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Report n°2: An integrated approach to economic and social contestability in business

Informational aspects of transactions regarding scrap metal batches

Analysis of the informational conditions under which the transactions of batches of materials for recycling take place highlights two sets of informational asymmetry: the first on the supply side ("the collectors") and the second on the demand side ("the recycler").

The prevailing transactions conditions on the inputs market indeed present four essential characteristics. The first is the absence of technological resources enabling objective measurement of the quality of the batches offered by the collectors. The buyer is relies on an imperfect visual evaluation of the batches. The presence of layers of low quality or dangerous wastes hidden in the batch is a private information of the collector.

One must then take into account the sequential structure of the buyer's evaluation of the quality of a batch. The recycler's receiving agent first inspects the quality of the batch and only then announces the quality that corresponds to the batch contents and the unit price at which he will purchase the batch.

This sequential structure is not without consequence if one takes into account a third characteristic: the existence of an asymmetry of expertise in the buyer's favour, this time, since this latter is particularly skilled at evaluating the quality of the pieces of scrap iron making up the batch, according to the requirements of demand on the outputs market. The buyer has superior ability to grade a given material i.e. match it to the corresponding quality category defined on the basis of the in used evaluation criteria.

The fourth aspect operates in the sense of maintaining the expertise differential between the recycler and the collector(19): the buyer's aim is to not reveal the relevant characteristics of the grading system used by the recycler. In other terms, the recycler selectively hides from some suppliers the information that would enable each of them to predict the grading system operated by the buyer. In addition to not revealing the definitions of the individual grades used in the transaction, the collector also maintains uncertainty as to the unit value of each grade. Concerning both the definition of each grade and corresponding unit price, the consequence of his refusal to share this information is to keep private the detailed grid showing the relations between grades and prices.

Asymmetric information on batch content...
In the transactions studied, the first asymmetry is the one we usually associate with Akerlof's famous "Market for Lemons" (1970). This is a case of asymmetric information on the quality of the exchanged good. In the case studied by Akerlof, the vendor is assumed to be perfectly aware of the quality of his car, but the buyer lacks the objective means to assure himself of that quality. As the buyer is incapable of discerning good from bad quality, the vendor is offered a price for a lower quality, that is a price incorporating a risk premium. By doing so, an adverse selection phenomenon is triggered, the market shrinks to low qualities and high quality product are not exchanged. The consequences of a potential market failure due to this asymmetry are fairly considerable both for the development and for the smooth functioning of a recycling materials market and for the economic activities further down on this market.

With regard to recycling, the quality stakes bear in particular on the potential presence of abnormal wastes(20) in the delivered batches. As the batch is made up before delivery, the collector generally knows better than the recycler if the batch contains any abnormal waste. There is certainly nothing ambiguous about the status of "abnormal waste": those waste are designated by name by the buyer (tyres, concrete slabs, straw, cylinders, etc.) and their status is common knowledge. Although the definition of the objects belonging to this category of waste does not pose a problem (with the notable exception of the ambiguous description of batteries), their presence in the batches is a private information of the collector . The latter knows what constitutes abnormal waste and if he made the required extraction efforts . This asymmetry of information is detrimental to the recycler. Indeed, if he does not discover the waste, the recycler pays for it at the stated price for the grade announced for the batch; furthermore, the unobserved abnormal waste may create a variety of risks: for the industrial equipment itself and for those operating the production tools (e.g. cause of explosions in the shredder or shearing machine), for the production tools of various operators situated further down the branch (for instance when a steel manufacturer uses contaminated material) or for local residents(21) surrounding the recycling site; the latter may launch a protest against the nuisance caused by smoke fumes and explosions, etc.

These different risks arise when abnormal wastes are present in the batches of materials for recycling; the occurrence of such risks is therefore directly related to the probability of the presence of such abnormal waste and inversely proportional to the probability that the recycler detected these wastes. Detection by the purchaser will be all the more probable when the batch is a small one and the time spent examining the batch is long. Although these two conditions increase the probability of discovering abnormal waste during inspection of the batches, such waste is nevertheless frequently found, either after purchasing the batches or during the transformation process (shredding or shearing-compacting).

(19) This proposition will be put into context later. As expressed here, it highlights one observation: apart from a written statement of the terms of the exchange (mainly the quality grading statement, the unit price and the batch weight), the collector has no details about the quality of the batch or the characteristics of the materials he can use to judge the detailed quality implied by the fixed price.

