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CHAPTER 15 - ASYMMETRIC INFORMATION AND ORGANIZATIONAL DESIGN Opening Case: Incentive Pay at DuPont, where standard pay raises were eliminated and replaced by an incentive-based bonus system for all managers and employees, based on profit goals for each division. Advantage: employees focused more on overall company performance instead of narrowly focusing on their own particular job, and they now had more incentive to suggest strategies to cut cost and increase revenue. Result: Better alignment between goals of shareholders and managers-employees. The issues raised by the DuPont case include: asymmetric information between shareholders and managers, imperfect alignment of the interests of the two parties, the potential that one party in a transaction will take advantage of another party, incentive compatible arrangements, separation of ownership and control, etc. These are all important issues for the corporate structure, and we address these issues in CH 15. ASYMMETRIC INFORMATION The typical situation in a business arrangement or contract where there is an inequality (asymmetry) of information about key economic facts. Example: In an employment situation, as an applicant and potential employee for a firm, you know more about your true abilities and your willingness to work and your commitment to stay with the firm, etc. than the employer does. The employer knows more about the potential for advancement, the chances that the firm will be in business in five years, etc. Example: you apply for a student loan or a business loan, and you know more about your intentions to pay back the loan, make the payments on time, etc. Example: you are selling a used car, and you know more about the existing and potential problems than the buyer. Or for a rare car, the buyer may be a collector and know about the true value, which may be underpriced. Asymmetric information can lead to two problems: adverse selection and moral hazard . ADVERSE SELECTION Example: In insurance markets, there is asymmetric information because the insured party has more accurate information about their true risks than the insurance company. What can happen is that people with the greatest risk, and/or those most likely to file a claim, will be those most actively and aggressively seeking insurance, a problem called adverse selection , or adverse “self-selection.” Example in book (p. 631): Company introduces maternity coverage to its employees for an additional premium. Based on records over the last ten years, 1 out of 20 employees has a new baby each year, and the premiums are set based on a 1-in-20 payout rate. A few years after the introduction of the new ECN 469: Managerial Economics Professor Mark J. Perry 1
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insurance program, the company lost a lot of money. Why??? Adverse selection.
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