Chapter 15

Challenge To Market Effectiveness 5:

Incomplete Information

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

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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?

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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.

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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.

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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 $67.5 billion

Microsoft $59.9 billion

IBM $53.4 billion

GE $47.0 billion

Intel $35.6 billion

Nokia $26.5 billion

Disney $26.4 billion

McDonald’s $26.0 billion

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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.

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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.

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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.

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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.

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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.

• 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.

Car’s quality Car’s value to buyer

High $10,000

Low $3,000

As adverse selection lowers the price of used cars, fewer used cars of high quality are sold.

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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.”

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.15-20

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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.

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Coming Up

What is inequality?

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