So far, we assumed there’s no uncertainty in the world. But, in reality, these payoffs are uncertain, most business outcomes are uncertain as well. In this chapter, we will learn: Risk analysis, Moral Hazard/Principal-Agent Problem. Inviting you to refer.
Week Risk Analysis and Moral Hazard Today’s Agenda Risk Analysis Moral Hazard / Principal-Agent Problem Motivation So far, we assumed there’s no uncertainty in the world • In the OPEC game, if Kuwait and Saudi share the market, they will both earn $180,000 But, in reality, these payoffs are uncertain • In economics, it’s called “risky payoff.” • In statistics, it’s called “probability distribution” Most business outcomes are uncertain as well • In order to make good business decisions, it’s very important to understand this uncertainty and to measure the risk properly Attitudes toward Risk Suppose there are two salary options Fixed salary of $100,000 Uncertain salary depending on coin toss outcome – $0 if Heads and $200K if Tails The preference between these options will reveal the attitude toward risk Attitudes toward Risk (cont) Risk Averse • If you prefer options #1, the fixed payoff Risk Neutral • If you are indifferent between #1 and #2 Risk Loving • If you prefer options #2, the uncertain payoff Almost all people are risk-averse • But the degrees of risk-aversion differ among people • Some people are more risk tolerant than others Moral Hazard Let’s consider an auto insurance • By design, insurance pays for costs if certain events occur Insured people may have distorted incentives • Insurance company wants you to drive safely • But the insured may drive less carefully Moral hazard • What the insurance industry calls this distorted incentive The Principal-Agent Model Moral hazard • Economists use “principal-agent models” to analyze moral hazard The Principal-Agent Model • agents work on behalf of the principals • the problem of different incentives between agent and principal • occurs because of asymmetric information Principal-Agent Problem (cont) Asymmetric Information • One party has more private information than the other • The party with private information is called “Agent” • The other party without private information is called “Principal” There are many applications of principal-agent problem • Shareholders vs Managers (in corporate finance) • Employer vs Employee (managerial accounting) • Politicians vs Public (in political science) • unemployment, life, & auto insurance (in economics) Solving principal-agent model Several methods depending on the case Monitor agents more carefully • have health insurance customers come in for regular exams • monitor employees at work – Monitoring can be too costly Use appropriate incentives • co-payments in insurance • performance based salary pay New idea: give ownership to the agent • independent contracting instead of employment • outsourcing • franchising Adverse Selection Suppose you purchase a new car for $20,000 • drive it for day & then sell it the next day –what would a buyer think about your car? –what price will you get for your car? Why? Asymmetric information: • sellers know the true quality, but buyers not • this leads to adverse selection, often known as the “lemons problem” –George Akerlof (2001 Nobel prize) 10 Summary Adverse Selection: • If there’s private information to one party, bad guys will drive out the good guys from the market – which leads to inefficiency or worst outcome • Used car market – Seller has private information • Insurance market – Buyers have private information How to solve the adverse selection problem? • Signaling • Self-selection 20 Auction Auction Types Class experiment • dollar auction Keys to eBay’s success Types of Bidding strategies in eBay Winner’s Curse 21 Online Auction Revenues from online auctions • $6.5 billion in 2000 • $30 billion in 2003 • Expected growth rate of 68% through 2006 Up to the third-quarter of 2012, Net revenue of $10.079 billion, up to 21.8% from $8.272 billion in the same period of 2011 22 Normal Auction vs Reverse Auction Normal Auction • A service or product is made available by the seller • Buyers bid for the ownership rights Reverse Auction • Buyer announces the need for a product or service • Sellers bid for the right to sell the buyer 23 Types of Auction Mechanisms English Auction • Ascending-bid • Most common, Standard form for eBay Dutch Auction • Descending-bid – The price decreases until a buyer bids • In eBay, used for large quantity auctions – All winners pay the lowest winning bid Sealed-Bid Auction • Mainly used for reverse auctions Second-Price, Sealed-Bid Auction • Vickrey, 1996 Nobel Price 24 Keys to Ebay’s Success? Network Externality • eBay: customer to customer (C2C) internet