Managerial Economics Lecture Twelve Winter 2013

8/14/2019 Managerial Economics Lecture Twelve Winter 2013

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ASYMMETRIC INFORMATION Managerial Economics

Jack Wu



NTUC INCOME: PREMIUMS FOR $200,000 LIFE INSURANCE

female male

civil servant group policy• maximum coverage limit• no medical exam

$240 $240

individual policy• no maximum coverage• medical exam required

$991 $1849



IMPERFECT/ASYMMETRIC INFORMATION

imperfect information – absence of certainknowledge (uncertainty)

asymmetric information -- one party has better information than the other

party with worse information also suffers from imperfectinformation



RISK

uncertainty about benefit or cost

arises from imperfect information

risk-averse person prefers certain payment to

uncertain payments with same expected value risk-averse person will buy insurance



0

2

3

5

7

8

1 2 3 8

supply of good vintage

combined supply of good and bad vintage

actual demand(marginal benefit)

demand (marginal benefit)for good vintage

Quantity (Thousand cases a month)

P r i c e

( H u n d r e d

$ p

e r c a s e )

WINE MARKET EQUILIBRIUM, I



WINE MARKET EQUILIBRIUM, II

actual demand = combined supply of good and bad

at equilibrium price

actual marginal benefit (adjusted for prob of getting badvintage) = price

actual marginal cost (of good vintage) = price



ADVERSE SELECTION

economic inefficiency

possible market failure



0

2

8

F 8

c

d

combined supply of goodand bad vintages

actual demand(marginal benefit)

demand (marginal benefit)for good vintage

Quantity (Thousand cases a month)

P r i c e

( H u n d r e d

$

p e r c a s e )

MARKET FAILURE, I



M ARKET F AILURE, II

conventional market: when supply exceeds demand,lower price restores equilibrium

wine market with adverse selection: lower pricedrives out better vintages, leaving even worseadverse selection



LIFE INSURANCE, I

Coverage = $200,000 for 43 year-old male

NTUC Income

Singapore

Pacific Century

Hong Kong

Group policy $240 $212

Individual (non-

smoker)

$1849 $466

Individual (smoker) $1849 $1120



LIFE INSURANCE, II

group policy avoids adverse selection

individual policy attracts adverse selection

no maximum policy coverage

medical examination required



APPRAISAL

characteristic is objectively verifiable

potential gain covers appraisal cost



• less informed party indirectly elicitsother party’s characteristic through

structured choice• better informed party must be

differentially sensitive to the choice

SCREENING



WHO’ S THE REAL MOTHER?

Solomon: “Divide the living child into two, and give halfto the one, and half to the other.”

Woman whose son was alive: “give her the living child,and by no means slay it.”

Other woman: “It shall be neither mine nor yours; divideit.”



INDIRECT SEGMENT DISCRIMINATION

restricted vis-a-vis unrestricted air fares

separate cable channels vis-à-vis bundle

cents-off coupons



MULTIPLE ASYMMETRIES

screening mechanisms may conflict

example -- auto insurance policy: higher deductible

screens out bad drivers

screens out more risk-averse



AUCTION

auctions to sell: seller doesn’ t know buyers’ valuations

auctions to buy: buyer doesn’ t know sellers’ costs

use competitive pressure to force bidders toreveal their information



AUCTION METHODS

open/sealed bidding

discriminatory/non-discriminatory pricing

reserve price



WINNER’ S CURSE

In auction to buy: winning bidder over-estimates thetrue value

In auction to sell: winning bidder under-estimatesthe true cost

More severe where more bidders

true value/cost more uncertain

sealed-bid auction



• better informed party communicatescharacteristic through signal

• cost of signal differs according tocharacteristic self-selection signalis credible

SIGNALING



SIGNALING: EXAMPLES

auto manufacturers – extended warranty

Intuit – money-back guarantee on Quicken

U.S. publicly-listed companies -- dividends



ADVERTISING AS A SIGNAL

advertising expenditure must be sunk

buyers must be able to detect poor quality

information about poor quality must quickly spread

and cut into seller ’ s future business



CONTINGENT CONTRACT

Payment is contingent on realized characteristic:

international trade -- buyback (supplier of technologymust buy future product)

mergers and acquisitions – payment in shares



CONTINGENT FEE

Lawyer has better information about likelihood ofsuccess at trial

contingent fee

time-based fee



DISCUSSION

This question applies the technique for deriving a marketequilibrium with adverse selection presented in the mathsupplement. Suppose that the demand for genuine antiquesis D = 4 - p, and the supply is S = p - 2, where D and S are inthousands of units a month, and p represents price inhundreds of dollars. In addition, some sellers produce 500

fakes at zero marginal cost.

In a market of purely genuine antiques, what will be (i) thebuyers' marginal benefit from a quantity Q, (ii) the sellers'marginal cost of providing a quantity Q, (iii) the marketequilibrium price and quantity.

In a market including both genuine antiques and fakes,what will be (i) the buyers' marginal benefit from a quantityQ, (ii) the sellers' marginal cost of providing a quantity Q,(iii) the market equilibrium price and quantity.

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Managerial Economics Lecture Twelve Winter 2013

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