Asymmetric Information in Finance Explained - Raghavendra Rau

In every financial transaction, one side has more information than the other. For example, when someone buys a used car, the seller will know better than the buyer whether the car is a plum or a lemon. Does more information leave you better off?

One of the fascinating ideas behind the concept of asymmetric information is that more information can lead to you being actually worse off.

This lecture was recorded by Raghavendra Rau on 20th May 2024 at Barnard's Inn Hall, London

The transcript of the lecture is available from the Gresham College website:
https://www.gresham.ac.uk/watch-now/asymmetric-information

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Transcript

0:05

So this year I've been giving a series of lectures on the big ideas of finance. And so this is the fifth in that series. And as a little bit of plugging here, all the ideas are in my textbook. So this is 180 page textbook. This is chapter six in that particular textbook. Anyway, so what are these six basic ideas of finance? What have we covered so far and what are we going? The first basic idea of finance was that of net present value off the six ideas of finance. It's the only idea we did not win a Nobel Prize, mainly because the idea is so obvious that nobody could take credit for saying, okay, I came up with that particular idea. But the second idea of finance portfolio theory and the capital asset pricing model did get a Nobel Prize for its originators, markowitz and sharp back in 1990. The third idea of finance was that of capital structure theory, and two people got a Nobel Prize, Molan and Miller for those. That idea last time we covered the idea of option pricing and S sch and Merton got a Nobel prize for that. Today we are going to the fifth idea that of Asymetic information and three people, alof Stinson STIGs shared the Nobel Prize for that in 2001 in early June. We'll have final lecture in the series on market efficiency, and lots of people have Nobel prizes for that. And what we'll see next time is all of them disagree with each other, and many of them got the Nobel Prize in the same year for saying two completely opposite things. Well, you know, that's why the Nobel Prize in economics is kind of like more storytelling competition. We are not really, we are not a science, but we tell good stories. Okay, so what is the concept behind all these ideas? There's only one concept in finance, right? It is about what is the value of a promise. Essentially, everything in finance comes back to this. Some person comes to you and says, I'm going to give you a huge sum of money in the future, in return for your investment today. So you give me money today and I will give you money at some point in the future. And everything in finance consists of trying to figure out what are these promises worth, right? So the first idea of net present value was simple. The idea is that promise is coming to you five years from now, 10 years from now, they're giving you that sum of money then, but you are being asked to spend money today. Is it worth it? How do you compare a sum of money five years from now, but a pound amount or a dollar amount today? That's the first question. And the formula is pretty straightforward. What you do is you take the cash flows, which come from any investment, and take the present value of the cash flows today and compare it to the amount you're spending on it today. Very straightforward, very simple idea. And the rule is give invest in something. Only if you get back more than you invest, if you get back less than what you invest, you'd be just burning money. There's no, no, there's no reason you should do that. But the problem here is you need an interest rate. So that was the second big idea of finance. Where do we get that interest rate from? And so the idea here is someone is coming to you and asking you for this to invest in their company. And the question you have for them is, well, if I don't invest in your company, where can I put my money? Where is the next best opportunity that I can put my money in? So in other words, you're trying to figure out what is the opportunity cost of investing in this particular investment. If you give up returns on something else because you put your money, locked it up in this particular investment. Now, what Markowitz and Sharp said was the opportunity should have the same level of risk. And they, because they went through a whole bunch of statistical formula to show that every rational person should invest in the market portfolio. So a combination of a risk-free asset, a government bond, and the entire market, never an individual stock. So that means if you're now looking at risk, I'm taking your stock, I'm adding it to my market portfolio, what's the core variance with the market portfolio? You standardize that core variance, and that's called the beta. And the capital Asset Pricing model just said the discount rate is the risk-free rate plus the beta times, something called the marketer's premium. So we covered that last year. The next question was, how much should you borrow? Well, this is goes to the financing decision of the firm. What should I, should I borrow? Should I raise equity? What should I do? How should I get the money from these people who want to invest in my company? And Ian Miller got a Nobel Prize for showing in a perfect world with no taxes, no lawyers, no government for them. That is a perfect world. The University of Chicago economists. And so it doesn't matter, debt doesn't matter. Equity doesn't matter. It's the same thing. Regardless, in a world with taxes, you should borrow as much as we can. But in reality, we know the firms don't borrow as much as they can. So the idea was if you have a world with taxes, with lawyers, with governments from balances, benefits of debt they get from taking, from reducing the taxes they pay with the financial distress cost of taking too much debt. And there's an optimal capital structure. The fourth idea, which we talked about last time in February, is, is about what is the value of being able to change your mind? So these are what we call contingent investments. What that means is I'll give you some money in return for your promise, right? So you're promising to pay me some money and I'll give you some money today, but if I give you the money, can I change my mind after giving you the money? Is there something in the contract that allows me to get the money back if I find out something new about you? That's an option, right? And so these things are how, what is the value of that ability to change your mind after making an investment? That's an option. But all these four ideas have one common assumption, right? That common assumption is everyone has the same information, right? Well, I actually, I misspoke a little. It's like, you know, Monty Python and the Spanish in acquisition, there are actually two common idea assumptions behind all these ideas, right? One is, of course everyone has the same information. And the second is everyone analyzes the information in the same