business • Needs to get critical mass –First movers advantage –Many other auction sites failed » Onsale.com, ubid.com (?) Customer Service • Feedback Ratings –biggest fear among online customers = Fraud, Scam –Ratings provide a safety check to the customers • Easing the transaction between buyer and seller –purchasing paypal 25 Online Fraud • Online auction fraud is #1 internet fraud (FTC) Scam • To avoid scams, check feedback ratings • Other methods? Shilling • Colluding, bid rigging by sellers – Sellers try to hike up the price by bidding under aliases » Email address is all needed to open up Ebay account • Very hard to detect • Known indicators – Same shill appears frequently in seller’s auctions → Check the bidding history of completed items → Bids are significantly higher than current bid (unmasking strategy) 26 Ebay Auction Specifics Various Formats: • Standard English Auction • Dutch Auction • Buy It Now Fixed End Time • different from standard English auction Minimum Bid Increment Proxy mechanism: • Customers set the maximum willingness to pay and computer automatically increases their bidding up to the maximum • Winning bid depends on the 2nd highest bidder – Winners usually pay less than their maximum bid (Consumer surplus) 27 Bidding Strategies Late Bidding • 58% of biddings were placed in the last day • Sniping: bidding at the very last seconds Evaluator • Have a clear idea of his valuation (willingness to pay) • Bid early at significantly higher price than the current bid Skeptic • Always bid current bid + minimum increment • Multiple bids, if outbid • Skeptical on proxy bidding Unmasking • Bid at current bid plus variable increments • Tries to expose winner’s maximum bid • Usually early in the auction (not at the last minute) 28 Winner’s Curse Winner’s Curse: Paying more for item than its value • Winner realizes that his bid is the highest among all bids • Unless he knows the exact value of the item, his bid is likely to be higher than the real value • In short, he wins the auction but he actually loses money Consider a standard Sealed-bid Auction • For fear of winner’s curse, most bidders bid less than their value of the item • Standard sealed-bid auction does not guarantee the maximum profit to the seller 29 Vickrey Auction Second-Price, Sealed-Bid Auction • Winner will not pay his bid (the highest bid) • But pays the second highest bid Bidders • Adjust their bids upward because they will not pay too high a price • In other words, people don’t fear winner’s curse Vickrey shows • The optimal bidding strategy is to reveal their assessed value – In the standard auction, they bid less than the assessed value • Hence, this will generate the highest profit to the seller Applications • Not common • Can be found in stamp collection auctions • eBay’s proxy bidding is similar but it’s not sealed bid 30 Summary Types of Auctions • English • Dutch • Sealed-bid Types of Bidding strategies in eBay Winner’s Curse and Vickrey auction • Vickrey auction will reveal the bidder’s true value 31 Organization Design How are profit-maximizing firms organized? What is the optimal size firm? How does a firm decide which activities to conduct within the firm (internal production) versus using the external market (outsourcing)? How should the firm organize to maximize profits? These questions come under the topic of “The Nature of the Firm.” 32 The Nature of the Firm “The Nature of the Firm,” written by economist Ronald Coase in 1937 It involves weighing the tradeoffs, costs and benefits, advantages and disadvantages, of various types of organizational structure and design, which brings up such issues as: 1> The boundaries of the firm, optimal size of the firm, issues of internal production vs external production 2> Centralization vs decentralization of decisions and information within the firm 3> Monitoring and rewarding performance (separation of ownership and control in most large firms) 4> General compensation rules 33 MECHANISMS TO MINIMIZE POTENTIAL Principle-Agent PROBLEMS OF CORPORATIONS 1> Shareholder Empowerment 2> Corporate Governance Reforms 3> The Market for Corporate control 34 ... carefully Moral hazard • What the insurance industry calls this distorted incentive The Principal-Agent Model Moral hazard • Economists use “principal-agent models” to analyze moral hazard The... between #1 and #2 Risk Loving • If you prefer options #2, the uncertain payoff Almost all people are risk- averse • But the degrees of risk- aversion differ among people • Some people are more risk tolerant...Today’s Agenda Risk Analysis Moral Hazard / Principal-Agent Problem Motivation So far, we assumed there’s no uncertainty in the world • In the OPEC game, if Kuwait and Saudi share the market,