Transcript Asymmetric Information

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 underestimates 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
DISCUSSION

This question applies the technique for deriving a market
equilibrium with adverse selection presented in the math
supplement. Suppose that the demand for genuine
antiques is D = 4 - p, and the supply is S = p - 2, where D
and S are in thousands of units a month, and p represents
price in hundreds of dollars. In addition, some sellers
produce 500 fakes at zero marginal cost.



In a market of purely genuine antiques, what will be (i)
the buyers' marginal benefit from a quantity Q, (ii) the
sellers' marginal cost of providing a quantity Q, (iii) the
market equilibrium price and quantity.
In a market including both genuine antiques and fakes,
what will be (i) the buyers' marginal benefit from a
quantity Q, (ii) the sellers' marginal cost of providing a
quantity Q, (iii) the market equilibrium price and
quantity.