way. Now, the second one I'm gonna talk about next time, this time I'm gonna talk about what happens if not everybody has the same level of information, basically asymmetric information, okay? So let's start with the question which I asked back in my first class, right? So when we had my first lecture, I said, in whose interest do you think a firm should be managed? And there were a huge number of answers. You could be workers, you could be creditors, suppliers, managers, customers, debt holders, shareholders, all of the above. And I'd like to ask you what you think. So if you have your phone, you can use that QR code to tell me what you think is in whose interest do you think the firm should be managed, right? Customers, workers, creditors, suppliers, shareholders, society, all of the above. Excellent. We see a significant number of people saying all of the above, but also a significant number of people saying shareholders only. Now this is interesting because when I first gave this uh, lecture back last year, almost nobody said shareholders only. So I see that quite a few people are actually paying attention to what I said. So in reality, the answer for a finance person, for for a person who thinks in the finance way, it should be shareholders alone. Now, why shareholders alone? The answer actually goes back to Milton Friedman. Milton Friedman wrote a very influential article in 1970. It was published in the New York Times. And in that article, he said, the primary responsibility of a business is to maximize its profits, not about social responsibility. It's not about responsibility to society, it's about just maximizing profits. And then he was asked, you know, what about society? What about everybody else? Well, he says in the article, he says, the key part is the executive is an employee of the owners of the business, the shareholders. So he's supposed to do whatever the shareholders want. But you didn't answer the question of why are the owners of the business shareholders, why not the workers? They work for the company. So why don't they own the company? Well, if you think about it, one interesting answer is you have to focus on one group. What Friedman says is, if you have a question that says, run the forum in the interests of everybody, what's the manager going to do? Because the manager has information about everybody else, but they don't have information on what he's doing. What he's going to end up doing is basically treating off groups of people against each other and putting the rest of the money in his own pocket. So for example, if the workers want a bonus, he's going to pretend to the workers that maybe the bond holders are after him to pay interest. So I can't pay you interest because I have to pay the, uh, I have to pay the workers, I have to pay, I tell the workers I have to pay the bond holder. So I trade everybody off, end up with a big sum of money, and I pay myself a big bonus, right? So that's the point here. You have to focus on one group. And why shareholders? The answer's simple. Well, they get paid after everybody else. They are the last to be paid. So in other words, if you make, for example, the workers unhappy, they don't work hard for you and you end up with a lower share price. If you treat your suppliers badly, they don't give you good products, you end up with a lower share price. The key is the shareholders are paid at the end, and this is an easy number to focus on. The share price, right? It's just one number. Number goes up, you've done a good job, number goes down, you've done a terrible job. That's pretty much it, right? Dead easy. But that's not the whole story. The second part of the story comes into what is contractable and what is not Contractable? What does that mean? Contractable? Well, think about yourself working for a company. You have an employment contract. The contract tells you your compensation, your pension, severance, pay, performance targets. You have an option to resign. And if your employer violates the terms of your contract, you can sue him in a court of law, right? Similarly, same thing for customers. They have warranties. Same thing with bond holders. They have an enormous number of protections. Same thing for suppliers. What about shareholders? They don't have any. For example, think about the dividends. Do they have a right to being paid dividends? No. Right? The company doesn't have to pay your dividends. So they, they have no rights except they have voting rights and they have the right to whatever is left over when the firm goes bankrupt. That's literally only rights they have. So going back to what we just said, there's one more thing here, is that shareholders have no explicit protection. And because of that, they are most vulnerable to the idea that managers know more than them. If you're a worker and the manager knows more than you, it doesn't matter. Why? Because you are protected. You have a compensation contract As a bond holder, are you worried that the manager knows more than you? Again, no, because you know exactly what you're gonna get as a shareholder. That's not true. Asymetic information is crucially important for a shareholder, not so much for the other stakeholders, because the other stakeholders are protected by explicit contracts. So that means that asymetic information is a very big, uh, problem. And this is a class of problems in economics called principle agent problems, right? So what are principle agent problems? Well, a principle is someone who needs something done, right? Someone who wants somebody else to carry out a job for him. That second person is called the principal agent. And so the principal can use a mixture of explicit or implicit contracts con to control the agent. So for example, if you think about, um, you taking your car to a mechanic, if you take your car to a mechanic, you are the principal. The mechanic is the agent, right? You have your house painted, you are the principal, the house painter is the agent. So the person doing the work is the agent, the principal is the person hiring the agent. So now let's take a word where there is no asymmetric information. Everybody has the same level of information, okay? In this symmetric world, how does trade happen? Let's say for example, I am a seller and I want to sell, maybe this, it's a pretty warm day. So I want to sell a glass of water. I might say my willingness to accept the minimum price, I'll charge for this inexpensive glass of water, but it'll be five pounds. So will the trade happen? The trade will only happen if the buyer is willing to pay more than five pounds. That's so called the willingness to pay. That's called the willingness to accept. And the condition for a good trade is the willingness to pay must be bigger than the willingness to accept. So if that happens, the trade is okay. If it doesn't happen, no trade is gonna happen. If I'm charging five pounds for that glass of water, but nobody's willing to pay five pounds, no trade is gonna happen, right? And economists call that difference between the two, the economic surplus. And what they say is there is an