Asymmetric Information

ASYMMETRIC INFORMATIONManagerial EconomicsJack 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

RISKuncertainty 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)

Price

(Hun

dred

$ p

er c

ase)

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 bad vintage) = price

actual marginal cost (of good vintage) = price

ADVERSE SELECTION economic inefficiency possible market failure

0

2

8

F 8

cd

combined supply of good and bad vintages

actual demand(marginal benefit)

demand (marginal benefit)for good vintage

Quantity (Thousand cases a month)

Price

(Hun

dred

$ p

er c

ase)

MARKET FAILURE, I

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 IncomeSingapore

Pacific CenturyHong 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 elicits other 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 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

• better informed party communicates characteristic through signal

• cost of signal differs according to characteristic self-selection signal is 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 CONTRACTPayment is contingent on realized characteristic:

international trade -- buyback (supplier of technology must buy future product)

mergers and acquisitions – payment in shares

CONTINGENT FEELawyer 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.