Market Failure Due to Asymmetric Information - Adverse Selection and Moral Hazard

In the book based on an inquiry into the nature and causes of the 2008 Global Financial Crisis entitled "FREEFALL - Free Markets and the Sinking of the Global Economy", Economics Nobel Prize Laureate (2001) and Columbia University Professor Joseph E. Stiglitz wrote:

Quote

"Finding root causes is like peeling back an onion. Each explanation gives rise to further questions at a deeper level: perverse incentives may have encouraged shortsighted and risky behavior among bankers, but why did they have such perverse incentives? There is a ready answer: problems in corporate governance, the manner in which incentives and pay get determined. But why didn't the market exercise discipline on bad corporate governance and bad incentive structures? Natural selection is supposed to entail survival of the fittest; those firms with the governance and incentive structures best designed for long-run performance should have thrived. That theory is another casualty of this crisis."

Unquote

Market failure is a common term in microeconomics to reflect the need for some form of regulations and accountability of agents (consumers and producers) in the unfettered free market when externalities, imperfect information, socially undesirable market dominance etc arise. In the area of perverse incentives in the market place, two forms of asymmetric information can be associated with such possible market failure. One, adverse selection; and two, moral hazard. To simplify the understanding of such market failure, let's take two simple examples.

For moral hazard, a similar example in day to day economic activities is that of motor insurance. Why is moral hazard considered a form of market failure and thus socially undesirable? This is because no insurance company can be certain, at the point of underwriting the motor insurance of any driver, of the future behaviour of the driver. Motor insurance companies would be OUT of Business if there is no way of ensuring the responsible FUTURE behaviour of drivers insured under them. Thus, there is this concept of CO-PAYMENT known as "EXCESS" or "DEDUCTIBLES" mechanism built into a motor insurance agreement. For example, if the excess of a motor insurance is $3,500, then any accident repair amount below that sum is fully borne by the driver/ owner of a vehicle. By having the co-payment mechanism built-in, motor insurance become feasible in the market place and minimise the moral hazard of reckless FUTURE behaviour.

In the banking sector where executives take undue risks for short term gain (such as those causing the 2008 GFC), inherently similar moral hazard exists but DOES NOT seem to be mitigated by any "co-payment' mechanism in the {perverse} incentive packages they receive.

In 1970, another Economics Nobel Prize Laureate (2001) Professor George Akerlof (husband of former FED chair Professor Janet Yellen) of University of Berkeley, California published a paper entitled "The market for 'lemons': quality uncertainty and the market mechanism" which led to the growth and research in the field of asymmetric information. This publication subsequently led to the enactment of the "Lemon Law" in many countries including the United States, Canada, Australia, and in recent years Singapore {Consumer Protection (Fair Trading) Act} where it addresses the market failure arising from adverse selection in the used car market and other consumer goods.

Now, market failure due to asymmetric information arising from moral hazard and adverse selection in different sectors of an economy is CERTAINLY NOT NEW as it can be traced as far back as 1970 which is almost half a century ago.

ALAS, in the field of banking, unfortunately and mostly, moral hazard in the area of excessive risk taking is left to the free market mechanism (as what happened during the 2008 GFC). There does not seem to have any material "co-payment mechanism" to keep the market failure of moral hazard in check. What were the consequences?

Professor Joseph Stiglitz wrote in his book "FREEFALL":

Quote

"In the great recession that began in 2008, millions of people in America and all over the world lost their homes and jobs. Many more suffered the anxiety and fear of doing so, and almost anyone who put away money for retirement or a child's education saw those investments dwindle to a fraction of their value. A crisis that began in America soon turned global, as tens of millions lost their jobs worldwide -- 20 million in China alone -- and ten of millions fell into poverty.'

Unquote

What is the lesson learned?

Quoting from Professor Stiglitz again: "We have to be wary of too facile explanations: too many begin with the excessive greed of the bankers. That may be true, but it doesn't provide much of a basis for reform. Bankers acted greedily because they had incentives and opportunities to do so, and that is what has to be changed."

In short, could perverse incentives be the ROOT CAUSE?

Professor Stiglitz made the following observations in the same book: "In peeling back the onion, we need to ask, Why did the financial sector fail so badly, not only in performing its critical social functions, but even in serving shareholders and bondholders well? Only executives in financial institutions seem to have walked away with their pockets lined -- less lined than if there had been no crash, but still better off than say, the poor Citibank shareholders who saw their investments virtually disappear."

Could it be the skewed structure of "perverse incentives"? Despite technology disruption and what not, this so called supposedly modern economic system and technological advancement in this age of AI (artificial intelligence) seems to be at a loss (and clueless) in the field of building in a mechanism of accountability and "co-payment" when potentially rogue high pay executives run amok and threatened to bring down the entire system, just as what happened in the 2008 GFC (Global Financial Crisis).