efficient trade. When you maximize the value of that surplus, you're transferring an item from somebody who values it less to somebody who values it more. That's what we mean by efficiency. Okay, fine. Unfortunately, asymetic information complicates everything. What does it do? For example, right? The key point here is one group of people, either the buyer or the seller has more information than the person on the other side, okay? So that's the area of asymmetric. And problems arise when you don't know enough and you know less than the other person. What are the problems? Well, problem number one, maybe the market outcome is distorted. I know more than you, so I'm able to manipulate the terms of trade. So I end up better off than you are. Or maybe you can do that. One of the two sides will divert the economic surplus towards them. The other possibility is, the worst case scenario is that the trade breaks down completely, regardless of there's a good trade or not. I cannot convince you that this is a good trade. I will think the other person is ripping me off and I will never enter into a trade with him, even if that person actually is telling the truth, the trust. There's no trust in this scenario. That's the worst case scenario. So when does this information asymmetry happen? Let's take some examples. Think about a financial market. You have a founder of a startup firm. This founder is trying to sell shares in their company to raise cash for a project. Now, who knows more about the quality of that project? It's definitely the founders. So if the founders are selling shares in the company, that means they were thinking, I'm giving you dollars or pound. I'm giving you a share in something for say a hundred pounds. Am I going to give you a share in a company which is worth more than a hundred pounds per share, even return for getting a hundred pounds from you, right? I mean, obviously not, right? If I'm, if I'm the manager and if I'm the staff founder, and I know that my company is worth 120 pounds per share, but the market price is a hundred pounds per share, I will never give you the shares. I will only give you the shares if I think the market price is a hundred, but I think it's worth less than a hundred. So I'm giving you something that's worth more, right? Okay, that's one point here, right? Or let's take another example. Labor markets. Now, as a worker, if I were to ask any of you, right, are you a good worker or what about you, right? Are you a good student? What would you say? Right? But he would say that even if he was not right. That's the idea of asymetic information. Everybody, the employer asks you, are you a good student? Are you a good worker? You would say, of course I am. I'm passionate about your company. Half the time you might be lying, but that's asymetic information, right? So the worker knows really about their abilities, their experience, the work ethic. The employer cannot get that information. That's another example of information asymmetry. Okay, fine. So now let's get to George Oloff. George Oloff decided to study, which he wrote this paper called The Market for Lemons. It's one of the most heavily cited papers in economics. And the paper, when it was first submitted, it turns out the paper was rejected by the journal. The two referees. One referee said, markets don't work like this. This is stupid. The other guy said, oh, it's obvious that markets work like this. I don't need a paper to workable. Work it out, right? So the paper rejected. Dave Ackoff shopped it around to a few more journals, rejected every single time. Eventually, some of his friends convinced the editor of the first journal to come back and publish this journal, uh, publish this article. And this article really made that journal is the most heavily cited paper of all time. So what is this market about? He basically explored the used car market, right? So the idea is you are in the market for a used car. Okay? Now, who has more information about the quality of that car? The buyer or the seller? Obviously the seller, they've been driving it for a few years. They know the quality. So at this stage, let me ask you a question. The seller has a bigger information advantage than the buyer who has an advantage in actually making the trade. The person with more information, the seller or the person with less information, the buyer. And this is actually why LOV got the Nobel Prize, because the answer is not obvious, right? What he said was, in most things in life, having more is better. Bigger house, better than a smaller house, right? More money, better than, less money. More children. Oh wait, it doesn't hold for children, okay? But almost everything else, right? But he said if you take information, sometimes a person with more information can actually be worse off than a person with less information. How is that possible? Right? That insight got him the Nobel. So let's take a look at what his insight was. So you in the market for a used car, and it turns out there are two types of cars. The plums, which are good cars that never break down. There are lemons that break down all the time, okay? Now we also know that plums worth 3000 pounds to buyers, and they're worth 2,500 pounds to sellers, okay? Lemons. In contrast, people would buy lemons soup, but they just won't want to pay the same price as for a plum. The plum is 3000. The buyer might be willing to pay 2000 for the lemon because they will have to have it fixed up after they buy it, right? But the seller values the lemon at 1500 pounds, okay? So that's what we have market. And I'm gonna assume there are more buyers and sellers, and I'm going to assume because of that, lots of buyers, very few sellers, I'm gonna assume that all the bargaining power is with the sellers. Okay? So I'm giving them everything. I've given them more information. I've given them more bargaining power. They seem to have all the advantages. Okay? So First question is, do these trades make sense from an economic perspective? Right? Well, the problem is worth 3000 to the buyer. 2,500 to the seller, that means the seller is willing to sell for 2,500. The buyer is willing to buy for 3000. It makes sense. The economic surplus is positive. 500 pounds. Same thing with a lemon. 