Asymmetric Information Managerial Economics Jack Wu

NTUC Income: Premiums for $200,000 Life Insurance female male civil servant group policy maximum coverage limit no medical exam $240 individual policy no maximum coverage medical exam required $991 $1849 Premiums are annual, in Singapore dollars, effective May 2000. Civil servant group policy: maximum policy coverage is for person aged below 45, $300,000 for person aged above 45, $200,000 no medical examination What explains the differences in price and sales conditions?

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 Examples of imperfect information: tomorrow’s weather tomorrow’s S&P 500 Index or Hang Seng Index All people have equally poor information about future event – no asymmetry. Contrast: auto insurance: driver has better information about care and habits than insurer – asymmetric information insurer also has imperfect information about driver’s care and habits

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 Many people may have imperfect information about some event, only person with something at stake will bear risk Contrast next month’s weather for farmer school-teacher Contrast next year’s S&P500 for investor person with no stock market investment

WINE MARKET EQUILIBRIUM, I 8 supply of good vintage 7 combined supply of good and bad vintage 5 Price (Hundred $ per case) actual demand (marginal benefit) demand (marginal benefit) for good vintage 3 Essential problem: two markets – one for high quality and one for low quality – compressed into one What will be the equilibrium? supply: 1000 cases of bad quality and Q thousand cases of good vintage combined supply begins with bad quality – has lower marginal cost demand: consumer’s actual marginal benefit is (Q - 1) / Q of the marginal benefit for good vintage actual demand curve is lower than demand for good vintage 2 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 Market equilibrium at quantity = 2000 cases/mth price = $300/case Market equilibrium is economically inefficient: at that quantity, marginal benefit for good vintage > marginal cost of good vintage

Adverse Selection economic inefficiency possible market failure Adverse selection -- getting disproportionately bad selection; auto insurance -- insurer who offers to insure everyone will get relatively more of drivers with many prior accidents and driving convictions, and drivers who drink heavily. credit card -- issuer who offers card without credit check will get relatively more customers with bad credit records. Economic inefficiency: marginal benefit not equal to marginal cost opportunity for profit by resolving inefficiency extreme case of inefficiency  market failure

MARKET FAILURE, I combined supply of good and bad vintages 8 combined supply of good and bad vintages Price (Hundred $ per case) actual demand (marginal benefit) demand (marginal benefit) for good vintage When actual demand is so low (owing to high proportion of poor quality) that it passes through vertical portion of combined supply, there is no equilibrium --> market failure: sellers of good vintages withhold the supply only bad vintages --> consumers do not buy extreme case of economic inefficiency: no market at all c 2 d 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 In example of wine market, market failed because supply comprised only bad vintages reducing price to “clear the market” doesn’t help – the better of bad vintages drop out of supply, further degrading the quality of supply Essential problem: two markets – one for high quality and one for low quality – compressed into one, for average of quality average quality depends on behavior of high quality sellers – whether they offer or withhold their product

Life Insurance, I Coverage = $200,000 for 43 year-old male NTUC Income Singapore Pacific Century Hong Kong Group policy $240 $212 Individual (non-smoker) $1849 $466 Individual (smoker) $1120 Purest insurance, eg against weather addresses risk that arises from imperfect information probability of event is outside control of insured party; In many situations, there is also asymmetric information that affects probability of loss: applicant for insurance has better information than insurer insurer must take precautions against adverse selection Group life insurance: if insurer covers whole group, then will not get adverse selection; Sources: NTUC Income, Singapore; all quotations in Singapore dollars; May 2000 Pacific Century Life Insurance, Hong Kong, May 2000. Group size: 100; Sum assured per member: HK$200,000 Average age of the group: 40; male; Occupational class: Class 1 (e.g. office staff) Est. annual premium per member: HK$212.- Question: Shouldn’t NTUC Income offer different rates for smoker and non-smokers?

