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Asymmetric Information

Asymmetric Information. Managerial Economics Jack Wu. NTUC Income: Premiums for $200,000 Life Insurance. Imperfect/Asymmetric Information. imperfect information – absence of certain knowledge (uncertainty) asymmetric information -- one party has better information than the other

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Asymmetric Information

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  1. Asymmetric Information Managerial Economics Jack Wu

  2. NTUC Income: Premiums for $200,000 Life Insurance

  3. 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

  4. 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

  5. WINE MARKET EQUILIBRIUM, I 8 supply of good vintage 7 combined supply of good and bad vintage 5 actual demand (marginal benefit) Price (Hundred $ per case) demand (marginal benefit) for good vintage 3 2 0 1 2 3 8 Quantity (Thousand cases a month)

  6. 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

  7. Adverse Selection • economic inefficiency • possible market failure

  8. MARKET FAILURE, I 8 combined supply of good and bad vintages actual demand (marginal benefit) Price (Hundred $ per case) demand (marginal benefit) for good vintage c 2 d 0 F 8 Quantity (Thousand cases a month)

  9. 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

  10. Life Insurance, I

  11. Life Insurance, II • group policy avoids adverse selection • individual policy attracts adverse selection • no maximum policy coverage • medical examination required

  12. Appraisal • characteristic is objectively verifiable • potential gain covers appraisal cost

  13. Screening • less informed party indirectly elicits other party’s characteristic through structured choice • better informed party must be differentially sensitive to the choice

  14. 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.”

  15. Indirect Segment Discrimination • restricted vis-a-vis unrestricted air fares • separate cable channels vis-à-vis bundle • cents-off coupons

  16. Multiple Asymmetries • screening mechanisms may conflict • example -- auto insurance policy: higher deductible • screens out bad drivers • screens out more risk-averse

  17. 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

  18. Auction Methods • open/sealed bidding • discriminatory/non-discriminatory pricing • reserve price

  19. 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

  20. Signaling • better informed party communicates characteristic through signal • cost of signal differs according to characteristic  self-selection  signal is credible

  21. Signaling: Examples • auto manufacturers – extended warranty • Intuit – money-back guarantee on Quicken • U.S. publicly-listed companies -- dividends

  22. 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

  23. Contingent Contract Payment is contingent on realized characteristic: • international trade -- buyback (supplier of technology must buy future product) • mergers and acquisitions – payment in shares

  24. Contingent Fee Lawyer has better information about likelihood of success at trial • contingent fee • time-based fee

  25. 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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