2000 is the price. The sellers are, the buyers are willing to pay. The seller's willing to accept 1,500. Again, positive economic surplus. So these are good traits. So let's start with the first question, which is in the case of symmetric information. Question here is, you walk in there, there's no asymmetric information. You walk in, you look at the car and say, oh, that's a plum, that's a lemon. Instantly, it's obvious to everybody, okay? Everybody has the same information in this question. In this case, what price would the cars go for? So let me ask you this. So if you take the plum alone, what price would they go for? 3000 is the buyer's valuation of plum. 2,500 is the seller's valuation of plum. This is between the two. That's the buyer's valuation of the lemon seller's valuation of the lemon. And the answer Is indeed, 3000 pounds. Why 3000 pounds? Because of the assumption I made that there are many more buyers and sellers. So if you offer less than 3000, what's gonna happen? The seller's going to say, Hey, I'll wait for somebody else. I'm not gonna sell to you I 2,500, even though everybody knows it's worth 2,500. But there are so many buyers, so few sellers, the seller's not gonna sell. So the price is 3000. Alright, fine. Now let's introduce Asymetic information. Asymetic information. I don't know whether this is a plum or a lemon. All I know is based on the past, there's a, there is a 70% chance this car is a lemon and a 30% chance that this car is a plum. Okay? That's all I know based on statistics, based on history, based on MOT tests, whatever. But I don't know about this one. The seller knows a hundred percent whether this is a plum or a lemon. So the question is, what price will you put on the car as a buyer? So let's go back. You can use the scale, draw the thing cross. Excellent. The correct price should only be 2000, never more than 2000. Why 2000? Well, let's go back to the question, right? The plum is worth 3000 pounds for buyers, 2,500 for sellers. But that's 70% of the cars are lemons. And you know, this is a buyer. So what price do you bid? The rational price to bid is 70% of the lemon price times 2000, plus 30% of the plum price, which is 2300 pounds, right? The problem is the moment you bid 2300, will the plum seller sell? No. Right? The plum is worth 2,500 to them. So they're not gonna sell for 2300. That means that if you, if you bid the rational price 2300, you will never get a plumb. You're guaranteed you're gonna get a lemon. But as a bayou, you know this. So if you, if you know that are 70% of cars are lemons and 30% of plums, the only rational price to bid is 2000, because you bid more than you're going guarantee you're gonna get a, a lemon, right? So you might as well just bid 2000. So who's hurt from this? Well, the buyers aren't hurt because they know they're gonna get a lemon and they get a lemon. It's exactly the symmetric information case. The lemon seller isn't hurt because they get 2000 symmetric information case they get 2000. But the plum sellers are hurt because they have superior information and a better product, but they're not able to sell that product because they cannot convince the person on the other side that they have a plumb. That's the essence of this situation. Let's go back to look at this opposite case here. 30% of the cars are lemons and 70% are plumps. What price do you bid? Right? Answer is exactly the opposite. So what you do is 30% of the cars are lemons and 70% of them are good. You bid 2,700 pounds. Now, if you bid 2,700 pounds, what do you get? Will the lemon sellers sell? Of course they'll sell. They're getting said 2,700 for a car, which is otherwise worth 2000. What about the plum sellers? Will they sell? Yeah, they will because they're for them. The plum sellers worth 2,500. You know, the plum is worth 2,500. They're get lease, they're getting 2,700, they will sell, but they're not happy about it, right? The buyer doesn't care because the buyer just gets, pays the average price. So sometimes 30% of the time they're overpaying for a lemon, but 70% of the time they're getting a plum cheap. That's the basic story of asymetic information. The buyer knows that they have less information, so they take that information into account when they're making a bid. In contrast, the only people who get hurt in this market are people who have more information and a better product because they cannot persuade the buyer to pay more than the average. That's the essence of the story. Okay, fine. Oh, there is a parallel to this, by the way, and that goes back to the founder of this college, Thomas Gresham, who came up with a law, Gresham's law, right? You may have heard of it, just says bad money rises out the good. And that's something similar to the same story. What you have is you have currency, which can be used in two alternatives. One as a medium of exchange, and one as to be used as something. You use that something, use the money for the something which is worth it and you only pass out the bad money. The so bad money is the one we circulate as a rough example, think of the old days when we had actual paper pound, uh, you know, five pound notes and 10 pound notes, right? Which were the coin, which were the notes you see in circulation? Not the nice ones, because if you get a nice one, that's the one you don't spend. You spend the crappy one because you know you want to get rid of it and pass it on to someone else. Of course, that's not a perfect example, but it's very, very similar. It's the same idea. Okay? So what are the two problems of information asymmetry? The first problem is called adverse selection, which means I'm a principal, I'm trying to find an agent, how do I get the right type of agent? The second one is called moral hazard, where the agent shirks after being hired. So one is before you write the contract, the other is after you write the contract. Okay? So how, what's the easiest way to illustrate this? Well, one easy way is you're gonna think of the word agent. Who do you think of? So let's solve these two problems of adverse selection and moral hazard using the example of oh oh seven, right? I guys have seen the latest movie. I think it's no Time to Die, right? A lot of you, yeah. Well, I was kind of disappointed in that movie because he died. Oh shoot, sorry, spoiler alert didn't mean to give away the ending, but anyway, he dies. So the moral problem is that was very deceptive, right? I mean, no time to die, but he's dead. What? Where, where did that? So, okay, so anyway, M is now in the business of finding a new oh oh seven, right? We need a new one. But how do they find a new oh oh seven? What are the characteristics of James Bond? What are the most, what are the, what do you look for when you come to James Bond? Anybody? Athletic. Sorry? Athletic. Athletic, okay. But the most important thing about James Bond is not that tism bit. It's a double O prefix, right? What does a double O prefix stand for? A license to kill right now? It's difficult to kill people. It's very difficult even to hurt people. Most normal people don't like hurting other people physically. We don't. It's, it's kind of inbuilt into most of us. This one is willing to kill. So in effect, it's a psychopath. But more important, you don't want to advertise for someone who likes to kill other people. Why? You could end up with James Bond, but you could also end up with Hannibal Lecter from Silence of the Lambs, right? You do not want him acting as James Bond. So essentially you want someone who's willing to kill, but only on behalf of his or her country, basically a patriotic psychopath in some way, right? Okay, so that's the adverse selection problem. How do we find the right type of James Bond? But there's a bigger problem, mall hazard. If you read the books, not the movies, the movies don't show this, but Bond was a male in the 1960s, a bachelor living in Mayfair, pretty grotty, you know, one bedroom apartment, but bachelor. So