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A Man's Random Walk

politik, economik, foreign affairs
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Thursday , November 20 , 2008

Thai Politics and Asymmetric Information (Part 2)

Posted by Ginola , Reader : 595 , 10:28:15

In my previous blog (revised version), I talked about adverse selection in Thai politics and how it causes the market for policies to be flooded with low-quality, corrupt politicians. In this blog, I'll present another type of market failure resulting from information asymmetry called moral hazard. Moral hazard can arise whenever two parties enter into some kind of agreement and one side of the contract does not have perfect information about and cannot fully monitor the other side's behavior. This uncertainty about the behavior of the other side and the difficulty of monitoring the behavior means that there is a possibility that the other side will behave in a way that is contrary to what has been agreed in the contract. The banking system is an excellent example to illustrate moral hazard problems. It is natural that the applicant for a loan has a much better idea of her her intention about what to do with the loan than the bank does. Let's say the bank approves the loan contract believing that the borrower is a good client who will behave responsibly and put the loan money into profitable investment with moderate risk. Once she gets the loan, however, the bank cannot accurately monitor her behavior. The borrower thus has an incentive to undertake a highly risky investment (with potentially high return) contrary to the loan contract. This incentive exists because the borrower is playing with the bank's money, not her own. Her project's loss is insured by the someone else. She is thus engaging in the game of "heads, I win; tails, someone else loses" and behaves recklessly as a result. By undertaking high-risk investment, however, it becomes more likely that the borrower's investment will fail, causing the bank to incur a loss. The market failure that could result from this is the situation in which most of the banks' borrowers take on high-risk investment projects, and thus many loans turn bad, thereby causing banks to incur huge losses and potentially run out of business. Thus, uncertainty in information about the borrower's action can cause the banking market to fail. This moral hazard problem has always played a role in virtually all financial crises that have occurred around the world, including the current one. Moral hazard is also found in many other situations. In an extreme situation, if my car is fully insured against robbery, I may behave carelessly and may not lock my doors because I know that I'd get a new car if this one is stolen. So, moral hazard arises whenever an insured party cannot be monitored accurately and thus will tend to behave less cautiously. A related problem is called the principal-agent problem. An agent is an individual employed by a principal to achieve the principal's objective. That is, an agent works for the interest of the principal. The principal-agent problem arises when agents pursue their own goals rather than the goals of the principal. Consider a firm in which the owner/shareholder of the firm hires managers to manage the firm. The managers (agents) may pursue their own private goals (increase their own salaries, order a luxury car for their managrial position's car, and so on), even at the cost of lower profits for the firm's owners (principal). Because the owner (principal) cannot accurately monitor the behavior of the managers (agents), the managers may not act in the best interest of the owners. They may 'slack' and perform below their capabilities, or they may do things that unnecessarily increase the costs of the firm. ......... Now, let's look at Thai politics and see if moral hazard and principal-agent problems exist. Recall that politics is viewed here a market for policies. In this market, politicians 'sell' their policies while voters 'buy' these policies through their voting decisions in elections. In a sense, politicians and voters enter into a contract (social contract, if you like) in which the politicians promise to deliver policies favorable to the voters after winning the election. However, from the perspective of the voters, there certainly is some uncertainty about an elected politician's behavior after elections. That is, a voter may not know beforehand whether the candidate that she votes for will deliver the policies as promised. So, information asymmetry exists in this market, with the politician having a better idea about what he is intended to do after being elected than the voters. After an election, the elected candidate is, to some extent, insured against the risk of losing office. Having been elected means he would likely stay in office for up to 4 years. Now, because voters cannot accurately monitor the elected candidate's behavior (as monitoring is costly to do), the elected candidate has an incentive to behave differently from the 'contract' he has agreed to before the election. That is, he may not deliver the policies promised to the voters. Thus, moral hazard problem could arise because of costly monitoring