Transcript Externality and Asymmetric Information

IMPERFECT MARKET
IMBA NCCU
Managerial Economics
Jack Wu
IMPERFECT MARKET
Externality
 Asymmetric Information

EXTERNALITY
EXTERNALITIES

one party directly conveys benefit or cost to
others
•
•
positive
Negative
SAK’S POSITIVE
EXTERNALITIES
Marginal benefit/cost
(Hundred thousand dollars)
15
13.4
group marginal benefit
10
Sak’s marginal benefit
9
florist’s marginal
benefit
4
3.6
profit gain from
additional investment
1
0.8
marginal
cost
0
1
shoe store’s
marginal benefit
5
9
10
Hundred thousand dollars of investment
SAK’S NEGATIVE
EXTERNALITIES
10
marginal benefit
profit gain from
reducing investment
group marginal cost
b
a
2
Sol’s marginal cost
1
0
c
5
7.5
9
Sak’s marginal cost
10
Hundred thousand dollars of investment
RESOLVING EXTERNALITIES
Economic inefficiency  opportunity for profit
 merger
 collective action
Cooperative advertising resolves positive
externality from one retailer to other retailers
Externalities
INTEL INSIDE
(c) 1999-2001, Ivan Png
NETWORK EXTERNALITY
Externality where benefit/cost depends on total
number in network
 English language
 Internet email
 international telephone service
NETWORK EFFECT
benefit/cost depends on total number in network
 through market, not directly conveyed
 resolved by producer or service provider
CRITICAL MASS

definition: number of
users at which demand
becomes positive
NETWORK EFFECTS:
DEMAND ELASTICITY
highly elastic around tipping point
highly inelastic at low demand levels
ASYMMETRIC INFORMATION
CASE: 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
 U.S. publicly-listed companies -- dividends

MORAL HAZARD
asymmetric information about action
 conflict of interest

MORAL HAZARD: DOCTORS
•
•
Brazil: among pregnant women,
rate of cesarian section
– 30% (81 of 269) in public
hospitals
– 66% (117 of 177) in private
hospitals
Happy coincidence?
MORAL HAZARD IN EMPLOYMENT
employer’s
marginal benefit
worker’s
marginal
benefit
Quantity (units of effort)
worker’s marginal
cost
efficient effort
RESOLVING MORAL HAZARD

incentive scheme
conditional payment
 quota


monitoring system

incentives must be based on observables
RELATIVE PERFORMANCE
employment -- promote the best worker
 sports -- gold, silver, bronze
 examination – grade on a curve

MULTIPLE RESPONSIBILITIES

strong incentive
more effort on that dimension
 less effort on other dimensions

DISCUSSION
Fixed Salary
 Commission rises from $1000 to $2000
 Quota