unmade bed, dirty dishes in the sink, things like that. But when he's on assignment, where is he staying? Staying at the Four Seasons. He has a fully stocked mini bar. His beautiful Russian spies. He's got the world, has his feet, does Bond want to come home? Probably not, right? M wants him to go out there, preferably on Rhine Air, right? Kill that per the government budget, right? Go out there, government budget, kill that person cheapest way possible, and then come right back, right? Hopefully on the same day. So we don't have to pay for overnight accommodation. But Bond on the other hand, doesn't wanna come home. So what's one going to say, oh, the security is extra tight. I have all these other problems. I haven't been able to get the information. All these problems arise during a Bond movie. You gotta wonder how much of that is due to mall hazard problems and how much is really the situation here. So the next time you watch a Bond movie, if there was no moha adverse selection problem, the movie would be over in five minutes. In real life it takes two and a half hours principal agent problem. But in case you don't believe me, there's actually a paper written about this and the paper said, what does Bond do on assignment? So this is a long paper published in the NB I'll talk about in a minute, but almost every pa, almost every book talks about how much he eats. He talks about half a point of orange juice, three scrambled eggs and bacon, double portion of coffee without sugar. He had turbo Porsche sauce musin half the best roast partridge he eaten in his life. He eats 12 times per novel or once every 21 pages. And if you take his, and if you take his budget, which he devote to that on his government salary, that would be 25% of his budget. That's a significant amount to eat out on a government salary. So the paper was, uh, by Julian Trim and Thomas Weiss called License to Dying. And what the paper concludes is a license to kill comes with a license to spend, right? Especially on meals. So that's the adverse selection problems we see. So what are the solutions to these adverse selections and moral hazard problems? First problem is signaling. Remember there are two types of agents. Agent number one, both agents have better information, they have superior information, but the first type of agent also has a better product. The second agent has superior information, but a worse product. So the better informed and better product agent chooses an action to reveal that type screening. The less informed a party, the principle gives the agent a menu of payoffs. What you pick tells me what type of person you are. Okay? So let's take an example of this one. So this is, now we're moving to Michael Spence. So why did he get a Nobel Prize? So Michael Spence's most famous paper was about the labor market. So he said, well imagine a labor market where there are two types of workers, good and bad, okay? Every worker knows whether he or she's a good worker, but there's no way for an employer to figure out whether they're a good worker or a bad worker. But the good workers are worth 80,000 to firm. The bad workers are worth only 50,000. The good workers have an outside option of taking a job in some other industry for 55 for bad workers, the alternative only pays 35. They don't really want to do this, but that's the worst case scenario. If they don't get a job in this industry, okay? Now the employer doesn't know who's good or bad, but they know that half the workers are good and half are bad. You just don't know which one. Okay? Now, competition among employers drives up the market wage to the true expected value of the employee. Okay? Now, assuming that's true, who is hired and at what wage? Remember that good workers are worth 80,000 to the firm. Bad workers are worth 50 good workers from an outside option taking that other job, which they don't really want, but they will take it if that's the worst case for 55 bad workers is 35. So if you're an employer, you think half the workers are good, half are bad, what will you pay number? There are very few workers, lots of employers, Right? So the correct answer is indeed 60 5K because it's halfway between 80 and uh 50, right? So coming back in here, you are offering 65,000, half, halfway, half the workers are good, half the workers are bad. As an employer, are you worse off? No, because half the time you're getting a good worker cheap. Half the time you're getting a overpaying for a bad worker. Well, so on average you don't care. What about a bad worker? Do they like getting paid 65? Of course they love it, right? They love asymetic information, they get more money. The only ones who don't like this are the good workers. So the good workers have an incentive to signal how good workers they are. So the question is, what is a good signal, right? The signal works like this. The signal must be costly. And for the good types, the benefit has to be bigger than the cost for the bad type. The cost has to be bigger than the benefit. So what could be a credible signal for the labor market to understand what a signal actually means? Let me show you a couple of examples. This is a photo I took up in Yorkshire and I saw the names of these solicitors, which I thought was extremely good. It's Golden Butcher solicitors. I thought they were, you know, for, I would love to have solicitors with that name, but would it be a good signal? Would it be a signal of a good solicitor? Right? Obviously not. Because if it, if people started hiring these people on the basis of their name, what would every other solicitor do? They would change their names, right? Destroy and rubs or something like that, right? Or let me give another example. Um, anybody in this room who hates running does not like running, you know, exercise running. Oh, I see some hands going up in the back. Excellent, right? But being an athlete is seen as a good thing. So here is a possibility, right? You can sign up for what's called the home run marathon and you get a T-shirt saying, I ran the home run marathon. The point is, you don't actually need to get out of bed because the best kind of running is not running at all. You just get a T-shirt which says, I ran the home run. So this is not a great signal though, right? Because very easy to copy, right? So just saying that someone's a marathon runner doesn't mean that they really like, or the exercise. So what is a good signal? Well, Spence said the answer is education. Why? Let's make an extreme assumption. Let's assume that you learn absolutely nothing when you go to a business school. Zero. And everybody knows this. They know that when you go to school, the professors teach you nothing. What's the value of going to school? What do you think? Well, Spence says, it's still can be extremely valuable. Let's show why. Let's assume it costs you 25,000 to apply to and graduate from a prestigious business school. This, by the way, is an underestimate. The prices are higher, right? So, but anyway, it's 25,000 pounds. But for a bad worker, because they're less motivated, they're less intelligent, they must spend an extra 10 k cost them 30,005. 