and the candidate being guaranteed the MP seat for at least some time. The principal-agent problem is also very much present. Because the principal (voters) cannot fully monitor the behavior of the elected candidate (agent), the politician may pursue goals that are not in the best interest of the voters. For example, the elected MP may engage in corruption practices for personal gains rather than working for the interests of the voters. In politics, however, moral hazard and principal-agent problems are alleviated to some extent by the fact that politicians want to be re-elected. Thus, they have an incentive to deliver the policies to make the voters adequately satisfied so as to vote for them again in the next election. However, this does not fully eliminate the problems because the politicians are still insured against losing their MP seats for perhaps a couple of years at least (before the next election happens) and because effective monitoring of the elected MPs is a costly and difficult process. Consequently, although the elected politicians will try to deliver some policies to make voters happy, the degree of policy delivery will likely be below the optimal level. In other words, if information is perfect and voters (principal) can monitor fully the behavior of the elected candidates and 'reward' or 'punish' them accordingly, the politicians (agents) will behave more in the interest of the voters and will deliver more policies to them. ......... So far, we have seen how asymmetric information problems can cause the market for policies to fail or to under-perform below the optimal level. Now, let's try to explain some of the political phenomenon by asymmetric information. Adverse selection and moral hazard may help explain the presence and prevalence of vote-buying practice. Because voters are uncertain about the candidates' honesty and cannot accurately monitor the post-election behavior of the candidates, voters cannot easily differentiate the good politicians from the bad ones. In such a situation, other factor(s) may emerge as the decisive factor in their voting decisions. One such factor is money! Because I am not sure which candidate is good or bad (or worse, adverse selection may cause me to be more inclined to think that all candidates are all corrupt 'lemons'), I may simply make my voting decision based on the money I get from the candidate, not on his/her real quality. At the same time, the honest candidates, by definition, will not buy votes. In fact, they can't afford to buy votes because being honest means they will not engage in corrupt behavior and thus they will not get rich from holding office. The candidates who can and will buy votes are only the dishonest ones who intend to reap private benefits later on when they are elected into office. The market outcome is that the "lemon" politicians will be more likely to get elected than the good ones. So, information asymmetry can create uncertainty about the quality and behavior of politicians, making it difficult for voters to distinguish between good and bad candidates, thereby making the voters more inclined to make voting decisions on such factors as money. And because the dishonest candidates will be the only ones buying votes, we end up with only the corrupt candidates being elected. Now, even if voters learn that an elected candidate performs badly in office and don't want to vote for him again in the next election, the problem is not resolved. Why? Because of adverse selection! That is, in the next election, voters still do not know for sure about which of the other candidates will be honest. Quality uncertainty still makes if difficult for voters to differentiate the good from the bad. Hence, they will still be inclined to accept money and vote according to money. Vote-buying thus continues to persist. Another likely outcome of asymmetric information problems is herd behavior on the part of the voters. Because candidates are all lemons in the eyes of the voter, she may base her voting decision on what others are doing. That is, in the absence of vote-buying or other factors that could differentiate the good candidates from the bads, the voter may tend to "follow the crowd." This is similar to the bahavior of international investors, who tend to follow the crowd when making decisions on where to invest in or where to get their money out. Hence, in Bangkok where vote-buying is not common, we tend to see voters' behaviors change according to popular 'trend' or 'tide' at the time. In any case, all the above analysis of politics using asymmetric information is a preliminary work with no empirical support. My hope is that it provides another theoretical framework through which we can look at various issues in Thai politics and make it function better. So far, we have assumed that market participants don't attempt to fix the problems of imperfect information. In reality, they do find ways to alleviate these problems. So, in the next blog, I will present some the ways through which asymmetric information problems have been alleviated in both the economic and political world. In doing so, perhaps we could obtain some insights on how to make the market for policies function more efficiently.

