors.
• Firms don’t have complete information about potential
employees and hence must guess based upon signals.
• Adverse selection contaminates most political
revolutions.
• Adverse selection creates potential problems for health
insurance companies.
• Uncertainty makes dating markets difficult to navigate.
• The cure for adverse selection is additional information.
21
15-21
Coming Up
What is inequality?
22
15-22