35,000 because they need prep courses to get, you know, admitted. They need tutors in school, they have psychic costs of working twice as hard. They don't enjoy this. The good worker enjoys this, cost them 25, bad worker, 35. Okay? Now the question is of of course, who gets a degree, right? So let's assume that if you have a degree, I will instantly assume as an employer that you are a good worker. Okay? So I come to you and say, are you a good worker? What would you say? Obviously, right? And so I say prove it. He pulls out his degree, slaps it on the table, he says, that's my proof. And I'm like, whoa, 80,000 right? Now how much does the degree cost? This person 25. So 80 minus 25 is still 55. That's just as worth badly off as this one here. However, let's look at the bad workers. I ask a bad worker, are you a good worker? And they say, yeah, of course I say prove it. If they get a degree, how much is costing them? 35? 80 minus 35 is 45. But if they never don't get the degree, they get 50 K. So the cost of the degree allows the good workers to separate themselves from the bad workers, right? The bad workers will say, and if I don't get the degree, I get 50. If I get the degree I get 45. So I might as well not bother getting the degree, okay? So that can actually be seen. For example, this is an article from the Wall Street Journal. We're talking about MBAs getting job offers before they step on the campus. So even before you start, you know, you are learning in business school, you already got a job. Again, it's a signal you manage to get in, you're good enough to get a degree, but signals are everywhere. Let's take an example. Peacock tails, right? Why does a male peacock have a tail? Why? But why? Why does it work as a signal? Sorry? It's colorful. Attraction. Attraction, yes. But the female peacock. Female peacock has a brain that about that size, right? I mean what does she know about attraction? Yes, very cost. Sorry, why? Exactly? Why?'cause you get eaten And uh, correct, right? That's a se cost of the signal. Look at this tail self, it's huge and it's colorful and it's very visible. Female peacocks can see it, but so can predators. Dogs, leopards, humans, whatever. If the peacock has survived to adulthood with a massive tail, that's saying to the female, I'm a tough guy. I'm really a tough peacock. Like a super peacock, right? So it evolution favors getting a massive, colorful and obvious tale. Or let's take another example. You have two choices working, uh, when you forget your first job, right? One thing is what we call the super hard worker strategy. Which means that you walk into office at five o'clock in the morning, you carry these heavy piles of paper around, you're sweating all the time. You look like you're obviously exhausted.

You leave at 8: 43:10

00 PM after everybody else leaves. That's the super hard worker strategy. The super smart strategy. You come into work about 10 o'clock carrying a tennis racket over your shoulder, you know, you breeze through the day, you leave at three in the afternoon, but you get the same amount of work done as the person who's apparently working. Super hard question for you guys is what do you think is a better strategy? The super hard worker strategy or the super smart worker strategy? Alright, so looks like the super smart worker strategy dominates. I would unfortunately go with the super hard worker strategy, right? And the reason is simple is because there are two types of information asymmetric here. One is they don't know your ability, right? You're trying to show that you're very able by coming in. You know, they're so, you're so smart, but the manager doesn't know how difficult the job is either. So they're giving you a job, you do it in 10 minutes. I like the job is too easy. You don't want that. Trust me, if you are working, you want to pretend the job is super difficult, but you're doing it anyway, right? So even if the job is dead easy, do not pretend the job is very easy. They'll just give you more work. Okay? So the signal here is the cost of trying to bear with this thing of, okay, I have eight hours to go. I finish my job already in five minutes, but I have to sit through this office for another eight hours. That's a cost. And for smart people it's a big cost. So that's the signal. How about emotions? Like getting angry? Why is that a signal <affirmative>? Well, is it good to get angry? Yes, yes. Some answers yes, some answers no. Getting angry is actually can be very, very dangerous, right? There's a lot of articles which show how it hurts your health. For example, you're significantly more likely to have, uh, heart attacks, blood pressure, blood damage, the lining of your arteries cause a buildup in fatty plagues. Whole bunch of things. So what is the evolutionary reason signal for getting angry? The answer is simple. It's about negotiation. If you are negotiating with somebody, there's a rational dis discussion discourse of, you know, people argue with each other, one of them wins, the other loses. But if that person who's losing gets angry is basically saying, I'm giving up control of my, my thinking part of my brain.'cause something which is gonna punch you in the face. If you don't, you know, giving to me the other person isn't angry, they're like, okay, you know what? I'll give it to you. Right? Know, unfortunately human beings both get angry and then it keeps escalating after that. So it's not a perfect strategy, but it is definitely a good strategy. Same thing you can talk about why do people fall in love, right? There's a difference between loving somebody and falling in love with somebody. So what might that be? The answer is about, again, falling in love with something you can't help. So the idea is, well, from an economic point of view, the idea is if you fall in love with somebody, your partner says, okay, this person can't get out of this very easily. They can't control the falling in love part. So they want abandonment. Some someone nicer comes along, right? But if you're calculating and saying, okay, this is a positive net present value investment, I'm gonna go with this person because a positive NPV, uh, then someone with a higher NPV comes along, you're gonna dump this person. So they're not gonna invest in the relationship either, right? So if you're a finance person, this does not happen very easily. Okay, what about screening? Let's say you're a travel agent who can put together seven safari trips at $9,000 each. Cost you nothing to put together a trip, but that's the cost of all the things you do. You think there are five buyers who are willing to pay 12,005 buyers who are willing to pay 10,000. Now they're buying with the internet. So you don't know these people, you've never met them. The question is, what price did you set? So you have, you can charge 10,000, 11,000, 12,000 or anything else. Remember it costs you 9,000 to put together the trip and you think five people are willing to pay 10,005 people are willing to pay 12, but you only have seven trips. Well, 11,000 is definitely not the right answer, simply