A is smoker, 10% probability that will die next year
$10,000 expected cost to insurer for $100,000 policy
A is willing to pay $11,000 for insurance
B is non-smoking marathon-runner
1% probability that will die next year
$1,000 expected cost to insurer for $100,000 policy
B is willing to pay $2000 for insurance
If insurer can’t get credible information on smoking and exercise habits
Price for insurance, if both A and B are both buying insurance must be at least, $5500 (average of $10,000 and $1,000)
But then insurance is not worthwhile to B
Adverse Selection II
Lemons problem
Used car purchaser has imperfect information
Willing to pay price that reflects average used car quality
But person who has above average quality used car doesn’t want to sell at average price, so doesn’t sell
But that lowers average quality and thus price, leading more used car owners not to sell
Other examples
Loans for new businesses
Responses to Adverse Selection
Ex ante information gathering
So can price product in accordance with individual characteristics, rather than market average
Life insurance – blood pressure and cholestoral screenings, different rates for smokers, etc.
Health insurance – exclusion of preexisting conditions
Inspection and certification of used cars
Warranties
Reputation
Mandatory insurance
So no one can drop out of market
Health insurance “mandates” / universal coverage
Questions on pp. 254ff
4. Consider an employment decision. A law firm is considering whether to offer an associate position to a 2L, and the 2L is deciding whether to accept the offer.
a) What are the information asymmetries in this potential transaction? What relevant information does the 2L know which the firm does not? What relevant information does the firm know which the 2L does not?
b) What can the firm do to (partially) overcome the information asymmetry?
c) What can the 2L do to (partially) overcome the information asymmetry?
d) Note that many law firms and lawyers have no written contracts. In such cases, the law provides default rules. One of those default rules is “employment at will,” which means that the employee can quit at any time, and the employer can fire the employee at any time. How does employment at will help overcome informational asymmetries or at least reduce their adverse affects?
e) Are there any legal rules which help overcome the informational symmetries?
Questions on pp. 254ff
5. Consider the way home mortgages are often sold. A bank contracts with a mortgage broker. A mortgage broker is an independent businessperson, not an employee of the bank. The mortgage broker solicits customers and, when a customer wants a loan, helps the customer fill out the relevant paperwork and sends the paperwork to the bank for approval of the loan.
a) The contract with the mortgage broker might specify that the mortgage broker gets a fixed salary – perhaps $3000 per month. What problems might occur under such a contract? Would the bank be wise to offer such a contract?
b) The contract with the mortgage broker might specify that the mortgage broker gets a percentage of the value of all loans approved. For example, the mortgage broker might get 0.5% of the value of each loan, which would be $2500 on a $500,000 loan. What problems might occur under such a contract? Would the bank be wise to offer such a contract?
c) What macro-economic problems might occur if most loans were negotiated through contacts such as those described in (b)?
d) Can you think of a better contract between the bank and the mortgage broker?
e) The relationship between a bank and a mortgage broker presents all three types of asymmetric information problems discussed in readings ##50-51, supra – adverse selection, moral hazard, and principal-agent. Identify which aspects of the relationship present which kinds of problems.
Detailed statements of facts concerning the relevant business
Including accuracy of financial statements, absence of particular liabilities, ownership and condition of key assets, pending litigation.
Seller liable if turn out to be false
Purpose. Provide credible information that is key to transaction and its pricing
Earn out provisions
Part of price depends on performance of business
Part of payment delayed and contingent on how well business does
Helps parties to agree on deal, even if disagree on profitability of business
Also gives former owners an incentive to help
Gilson, Corporate Acquisition Agreement II
Covenants and Conditions
Covenants. Agreement on how owner will conduct business in period between signing of contract and transfer of ownership
Conditions, if not satisfied, relieve buyer of obligation to purchase
Question on pp. 273ff
1. Would you characterize the informational problem in a typical corporate acquisition agreement as primarily an adverse selection, moral hazard, or principal-agent problem?
2. Gilson mentions “Convenants and Conditions” as one of the four main components of an acquisition agreement (see p. 258), but he doesn’t say much about them. What kind of informational problem do you think they address? Adverse selection? Moral hazard? Principal-agent?
3. Gilson focuses on private, contractual solutions to the informational problems posed by corporate acquisitions. Is there a role for courts, legal rules, and/or legislation?
