A V Vedpuriswar and V Pattabhi Ram
Service Sam was teaching “markets”. “Information drives the market,” he said swishing his mane. “Sam, but this presupposes that there is a free flow of information to which everyone has equal access.” It was Debbie, putting words into her professor’s mouth. “True,” said Sam appreciatively. And added, “In some situations, information stays private, i.e., it is available to very few persons and is too costly for others to obtain it”. The class sensed that they were on to something new. A backbencher remarked, “Sam, this would put some people at an advantage compared with others”.
Sam continued: “Yes. Private information affects transactions. Take driving, for instance. We know much more than the auto insurance company does about how carefully we drive”. The girl in the middle row (GITMR) snipped, “We know a lot more about the condition of our car than the prospective buyer does”. Goggles who had just broken up with his girlfriend whispered, “We know how much better we are than our friend does”.
Boka wasn’t impressed. He asked, “Sam, is life not about someone having more information than the other? Private information, in your lingo. Like, Albert Einstein had more information about science than you and I. That’s how he discovered the theory of relativity. Then why make this hungamma”? The professor dismissed Boka’s analysis as too simplistic and went on to explain how private information created two problems, namely Moral hazard and Adverse selection: “Moral hazard exists when a party to an agreement has an incentive, after the agreement is made, to act in a manner that brings additional benefits to himself at the expense of the other party.” Phew, jargon.
It was Flowers, who fought for grades with Boka, who first got off the mark. “So, when I drive a car and have taken insurance cover, I drive more recklessly than when the cover has expired. Sam would that be moral hazard?” he asked. “Absolutely,” said the professor smiling. Sam loved students who gave down to earth examples.
The professor then moved on to explaining adverse selection. Adverse selection is the tendency for people to enter into agreements in which they could use their private information to their personal advantage. “Suppose, I buy a second hand car that turns out to be worthless. I would have been better off buying a used car with no defects. But the used car market does not have two prices — a low price for defective cars and a high price for good cars. Why”?
Sam then ran some numbers. “Suppose a defective used car costs Rs 15,000 and a good used car costs Rs 75,000. Whether the car is defective or not is private information available only to the current owner. Buyers can’t tell the difference until they have bought the car and used it. So buyers want to pay only the price of a bad car. Just as buyers are unwilling to pay Rs. 75,000 for a used car, the owners of good cars will not be willing to sell, if they do not get Rs. 75,000. Hence only the owners of worthless cars are willing to sell, provided the price is above Rs 15,000!”
But, if only the owners of defective cars are selling, it means that all used cars in the market are defective cars! Thus the market for used cars will be a market for defective cars and the price will be Rs. 15,000.” Sam paused.
Boka put up his hand. “Sam, would that mean that moral hazard exists in the car market because sellers have an incentive to claim bad cars as good cars? Would it also mean that adverse selection results in only the defective cars being traded?” “True,” said Sam. “Here, the market isn’t working well. Good used cars are not getting sold, but people want to buy such cars”. He then asked, “How can the market be improved?”
Flowers responded: “We can introduce warranties. Ha. Dealers can tell a good car from a bad one since they might have regularly serviced it. They can convince buyers to pay Rs. 75,000 by giving them a warranty. Namely undertaking to bear the cost of repairing the car if it turns out to be defective”. Boka sided Flowers. “Cars with a warranty are good. Cars without a warranty are bad”. The class smiled.
Debbie who loved finance jutted in, “This warranty business can be called the signal effect”. Only the other day they had been taught about rights issue. “Buyers will believe the signal, because the cost of sending a false signal is high. A dealer who warranties a bad car ends up paying the high cost of repairs and also risks picking a bad reputation. So warranties enable the used car market to function with two prices, one for defective cars and another for good cars. Cars without warranty will fetch a lower price and those with warranty a higher price.”
Goggles hated cars. And so asked, “Would this be true for loans?” GITMR said, “Yes, it does. The demand for loans depends on the interest rate. The lower the interest rate, the higher is the quantity of loan demanded. The supply of loan depends on the cost of lending. This cost has two parts. One, the interest rate at which banks borrow. Two, the risk involved in lending which varies from borrower to borrower.
Say there are two types of borrowers: low-risk and high-risk. The former seldom default, the latter often do. Banks would like to charge a higher rate in the case of high-risk borrowers. But banks cannot identify them. Hence they must charge a uniform rate. If they offer loans to everyone at the low rate, they would attract a lot of high-risk borrowers, many of who will default leading to huge losses. If they offer loans to everyone at the high rate, most low-risk borrowers, the ideal customers for any bank, would be unwilling to borrow.”
“Faced with moral hazard and adverse selection, banks use signals to discriminate between borrowers. These include length of time in a job, ownership of a home, marital status etc. Banks also limit loans to amounts below those demanded. Further they insist on margin money.” The class clapped. Even Service Sam couldn’t have put it better.
Boka pitched in. “Auto Insurance companies too look for signals. The best signal customers can send is their driving record. When customers have an impeccable driving record, the insurance company will recognize them as good drivers. But bad drivers can fake their driving records. So, a better signal used in car insurance is the “no-claim” bonuses that drivers accumulate when they do not make an insurance claim.” Bravo. Bravo.