because it's either 10 or 12, right? If you sell, set your price at 10,000, you can sell seven tickets, all the seven trips, but you own only 1000 per trip. So make profit is 7,000. If you set it at 12, you sell only to five people. The five people who are willing to pay 12. But you end up with 3000 per trip. So 3000 times five you end up with a $15,000 profit. Okay? So it's better to set for 12 than for 10, okay? But what would be ideal if I can figure out how much you're willing to pay? And then I charge five people 12,000 and charge the remaining two people 10,000. That's screening. How do I elicit from you? How much you're willing to pay when you have more information than me? The buyer now has more information than the seller. So this is where airlines do a fabulous job of figuring out exactly how much you're willing to pay. For example, have you guys ever wondered when you're standing in line or you know, getting on the plane, who gets on the plane first business class, right? Why business class? It's inefficient because they're holding up the front of the plane when everybody else, you know, is waiting to get through the business class people. These guys are getting settled down. They're having drinks or whatever. So why? The answer is it's not about efficiency. It's about making you in the economy feel bad that if only you had spent that extra money, you could have been one of those guys sneering at the people behind you. It's all about that. Or let me ask you a different question. Have you noticed a seat pitch on most airlines? That's about 30 to 32 degrees. Look this up on seat guru.com. Seat guru.com tells you an economy class seat 32 degrees is the maximum recline you can have. Why? 32 degrees? Turns out, by the way, this is empirically demonstrated in Guantanamo Bay, perfect angle to torture suspects. You can't fall asleep, you're lying there and your back's hurting. You can't recline. There's a guy kicking you in the back of the knee, you know, then suddenly there's shine to bright light in your eye and say chicken or fish, and you say, I confess, I confess everything. Right? The seat's a bit close together. So if you go too far back, you hit the BroadB, right? That's another reason. So can airlines design more comfortable seats? Of course they can, but the problem is, the moment they design a more comfortable seat, the business class person will say, why am I wasting so much money on a business class seat? I, that's perfectly comfortable. You want the seat to be uncomfortable enough. So business class people don't go move back, but you don't want the seats to be so uncomfortable that they take the bus, the economy, you guys take the bus. So there's a narrow gap which they're trying to thread. And that's exactly what you do here. You try to do it making it as inconvenient as possible for the guys who are doing the 10 so that they will reveal that trying get shit, I'm willing to pay 2000 more for getting a better experience. Okay? Alright, so, but let's come to the last idea of credit rationing. You are from a banker trying to figure out which borrower will pay you back the money, right? You've lent out, lent out your money to people that borrowed money from you, and you know that there are some people who will never pay you back. Some will, some will not. So the question is, how do you make a profit given that you will never get your money back? In some cases, what do you think? You can type in what you want, Use a credit score credit, why these are legal ways of doing it. But if you take a country like India where there's credit scores are not that easy to get or Kenya or places like that, what do you do if there are no formal things? One possible answer is charge a higher interest rate, right? And that is, well, possibly not that, but yeah, ter terribly usually charge a higher interest rate. Interestingly, that is why Stickless got a Nobel prize. Stickless said that this is not gonna work. The reason is, if I charge a higher interest rate, right? Who's the person who's willing to borrow at that high interest rate? So if I charge 5% interest, maybe everybody will willing to, willing to, you know, borrow from me. If I charge 15% interest, only the people who have no desire or intention of paying back will borrow from me. So the more you raise your interest rates, the worse the pool gets because only the people who say, forget it, interested 50%, I'm happy to pay it. They're not gonna pay you. So stickler said, in a situation like that, banks don't charge higher interest rates. They just rush in their credit, right? And so that's why you see lots of banks don't make loans because proportion or bad borrowers in the pool is too big. In a situation which happened after the financial crisis, you'd lower interest rates, but nobody was lending why? Because nobody knew where the good, uh, the good loans were. Nobody knew holding the good loans. So everything messed up over there. So I'm just going to walk right through this. So we put this back. So the key part we're trying to say is, asymetic information is everywhere in our lives, right? The people who are hurt by asymetic information are not the people with less information. Because the people with less information know this, they know they have less information, so they will never pay the maximum price. They'll pay an average price, a price in the middle. So who is hurt by this? The ones with more information and who want a price higher than average. They're the only ones who are hurt. The ones who love asymetic information are the players with more information and inferior product. They're hoping to get the average price, but they're much worse than the average. So the two solutions we have looked at are signaling where the good players, the people who are su with superior products, they're the ones who use that information, they use signaling to distinguish themselves from the bad borrowers. Screening is where the less informed players use screening to distinguish the good from the bad players. And that's pretty much the whole lecture. Thank you. Okay, we'll have a just I guess a, a couple of minutes questions. We've got loads. Um, what's, uh, let's start with someone online. What is the role of corporate governance in mitigating the effect of as symmetric information? Excellent question. So, corporate governance, as you know, are these rules which companies use, um, in order to govern themselves. So for example, independent board of directors, separation of the role of the CEO of the board and the chairman of the board and so on. If you look at this from this perspective, if I don't have an independent board and I don't have a separate CEO and chairman, what will happen? A shareholder will say, this firm is probably not a great firm. I won't invest in this firm, so I will be able to raise less money. So in a way, a superior firm, a firm with good corporate governance is basically saying, I'm taking the cost of having an independent auditor. I'm having an independent board of director. This is all costly, but I'm willing to incur those costs so I can prove to