29 October 2007

Credible threats, moral hazard and Northern Rock

Continuing last week's post on game theory

Entry deterrence

'Entry deterrence' is an example of trying to manipulate a rival player's moves. In this case, it involves an incumbent firm trying to prevent the entry of potential rivals into a market.

Successful entry deterrence depends on avoiding the non-credible threat problem. If you want to make things too difficult for a potential entrant to bother entering, you have to do so in a way which binds you, i.e. you have to commit to a particular strategy. This has to involve ex ante (i.e. prior to the other player’s move) and irreversible action which prima facie is suboptimal for player 1 (and therefore is said to be ‘strategic’, i.e. undertaken only for the purposes of affecting the other player’s behaviour) but which ultimately pays because it succeeds in deterring entry.

Excess (in the sense of surplus) capacity is not an effective way of deterring entry; in fact it represents a non-credible-threat. An incumbent would never expand capacity in response to entry, he would always contract. (Unless there is imperfect information, in which case he may try to convince the other player he is irrational.) However, over-investment in capacity may succeed in deterring entry. This is the Dixit* model in which the incumbent invests irreversibly to expand the capacity at which he can produce at low marginal cost, beyond what he would do left to himself. The point is that this results in a post-entry equilibrium in which his output is higher than what it would have been, and the entrant’s lower — indeed, so low that the latter can’t cover its fixed cost.

Moral Hazard

'Moral hazard' arises when player A wishes to contract with player B for the performance of a variable task by B, the outcome of which will depend partly on (i) B's effort and partly on (ii) random factors, and where it is impossible to ascertain how much the outcome is due to (i) versus (ii). The problem is that B does not have as much incentive to perform as would be optimal. In the case of theft insurance, for example, the insured does not have the ideal level of incentive to protect his property because the insurer cannot monitor what he does, and he will therefore tend to under-protect it.

There is a connection between credible threats and moral hazard. To avoid moral hazard, A wants B to believe there will be penalties for indulging in 'immoral' behaviour. However, the threat to penalise errant behaviour has to be credible. Either the penalty has to be unavoidable, e.g. criminal legal sanctions, or it has to be somehow in A's interests to apply it. The problem is that the application of a punishment is not usually intrinsically beneficial for the punisher. One possible way out is through reputation: if A's reputation for truth-telling and toughness is valuable to A, then A announcing publicly that a penalty will be imposed could lead to a cost for A if he then fails to implement. In this way, the threat to punish would become credible.

Applying this to the Bank of England, a threat not to bail out a bank in trouble except in very limited circumstances is at risk of not being credible and therefore of not being effectual, unless reneging on the threat can be regarded as somehow costly for the Bank. However, it is not clear how the Bank, or any of its agents, could suffer from the failure to penalise an errant lender. Possibly when the Bank was still relatively controlled by the government (pre-1997), the desire of the ruling party to be re-elected could have provided such an incentive.

When there is imperfect information about whether the failure to carry out a threat is costly for the threatener, it is possible for the threat to be credible by exploiting uncertainty. However, once a player has reneged on his threat without obvious negative repercussions, the possibility of future credible threats is more or less eliminated.

* Dixit, A. (1980) 'The Role of Investment in Entry Deterrence', Economic Journal 90, 95-106.

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