Leo 81

Asians assisting the West to recolonise Asia

This topic could also be titled, Asian news to be reported by Asians. More than half a century has gone past and Asia is still unable to shake off the colonial yoke. Many Asian countries are still colonised by the West, some unknowingly, some happily. This phase of post colonial Asia is the colonisation of the minds, the thinking, the mindset, by the use of main media. The main media is the biggest culprit, the biggest instrument in the colonisation of the Asian minds to be continually subservient to the angmohs. Angmohs are great, smart, clever, sophisticated, kind, handsome, civilised and knows all, have great ideas and enjoy life, make living better. The Asians are daft, unthinking, cannot thinking, inferior, crude and base, completely devoid of ideas, did not know how to live life, basically backward and stupid, despite all the best education they could get in the best western universities.

This is not just a white lie, it is a lie that daft Asians conditioned themselves to believe in and to live in, with the help of the main media, with stories written and reported by the angmohs about them. Many Asian main media cannot live without the angmohs and some half baked Asians thinking like angmohs to tell them what is right, what is wrong, what is good, what is bad, what to think and what not to think, what to say and what not to say.

All Asian media have failed in this task, miserably, except for those countries that have some pride in themselves, in believing that they are not inferior to the angmohs.

It is high time that Asians start a news agency that reports news the Asian ways, news that are written and read by Asians, particularly of their respective countries. It is an insult to the respective people of their countries to have their own news, domestic news, written and told by the angmohs or fake angmohs. When would the Asians start to respect themselves to have their own people tell their own stories and not to be seen and told from the perspective and tainted views of angmohs whose interests are contrary to their well being?

There are many able Asians, politically conscious of what is going on around Asia, to take up this call, to set up an Asian media, with Asians managing and writing and telling Asian news. People like Jack Ma, Li Ka Shing, Robert Kuok or Ho Kwon Ping, just to mention a few, should step forward, individually or as a team, to form such a news agency, to educate and enlighten the daft Asians that they are not that daft, to have pride in being Asians and to think Asians. They could cooperate with the respective govts of Asian countries to have their respective news makers and producers, to tell the world about themselves, in their own words, and free their people from being colonised by the angmohs for the last time.

Asia is for Asians. Asians must take charge of their own lives and do, think, talk about what is good for themselves, not what the angmohs are saying and thinking for them. Asia must grow up, be adults, not forever be like children or adolescents, forever needing to be told and led by the angmohs. Asians must free themselves from being colonised by the angmohs and chart their own destinies, to be themselves and be proud of themselves, for their own good.

The last thing the literate Asians should do is to assist the angmohs to continue to colonise the minds of fellow Asians. You don't need the angmohs to tell you to hire them to teach in your universities to deserve higher rankings. You don't need the angmohs to tell you that you are well and good, to tell you who is the devil and who are the good guys. You have a mind to think for yourself.

You are Asians, not angmoh slaves and servants.

Firm's Objectives - Profit vs Non-Profit

Part 4: Firm's Objectives - Profit vs Non-Profit

Fundamentally, the management structure in Warren Buffett's Berkshire Hathaway is arguably the best incentive-driven to yield maximum returns, that is, investment-wise it is stable in the setup in relation to motivation and incentive to perform.

Warren Buffett and his right hand man bullionaire Charlie Munger are quintessentially significant sharehokders in their investment holding company and the classical economic theory of profit maximisation for firms fits in nicely.

But when there is significant "gap" in ownership-management relationship aka known in economics as principal-agent relationship, then economics theory has long acknowledged that the classical profit-maximisation theory would not hold but alternative goals of firms take precedence. It is especially so when executives KPI and incentives are "not non-perversely structured".

In such firms, not only is the classical economic condition (MR=MC) of profit-maximisation violated, some other objectives such as "SATISFICING" are deep-seated in their management corporate culture.

The performance-incentive relationship in such firms is essentially "not stable" and "distorted". One theoretical analogy can be in what is known as the Nash Equilibirum which is the cornerstone of Game Theory widely taught in or part of economic courses. Paramount to this concept is that the dominant strategy of both or all parties ends up in a Nash Equilibrium and no party has the incentive to deviate from it as it yields the best outcome for all. In short, it is a self-sustaining stable relationship.

But what if such a Nash Equilibrium is terms of the company structure is not forged and thus one party has the incentive to deviate from agreed goals such as profitability? One example is what happened in the risk-taking by executives in some financial firms leading to the last GFC in 2008. In their investment venture (or "adventure"), it was almost unmistakably "heads they win, tails they walk away" (often with a golden hand-shake). In a way, such "skewed-" incentives driven deep-seated culture is "perverse".

