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					ASYMMETRIC INFORMATION
Managerial Economics
Jack Wu
NTUC INCOME: PREMIUMS FOR $200,000
LIFE INSURANCE

                               female   male

  civil servant group policy   $240     $240
  • maximum coverage limit
  • no medical exam



  individual policy            $991     $1849
  • no maximum coverage
  • medical exam required
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

                             8

                                             supply of good vintage
Price (Hundred $ per case)




                             7

                                                       combined supply of good and bad vintage
                             5
                                                           actual demand
                                                           (marginal benefit)

                             3                                      demand (marginal benefit)
                                                                    for good vintage
                             2



                             0   1      2     3                            8
                                     Quantity (Thousand cases a month)
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

                             8
Price (Hundred $ per case)




                                                    combined supply of good
                                                    and bad vintages

                                                           actual demand
                                                           (marginal benefit)

                                                             demand (marginal benefit)
                                        c                    for good vintage
                             2
                                            d

                             0          F                            8

                                 Quantity (Thousand cases a month)
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          Pacific Century
                           Singapore            Hong Kong

    Group policy               $240                 $212

    Individual (non-          $1849                 $466
    smoker)

    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
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.

				
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