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.