Arguably, the shareholdership-management structure in Warren Buffett's Berkshire Hathaway is far more superior and stable and creates almost always a win-win scenario for both management and shareholders.

Sadly, from the financial carnages witnessed in the last GFC, the corporate governance in terms of incentives structure in many firms are found wanting and the executives' incentives are often "perversed" than not.

Leo81

Kim Trump Summit - Who is the rogue?

"The United States has never been closer to potentially having something happen with respect to the Korean peninsula, that can get rid of the nuclear weapons,"
Read more at https://www.channelnewsasia.com/news/asia/trump-says-singapore-among-possible-sites-for-us-north-korea-10189826

Read the above very carefully. Do you understand what it means? The impression given is that the world will be free of nuclear weapons. That is the fake news that Trump and the West have been blowing daily. When North Korea gives up its nuclear weapons, the world will be rid of nuclear weapons. Really? 

This is the kind of American and western propaganda that is being peddled daily for world consumption. And the stupid read this as the truth. And the Americans are not going to continue to possess the biggest nuclear arsenal in the world, they are going to make them more deadly, more destructive. When all the enemies of the Americans and the West give up their weapons, and the Americans and the West continue to possess them and increase their arsenal, the world is free from nuclear weapons.

The Kim Trump Summit is all about denuclearisation of North Korea, not of the American's deadly arsenal. This is Trump's main objective, no denuclearisation of North Korea, no talk. The more hideous objective is to bait Kim to travel out of North Korea.

The next agenda is choosing a meeting place. Where is a safe place for the two leaders to meet? Should the meeting be held in a country belong to the 'free' world or in a communist country? Which do you think is a safer place, a 'free' world country or a communist country? See the irony? 

Trump or any western leaders can visit any communist country, even North Korea, and can feel very safe from being assassinated. Kim Jong Un cannot visit any 'free' world country without being threatened by an assassination bullet. This is how free and how safe the western world has become. 

The so called 'free' world countries are very dangerous place as they are infested with rogues and assassins. Some countries are vying for the honour of hosting the Kim Trump Summit. Singapore is salivating for this privilege and great publicity. Have they ever think about their ability to prevent an assassin's bullet on Kim's head? There would be no assassin bullet on Trump's head for sure. No civilised people would do that. Only rogues would think of assassinating a head of state. 

Who is or are the rogues?

Would Singapore be so complacent to think that hosting this event is just like hosting a Saturday Night Fever party? Can Singapore prevent an assassination on Kim if the Summit were to be held here?

The free world is not free unless the Americans said so. They decide if a country is free or not free, a country is safe or not safe. They have an army of rogue assassins out there to do the killing of national and political leaders. This is the very reason why Kim Jong Un would not leave North Korea, or he would be dead like his brother Kim Jong Nam, assassinated in a so called 'free' world country.

PS. When Kim visited China, the whole trip was held indoor, including the inspection of the guards. China would not take the risk of having Kim walking on the streets even in China that is now as open as the 'free' world countries.  In the streets of Singapore, Kim would not stand a chance. Singapore should be smart enough to stay clear of this treachery scheme to lure Kim out of his safety zone.

Big money invest in big biz, not in kachang putehs

Warren Buffett's Berkshire Hathaway, invested US$232m in a Chinese company, BYD, a Shenzhen-based battery and electric car maker. The $232 million investment in 2008 is now worth about US$2.1 billion.

“When you got over $100 billion, you’re looking at any big market. We can’t go into tiny markets and really deploy enough capital,” he said. “We want to invest money intelligently. And obviously, big economies and growing economies have the potential.” Warren Buffett Yahoo News

The above comment by Buffett is what investment with big money is all about, invest in big economies, in big companies. How silly it is to have hundreds of millions invested in kachang puteh companies in sick economies. How silly it is to invest hundreds of millions in low skill, low tech, low capital and low barrier of entry companies.

Guess what type of big investment funds, with hundreds of millions to invest, would do exactly the opposite of what Berkshire Hathaway is doing? Would anyone with hundreds of millions of dollars to play with invest in tontine companies, in low level engineering companies, in hawker centres, in bakeries, in low tech, low skill mechanical workshops or in tuition centres?

Buffett said, invest intelligently in big economies, in growing economies, and in growing companies. Growing economies and growing economies must be really growing not by shouting that the economy is growing, the company is growing when they are not, not when growth is fiddling with numbers, juggling with numbers to make the icing looks good but in reality a rotten apple, rotten economies and rotten companies.

Is it so difficult to tell whether an economy or a company is all hype and nothing else? Oh, there are fake growth economies and fake growth companies, just like fake degrees and CVs. There are many con men everywhere with slippery tongues.

Is there anything to learn from Berkshire Hathaway? Or is it too late?