you that I'm a good company. So it's exactly information. Asymmetric. Thank You. Let's take a question from theologist gentlemen here, please. Thank. Hello, my name's Martin White. I'm a director of the UK Shareholders Association. I, I think I'd like to raise a situation that I'm not sure does suit the people with less information. Uh, an extremely socially important instance of asymmetric information is a position of the general public in relation to the financial sector. How do you possibly know who to trust if the agents and providers don't in law have a fiduciary duty to you? So what would you like to say about that? That's A, that's a very good question as well. So, as a member of the general public and you're trying to buy shares, this is a crucial part of information. Asymmetric. You don't know whether these guys are actually telling the truth or not. So there are some things that are mandated by law, so that applies to everybody. So that cannot distinguish a good person, a good company from a bad company, but you can look for other factors. For example, you can say in America, there was a paper which was written by, I think it was David Mack at NYU, but what he looked at was where the company holds its annual general board meetings. Turns out the more remote the area is, the more difficult the areas get to the worse is the financial results of the company because they don't want their shareholders flying, coming in, asking awkward questions. So just buying shares of companies with easily accessible, you know, AGMs versus really difficult to access AGMs is an easy way of saying that's a well governed company that may not be so well governed. Let me, um, ask a couple of more people and then come back over there. Yeah, over there. Yeah. Good afternoon. Thank you very much. My name is Lu. Um, as regards the anger aspect of it. Mm-Hmm.<affirmative>, I like you talked about the, um, smart worker and the hard worker in terms of the anger issue. I believe that anger is natural. Mm-Hmm, <affirmative>. And if someone gets you angry, you show your attitude reasonably. Mm-Hmm, <affirmative> more, especially if it is intentional, but in the other way around anger. Mm-Hmm, <affirmative>, if you are angry and you don't show it to me on my little knowledge of understanding, I believe it increases all the required diseases they're talking of. Either hypertension, because when you gets me angry and I go home and I don't react, I'll be thinking over it and it gets me more personally angry. Mm-Hmm, <affirmative>. Thank you. Okay. That's a excellent question. The key part about anger working as a signal is the fact that it's costly. It has to, it it affects your health. If it did not affect your health, it wouldn't work as a signal because everybody would pretend to get angry. The ideal, the ideal thing for you to be is to show outwardly that you're super angry, but inside you're as cool as a cucumber, right? Unfortunately, most people are terrible actors. It's very difficult to get that across. Have you, if you have kids, have you ever come up with a scenario where your kid has done something you are amused by, but you have to show that you are angry. How do you think your kid really buys that? You're angry at that point? You're kind of like, don't ever do that again. When you're kind of smiling, it's very difficult to fake anger. So, as human beings, when you get angry, the key part is we are giving up control of something. We are saying, I'm not using rational calculations or NPV anymore. You don't do what I'm gonna do. I'm gonna do something drastic. I'm going, maybe I'll regret it later, but at the moment, I'm, I'm going to give into my worst, uh, impulses. That's why it works as a signal. It's a costly, but you know, the cost is the signal. Hey, thanks for Alex was very useful. Uh, my name is Manny. I work as a doctor. I was wondering how this, um, concept of financial asymmetrical information applies in healthcare as well. Well, in life or situations, people are willing to pay anything, basically. So how do we figure out in those conditions, especially in a private healthcare systems, like in the United States or in India, countries like that. Mm-Hmm.<affirmative> that's in the healthcare system. Asymmetric information is very big, mainly because of the fact that the only people who know something about it is your doctor, right? Um, but there's another group of people as well, and they're the health insurance companies. So the health insurance companies don't want you if you're ill, right? You are loss for them. So essentially they put into place a lot of preexisting conditions and a whole bunch of rules just to prevent the bad guys from getting into that pool. Then the bad guys are the people who are ill. They don't want ill people. They will ensure you when you're healthy. So, um, from that perspective, that's the financial part of health, right? So how do you pay for this? And you can see that's when the, when the health insurance company is trying to figure out ways to, to say, are you healthy or not? In the old days, um, before Sky when Skyscape was started invented, but there were no elevators, a lot of people would put the insurance offices on the top of very tall buildings. If you're good enough to get to the top of that building, you could get insurance <laugh>, you know, so if you couldn't get there, tough luck. You're not gonna get insurance. What would be your analysis for something like the thas Water, for example, and how, how that functions? And there are lots and lots of other possible examples, but I'd be interested on your analysis on those things, right? So one of the things which, um, we talk about in economics, that's a good, great question. One of the things we talk about economics is this whole concept of are you able to capture the profits from anything? You know, it goes back to that concept of explicit versus implicit contracts. So if you are a company and you expect to be here for the long term, you have a superior product, you want to guard your reputation, right? But if you're a company that has been newly privatized, you don't know if the government is going to renationalize you again or something else. You have a short window of opportunity to extract whatever you can from the company before the company goes, you know, wherever. So one possibility, I'm not saying this is true, but there's definitely a possibility, is very simple. If you are the manager of 10 times water, you've just become part of the privatized utility. You give yourself massive bonuses, you give all the money out to the shareholders, skimp on infrastructure, but that creates a problem itself. That eventually, you know the company is going to go much worse, but that's because you're not guaranteed that long period of time when if something goes wrong, you are liable for it, right? It's like, I don't know who's gonna be in charge of it five years from now. Let me pay myself now and walk away. That's in, again, information asymmetry there. Well, I'm afraid we're running out of time, but thank you very much for this fascinating lecture for.