In my previous blog (revised version), I talked about adverse selection in Thai politics and how it causes the market for policies to be flooded with low-quality, corrupt politicians. In this blog, I'll present another type of market failure resulting from information asymmetry called moral hazard.

Moral hazard can arise whenever two parties enter into some kind of agreement and one side of the contract does not have perfect information about and cannot fully monitor the other side's behavior. This uncertainty about the behavior of the other side and the difficulty of monitoring the behavior means that there is a possibility that the other side will behave in a way that is contrary to what has been agreed in the contract.

The banking system is an excellent example to illustrate moral hazard problems. It is natural that the applicant for a loan has a much better idea of her her intention about what to do with the loan than the bank does. Let's say the bank approves the loan contract believing that the borrower is a good client who will behave responsibly and put the loan money into profitable investment with moderate risk.

Once she gets the loan, however, the bank cannot accurately monitor her behavior. The borrower thus has an incentive to undertake a highly risky investment (with potentially high return) contrary to the loan contract. This incentive exists because the borrower is playing with the bank's money, not her own. Her project's loss is insured by the someone else. She is thus engaging in the game of "heads, I win; tails, someone else loses" and behaves recklessly as a result.

By undertaking high-risk investment, however, it becomes more likely that the borrower's investment will fail, causing the bank to incur a loss. The market failure that could result from this is the situation in which most of the banks' borrowers take on high-risk investment projects, and thus many loans turn bad, thereby causing banks to incur huge losses and potentially run out of business.

Thus, uncertainty in information about the borrower's action can cause the banking market to fail. This moral hazard problem has always played a role in virtually all financial crises that have occurred around the world, including the current one.

Moral hazard is also found in many other situations. In an extreme situation, if my car is fully insured against robbery, I may behave carelessly and may not lock my doors because I know that I'd get a new car if this one is stolen. So, moral hazard arises whenever an insured party cannot be monitored accurately and thus will tend to behave less cautiously.

A related problem is called the principal-agent problem. An agent is an individual employed by a principal to achieve the principal's objective. That is, an agent works for the interest of the principal.

The principal-agent problem arises when agents pursue their own goals rather than the goals of the principal. Consider a firm in which the owner/shareholder of the firm hires managers to manage the firm. The managers (agents) may pursue their own private goals (increase their own salaries, order a luxury car for their managrial position's car, and so on), even at the cost of lower profits for the firm's owners (principal).

Because the owner (principal) cannot accurately monitor the behavior of the managers (agents), the managers may not act in the best interest of the owners. They may 'slack' and perform below their capabilities, or they may do things that unnecessarily increase the costs of the firm.

.........

Now, let's look at Thai politics and see if moral hazard and principal-agent problems exist. Recall that politics is viewed here a market for policies. In this market, politicians 'sell' their policies while voters 'buy' these policies through their voting decisions in elections. In a sense, politicians and voters enter into a contract (social contract, if you like) in which the politicians promise to deliver policies favorable to the voters after winning the election.

However, from the perspective of the voters, there certainly is some uncertainty about an elected politician's behavior after elections. That is, a voter may not know beforehand whether the candidate that she votes for will deliver the policies as promised. So, information asymmetry exists in this market, with the politician having a better idea about what he is intended to do after being elected than the voters.

After an election, the elected candidate is, to some extent, insured against the risk of losing office. Having been elected means he would likely stay in office for up to 4 years. Now, because voters cannot accurately monitor the elected candidate's behavior (as monitoring is costly to do), the elected candidate has an incentive to behave differently from the 'contract' he has agreed to before the election. That is, he may not deliver the policies promised to the voters. Thus, moral hazard problem could arise because of costly monitoring and the candidate being guaranteed the MP seat for at least some time.

The principal-agent problem is also very much present. Because the principal (voters) cannot fully monitor the behavior of the elected candidate (agent), the politician may pursue goals that are not in the best interest of the voters. For example, the elected MP may engage in corruption practices for personal gains rather than working for the interests of the voters.

In politics, however, moral hazard and principal-agent problems are alleviated to some extent by the fact that politicians want to be re-elected. Thus, they have an incentive to deliver the policies to make the voters adequately satisfied so as to vote for them again in the next election.