(20) It will be recalled that when the buyer discovers abnormal waste, the net weight is discounted. Depending on the type of waste, the deduction from the weight is fixed by agreement or is decided by the buyer.

(21) This point will be treated in detail later.

... and asymmetry of expertise

Another asymmetry allows distinguishing between the different types of collectors. Conversely to the "lemons" sold on Akerlof's second-hand vehicle market, the scrap studied is characterised by an asymmetry of expertise detrimental to supplier of the scrap metal. The configuration observed differs all the more from Akerlof's model in that it is the buyer (the recycler) himself who, based on a visual evaluation of the quality of the batches offered, will decide the unit price (price per kg) he pays the suppliers of the materials for recycling. So the asymmetric information on the waste content of the batch is counterbalanced by an inverse asymmetry of expertise: the recycler has superior knowledge of the quality - and hence the value of the supplied materials.

The expression "asymmetry of expertise"(22) used to designate the superior ability to recognize the economically relevant quality of the materials refers to two important aspects.

Firstly, the reference to expertise emphasises the necessary skill a collector-supplier should use to match the characteristics that he perceives in the batch of scrap he is offering for sale to the set of characteristics that are relevant in the eyes of the recycler. The criteria adopted by this latter determine how the pieces of scrap will be graded in the quality categories used as a basis to evaluate the batches and define their price. In other words, a collector's expertise resides in his ability to correctly classify a batch in one (or more) category(ies) that match the quality-price grid used by the recycler.

Secondly, by positing the existence of an asymmetrical relation in terms of a particular item of knowledge, the expression used underscores that the skill available to the parties is not evenly distributed between them. Asymmetry of expertise is favourable to the buyer, who determines the value of the materials he buys. This is due principally to the fact that the quality grid used for the transactions is not publicly known. Contrary to the way the scrap metal buyer (the recycler's receiving agent) acquires his expertise, the collector's ability to acquire that skill depends directly on two factors: firstly, on the nature of the scrap metal resources available to him and, secondly, on the accuracy with which the buyer imparts to the collector his assessment of the batch contents.

The nature of the sources has a direct influence on the level of expertise that the collector can develop. Two variables are of importance here: the size of the source and the type and quality of scrap of which it is made. A source generating a high flow of scrap makes for a higher frequency of transactions than a small source or small batches of materials for recycling; the collector will have to repeat the exercise of grading batches more often, and in doing so will progressively develop superior knowledge of which quality characteristics to take into account to anticipate without error the recycler's classification. The type of scrap making up the resource is also an important factor in developing the collector's expertise. This, allied with a high transaction frequency and the diversity of types of materials involved, helps the supplier glean an understanding of the underlying characteristics of the individual grades so that he becomes better qualified to anticipate the grading that the buyer will select(23).

If the size and spectrum of qualities characterising a scrap source are favourable factors to the development of the collector's expertise, the quality and speed of learning will depend on the level of precision that the buyer uses imparting information regarding the quality of the batches proposed to him. This information is proposed via acceptance notes and transaction forms stating the conventional quality or qualities of the purchased batch(es). In other terms, the recycler masters one important condition for the development of the collector's skill: if he decides to truthfully impart the real accurate quality of the batch for himself, he gives the collectors information that will help them know which materials to collect and exchange. If, however, the information imparted is unhelpful because the quality is announced only in rough categories, the collector will be unable to increase or improve on his prior knowledge of the characteristics that define a given quality.

Table 2 summarises the informational conditions governing the transactions that take place between the scrap metal suppliers and the recycler.

The transactional conditions identified thus far still give only an imperfect account of the real transactional conditions on the inputs market. Two additional aspects are worthy of mention. Firstly, the collector is an agent producing a collection effort, whose level he can choose depending on the pricing and grading strategy he anticipates the recycler will choose: if the recycler's commitment to fair and accurate pricing is deemed credible, the collector may respond by making more effort to collect and sort the kind of materials that will result in a higher quality of batches for delivery. Then too, not all collectors will have the same level of expertise: whether individually or collectively, superior knowledge of the nature of the materials collected will vary the expertise differential. The suppliers therefore form a heterogeneous population from the standpoint of the quality and size of batches delivered, but also from the standpoint of their finesse in evaluating the quality of the batches they offer the recycler.

(22) Refer to literature on the health economy, where there is an analogous focus on a "problem of expertise" in the relationship between doctor and patient.

(23) In particular, the amount of effort the collector devotes to collection depends on this ability to rightly anticipate grades and prices.

Table 2: Transactions conditions, informational aspects