Transcript 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 certain knowledge
(uncertainty)
 asymmetric information -- one party has better
information than the other
 party with worse information also suffers from
imperfect information
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
Wine Market Equilibrium, I
Price (Hundred $ per case)
8
supply of good vintage
7
combined supply of good and bad vintage
5
actual demand
(marginal benefit)
demand (marginal benefit)
for good vintage
3
2
0
1
2
3
Quantity (Thousand cases a month)
8
Wine Market Equilibrium, II
 actual demand = combined supply of good and bad
 at equilibrium price
 actual marginal benefit (adjusted for prob of getting bad
vintage) = price
 actual marginal cost (of good vintage) = price
Adverse Selection
 economic inefficiency
 possible market failure
Market Failure, I
Price (Hundred $ per case)
8
combined supply of good
and bad vintages
actual demand
(marginal benefit)
2
0
demand (marginal benefit)
for good vintage
c
d
F
Quantity (Thousand cases a month)
8
Market Failure, II
 conventional market: when supply exceeds demand,
lower price restores equilibrium
 wine market with adverse selection: lower price drives
out better vintages, leaving even worse adverse
selection
Life Insurance, I
Coverage = $200,000 for 43 year-old male
NTUC Income
Singapore
Pacific Century
Hong Kong
Group policy
$240
$212
Individual (nonsmoker)
$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
Screening
• less informed party indirectly elicits
other party’s characteristic through
structured choice
• better informed party must be
differentially sensitive to the choice
Who’s the real mother?
Solomon: “Divide the living child into two, and give
half to 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;
divide it.”
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 to reveal
their information
Auction Methods
 open/sealed bidding
 discriminatory/non-discriminatory pricing
 reserve price
Winner’s Curse
 In auction to buy: winning bidder over-estimates the
true value
 In auction to sell: winning bidder under-estimates the
true cost
 More severe where
 more bidders
 true value/cost more uncertain
 sealed-bid auction
Signaling
• better informed party communicates
characteristic through signal
• cost of signal differs according to
characteristic  self-selection  signal
is credible
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 technology
must buy future product)
 mergers and acquisitions – payment in shares
Contingent Fee
Lawyer has better information about likelihood of
success at trial
 contingent fee
 time-based fee