Navigating the Complexities of Market Failure and the Principal-Agent Problem Through 'Freakonomics'

Have you ever wondered what schoolteachers and car sellers have in common? Or what is the difference between real-estate agents selling houses for a client and selling for themselves? 'Freakonomics' by Steven D. Levitt and Stephen J. Dubner explore the hidden side of these interesting things from daily life. They use a different perspective to explain these things using economic principles.

The Case of Schoolteachers and High-stakes Testing

 

In 'Freakonomics', a case study is mentioned by Levitt and Dubner. Chicago had employed high-stakes test in 1996 and a school with low scores would be placed on probation and face the threat of being shut down. The staff of the school will be dismissed or reassigned. The intention of the test is to raise the standards of learning and gives students incentives to study. After the policy has deployed, cheating of students helped by teachers were found out. There were even teachers, erasing the wrong answers and fill in correct ones when they have collected the papers.

 

The teachers prioritise their job security over the learning of their students. In economic terms it is known as the principal-agent problem because the purpose of teachers, students and the government does not meet. This is usually caused by a difference in interests of the principal and agent and also asymmetry information between them. In this case, the teachers need a high test score to keep their jobs but do not have the ability or intention to boost the standards of learning. Cheating to obtain a higher score does not meet the intention of the government and the students. The result of this is the waste of resources which is a market inefficiency. Therefore, it is also a market failure.

 

But how does that have to do with selling cars? When a seller is selling a used car, he knows the history of the car while the buyer does not. Buyers, aware of this asymmetry, might be reluctant to pay premium prices for used cars, scared that they might end up with a ‘lemon’. This is also a principal-agent problem caused by asymmetry information where the buyer and seller does not have the same estimation for the car. This leads to a market inefficiency where good-quality used cars are undervalued and might not be traded at all, demonstrating a clear market failure like the example above as well.

 

The Case of real-estate agents

 

Another study mentioned by Levitt and Dubner is real-estate agents. Real-estate agents tend to sell much cheaper if the house is owned by their client but more expensive if the house is owned by themselves. The study also found that an agent keeps her own house on the market an average ten extra days, waiting for a better offer. This is because the real-estate agent only earns a small percentage of the final sale price. Increase the sale price by a small margin requires a significant amount of effort but can only have a small amount of additional earning. On the other hand, real-estate agents can earn all the extra amount if they are selling their own house.

 

This shows the asymmetry purpose between real-estate agents and their client. Also, real-estate agents have asymmetry information. They have access to the inventory of similar houses, the recent sales trends, the tremors of the mortgage market, perhaps even a lead on an interested buyer. Under information asymmetry, principals may not know the commission price at which the agent sells the house, so they face the threat of hidden information and adverse selection when contracting with agents. Besides, agents may engage in hidden behaviors such as aiming for a quick deal. Such moral hazard and adverse selection often lead to damage to principals' interests and distortion of market prices, triggering market volatility and failure. This is a clear illustration of principal-agent problem and market failure.

 

Therefore, principals can use cost sharing strategies where the key to success is that the contract utility outweighs the agent's reservation utility, thus motivating agents to obey instructions. If principals find the final closing price is lower than the actual valuation of the house, they have the right to claim damages from agents. Conversely, principals can set incentives (incentive-compatible constraints): when the house sells for a higher price, the agent is paid more, and agents are more motivated to help principals make a better deal. Contract theory is also applicable to address other market failures oriented towards asymmetric information.

 

Through engaging storytelling and rigorous analysis, 'Freakonomics' offers a fascinating glimpse into how market failures and the principal-agent problem manifest in various sectors. By applying microeconomics theories into real-life situations, Levitt and Dubner encourage reader to explore the world of economics.

 

Some extension

 

Information asymmetries are specific to different markets. Diamond has mentioned in his research that the monitoring of loans by a single intermediary holding private information can deviate credit markets from the competitive market structure of efficient allocation. However, information can be traded in other markets. In another study, Leland and Pyle show that setting information intermediaries can increase returns and thus promote efficient allocation of market resources. Furthermore, Admati and Pfleiderer's study demonstrates the possibility that contractual theory of real estate markets is mechanistically robust. Therefore, facing information asymmetry, different markets should have different solutions, such as strengthening regulation (covenants) and information transparency (third-party information intermediaries). It helps market participants to better understand each other and achieve a win-win situation in which both parties' interests are maximized and market resources are efficiently allocated.

 

 

Reference list:

 

Admati, A.R. and Pfleiderer, P. (1994) ‘Robust Financial Contracting and the Role of Venture Capitalists’, The Journal of Finance, 49(2), pp. 371–402. Available at: https://doi.org/10.2307/2329157.

 

Diamond, D.W. (1984) ‘Financial Intermediation and Delegated Monitoring’, The Review of Economic Studies, 51(3), pp. 393–414. Available at: https://doi.org/10.2307/2297430.

 

Leland, H.E. and Pyle, D.H. (1977) ‘Informational Asymmetries, Financial Structure, and Financial Intermediation’, The Journal of Finance, 32(2), pp. 371–387. Available at: https://doi.org/10.2307/2326770.

 

Levitt, S. D., & Dubner, S. J. (2006). Freakonomics: a rogue economist explores the hidden side of everything. New York: Harper Trophy