Can cost increases increase competition? Asymmetric information and equilibrium prices.

We present an analysis of competition under asymmetric information where prices react asymmetrically to changes in firms" marginal costs. When one firm has private information about some customers, an increase in an uninformed firm's marginal cost leads to a price increase, as usual. However, an increase in the informed firm's marginal cost causes the equilibrium price to fall by improving the distribution of customers served by the uninformed firm. The model applies to settings where information asymmetries are important determinants of competition, such as credit, insurance, labor markets, or for the sale of goods where repeat business is important.

1. Introduction

* Asymmetric information can alter or overturn some of the fundamental characteristics of standard models of competition. For instance, the exit of a competitor from a product market is usually thought to have a negative, or at best neutral, effect on consumers. However, as illustrated by Baye, Kovenock, and de Vries (1993) in the context of a common value auction, excluding an "especially informed" bidder may increase the competitiveness of the auction and the expected sale price. (1) Thus, the existence of asymmetric information can break the link between the number of competitors and the degree of competition. (See also Stiglitz, 1981 and Rosenthal, 1982 for models that do not depend on information asymmetries and in which increasing the number of competitors leads to decreased welfare and competition.) More generally, the presence of private information can have large effects on the sale prices of goods in common value auctions (see, e.g., Milgrom, 1981; Klemperer, 1998).

In this article, we show that asymmetric information may in addition alter the relationship between production costs and consumer prices. Specifically, we show that for a firm with superior information about customers in the market, an increase in its marginal cost can in fact lead to increased competition and a reduction in market prices. An increase in competition following the exit of a competitor who possesses superior private information then becomes an extreme manifestation of this effect.

We present a model of price competition under asymmetric information in which one firm (firm 1) has private information concerning the profitability of serving its customers, but faces the competition of another firm (firm 2) with no private information. This informational structure provides firm 1 with an advantage which allows it to earn quasi-monopolistic rents. Although the analysis is generally applicable to markets where information asymmetries across firms are important determinants of competition, we couch the presentation in terms of a credit market in order to provide a specific setting for our analysis. In this context, firm 1's private information concerns its loan customers' repayment probability. The uninformed competitor suffers an adverse selection problem in competing for firm 1's customers: any loan customers firm 2 is likely to finance can be expected to be worse than average credit risks. Therefore, the information asymmetry between firms 1 and 2 limits the degree of competition in the market, forcing firm 2 to compete less aggressively and charge a higher interest rate on its loans.

We find that, as in most standard models, an increase in the marginal cost of the uninformed competitor (e.g., an increase in its cost of funds) gets at least partially passed on to customers via higher interest rates. The usual logic applies here, in that an increase in the cost of financing a loan for the uninformed lender forces it to compete less aggressively and results in more costly credit for both lenders' customers.

However, we also find that a higher cost of funds for the informed lender often leads to lower interest rates being paid by all borrowers. This occurs because, when information asymmetries across lenders are sufficiently large, a higher cost of funds for lender 1 further restricts its ability to exploit its private information at the margin, leading to a lower adverse selection problem for its competitor. The net effect is that lender 2 bids more aggressively for the informed lender's business, and the interest rate offered to all applicant borrowers is lower. We also apply the model to the analysis of the exit from the market of a lender with private information. Because this firm's exit serves to reduce the adverse selection problem faced by other uninformed firms, it has an effect similar to that of a cost increase and likewise enhances competition among the remaining firms.

The results in the model are robust to a number of generalizations, as we illustrate in Section 5. In particular, we show that the assumption that only one firm has private information is not necessary to obtain the results, and neither is the specific extensive form with offers and counteroffers we present in Section 2. The key assumptions throughout are that the market be characterized by information asymmetries among firms, and that these asymmetries represent the principal obstacle to competition. Increasing the marginal cost of the informed firm serves to increase competition in this market by limiting the informed firm's ability to use its private information to its advantage.

The application to banking we present in the article is a natural one. First, information asymmetries have been identified as a key feature of credit markets, and are believed to have an impact on competition (see Rajan, 1992; Dell'Ariccia, Friedman, and Marquez, 1999; Dell'Ariccia and Marquez, 2004; Bouckaert and Degryse, 2006; von Thadden, 2004). Second, cost increases that affect the banking industry can be asymmetric, and affect competitors differently. For example, monetary policy shocks have been argued to have a differential effect on banks' lending abilities relative to that of public debt markets (see, e.g., Kashyap and Stein, 2000). Alternatively, differences in the lenders' liability structure may mean that interest rate shocks, to the extent that their effects are not equal across all financial instruments, will lead to greater cost changes for one lender over another (see Holod and Peek, 2007, for evidence). In this context, our article also contributes to the debate over the anticompetitive effect of the "too-big-to-fail" policy for bank regulation, which we discuss in Section 6. In a similar vein, the recent wave of bank mergers has raised concerns that as banks increase their size via merger, small business borrowers may be hurt if banks shift their lending policies away from these borrowers and toward larger corporate customers. The evidence on this front, however, is that small business lending by the remaining smaller banks has increased in many cases to more than compensate for the reduction in lending by larger banks (see Berger et al., 1998). This effect is consistent with our model, as the exit of the larger bank allows the smaller banks to compete more aggressively for the exiting bank's market share (see Section 4).

Other than credit markets, our results hold more generally in settings where information plays a main role in determining the degree of competition, such as the market for insurance or for skilled labor. For instance, in Section 6, we discuss a case where cost increases for leading insurance brokerage companies have been argued to have procompetitive effects. Similarly, the results can be applied to settings where firm-client relationships allow firms to extract future rents from their customers, such as when firms can discriminate among their prior customers and offer them different deals (see, e.g., Villas-Boas, 1999; Fudenberg and Villas-Boas, 2006, for a survey). We discuss these applications in more detail in Section 6.

In addition to the work cited above on auctions and banking, our article is also related to recent literature on the pricing behavior of firms under asymmetric information. Moscarini and Ottaviani (2001) focus on the role of private information on the side of the buyer. Levin (2001) analyzes the effect of information asymmetries on the gains from trade. Bulow and Klemperer (2002) demonstrate that increases in supply may raise the expected price in the case of the sale of common-value assets. This occurs for a reason similar to ours, in that increasing supply creates more "winners" and therefore reduces the well-known "winner's curse" problem, leading to increased competition.

The article proceeds as follows. Section 2 presents the model. Section 3 analyzes the equilibrium and presents the main results. Section 4 places the results in the context of a model of entry and exit. Section 5 addresses robustness issues by generalizing the model along various dimensions. Section 6 discusses some applications. Section 7 concludes.

2. A model of competition under asymmetric information