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.