However, this does not fully eliminate the problems because the politicians are still insured against losing their MP seats for perhaps a couple of years at least (before the next election happens) and because effective monitoring of the elected MPs is a costly and difficult process.

Consequently, although the elected politicians will try to deliver some policies to make voters happy, the degree of policy delivery will likely be below the optimal level. In other words, if information is perfect and voters (principal) can monitor fully the behavior of the elected candidates and 'reward' or 'punish' them accordingly, the politicians (agents) will behave more in the interest of the voters and will deliver more policies to them.

.........

So far, we have seen how asymmetric information problems can cause the market for policies to fail or to under-perform below the optimal level. Now, let's try to explain some of the political phenomenon by asymmetric information.

Adverse selection and moral hazard may help explain the presence and prevalence of vote-buying practice. Because voters are uncertain about the candidates' honesty and cannot accurately monitor the post-election behavior of the candidates, voters cannot easily differentiate the good politicians from the bad ones. In such a situation, other factor(s) may emerge as the decisive factor in their voting decisions.

One such factor is money! Because I am not sure which candidate is good or bad (or worse, adverse selection may cause me to be more inclined to think that all candidates are all corrupt 'lemons'), I may simply make my voting decision based on the money I get from the candidate, not on his/her real quality.

At the same time, the honest candidates, by definition, will not buy votes. In fact, they can't afford to buy votes because being honest means they will not engage in corrupt behavior and thus they will not get rich from holding office. The candidates who can and will buy votes are only the dishonest ones who intend to reap private benefits later on when they are elected into office. The market outcome is that the "lemon" politicians will be more likely to get elected than the good ones.

So, information asymmetry can create uncertainty about the quality and behavior of politicians, making it difficult for voters to distinguish between good and bad candidates, thereby making the voters more inclined to make voting decisions on such factors as money. And because the dishonest candidates will be the only ones buying votes, we end up with only the corrupt candidates being elected.

Now, even if voters learn that an elected candidate performs badly in office and don't want to vote for him again in the next election, the problem is not resolved. Why? Because of adverse selection! That is, in the next election, voters still do not know for sure about which of the other candidates will be honest. Quality uncertainty still makes if difficult for voters to differentiate the good from the bad. Hence, they will still be inclined to accept money and vote according to money. Vote-buying thus continues to persist.

Another likely outcome of asymmetric information problems is herd behavior on the part of the voters. Because candidates are all lemons in the eyes of the voter, she may base her voting decision on what others are doing. That is, in the absence of vote-buying or other factors that could differentiate the good candidates from the bads, the voter may tend to "follow the crowd."

This is similar to the bahavior of international investors, who tend to follow the crowd when making decisions on where to invest in or where to get their money out. Hence, in Bangkok where vote-buying is not common, we tend to see voters' behaviors change according to popular 'trend' or 'tide' at the time.

In any case, all the above analysis of politics using asymmetric information is a preliminary work with no empirical support. My hope is that it provides another theoretical framework through which we can look at various issues in Thai politics and make it function better.

So far, we have assumed that market participants don't attempt to fix the problems of imperfect information. In reality, they do find ways to alleviate these problems. So, in the next blog, I will present some the ways through which asymmetric information problems have been alleviated in both the economic and political world. In doing so, perhaps we could obtain some insights on how to make the market for policies function more efficiently.

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comment 2
rad date : 20/11/2008 time : 11.15
http://blog.nationmultimedia.com/rad

Ginola,
Thank you once again and again await the next edition.

I like your writing style, easy to read and easy to understand.

comment 1
Ian date : 20/11/2008 time : 10.44
http://blog.nationmultimedia.com/anterian36

Another factor is what I call the "4 year effect". Many voters do not have a sophisticated grasp of what is good for their country, they can only vote in terms of personal gain.
So if the government needs to raise taxes to finance a long term project, as an example, say health or education. This will adversely effect their chances of re-election. So politicians tend to think in short term policies rather than long term.

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