Life Insurance, II group policy avoids adverse selection individual policy attracts adverse selection no maximum policy coverage medical examination required Group policy avoids adverse selection in two ways: covers specific class of people, eg, civil servants, office workers – avoids risky groups, eg, construction workers limits coverage (people in poor health would seek large policies) Since adverse selection is limited, group policy can offer insurance without review of application (every member of designated group who applies must be accepted) no medical examination Individual policy attracts adverse selection in two ways: open to everyone, regardless of occupation unlimited coverage So, insurer resolves adverse selection by requiring medical examination and reviewing the application (has right to deny insurance) Question: Suppose we form a voluntary group (just for purposes of seeking insurance with high policy limit); Should life insurer offer same low group rates?

Appraisal characteristic is objectively verifiable potential gain covers appraisal cost Most direct way to address asymmetric information: uninformed party should get the information unknown characteristic must be objectively verifiable if not objectively verifiable, then cannot appraise, the uninformed party must “try for himself” Examples: wine critic medical examination for life insurance driving record for auto insurance credit check for loan application

better informed party must be differentially sensitive to the choice Screening less informed party indirectly elicits other party’s characteristic through structured choice better informed party must be differentially sensitive to the choice Self-selection: party with good characteristic chooses one way party with bad characteristic chooses the other way Screening typically implemented through menu of choices: auto insurance – insurer offers driver a choice of deductibles: higher deductible to attract better driver medical insurance – insurer offers a choice of co-payment: higher co-payment to attract person who pays more attention to health some employers offer a choice between fixed wage and commission: commission to attract more productive workers Question: in each example, what is the variable to which better-informed party is differentially sensitive?

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.” Jewish King Solomon: one of the earliest examples of screening. Source: 1 King 3, verses 16-27, Revised Standard Version Another historical example: Sun Yat Sen’s proposed reform of property taxation: require owner of real property to declare its value government then had choice of collecting the corresponding tax or buying the property at declared value

Indirect Segment Discrimination restricted vis-a-vis unrestricted air fares separate cable channels vis-à-vis bundle cents-off coupons Most prevalent application of screening: indirect segment discrimination to elicit buyer’s willingness to pay. Question: in the above examples, what is the variable to which better-informed party is differentially sensitive?

Multiple Asymmetries screening mechanisms may conflict example -- auto insurance policy: higher deductible screens out bad drivers screens out more risk-averse Another example – group life insurance policy: maximum limit on coverage screens out people in relatively bad health also screens out people who are more risk averse – the people who need insurance relatively more

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 Seller does not have information about buyer’s valuations selling continuously produced items, use indirect segment discrimination selling unique items, use auction

Auction Methods open/sealed bidding discriminatory/non-discriminatory pricing reserve price In discriminatory auction, each winning bidder pays the price that she or he bid In nondiscriminatory auction, all winning bidders pay the price bid by last successful bidder Reserve price: price below which the seller will not sell the item open reserve price to discourage low-value bidders secret reserve price deters collusion among bidders – their agreed bid may fall below the secret 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 Illustrate with class experiment: auction jar of pennies (See Instructor’s Manual for instructions).

better informed party communicates characteristic through signal Signaling better informed party communicates characteristic through signal cost of signal differs according to characteristic  self-selection  signal is credible Direct way to resolve information asymmetry: appraisal Indirect methods: screening – initiative of party with worse information signaling -- initiative of party with better information: to ensure self-selection: party with good characteristic chooses to buy signal party with bad characteristic does not

Signaling: Examples auto manufacturers – extended warranty Intuit – money-back guarantee on Quicken U.S. publicly-listed companies -- dividends Examples: auto manufacturer offers extended warranty (3/5 years) to signal product quality – manufacturer of poor quality should be less willing to offer extended warranty Intuit offers money-back guarantee on Quicken – this is even broader commitment than warranty, because it signals product’s suitability as well as conformance to technical specifications publicly listed companies pay dividends to signal financial strength: in United States, doesn’t make much sense to pay dividends since they are subject to income tax; companies should retain profit and shareholders get income by selling shares; so there must be another reason -- financially weak companies less able to pay 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 Advertising (building a reputation) is not credible if expenditure can be reversed – then provider of poor quality can also advertise, and get money back buyers cannot detect poor quality, eg, anti-rust treatment for automobiles little repeat business by same or related buyers, eg, fast food restaurants along highways For highway fast food restaurants, solution is to join a franchise: Png and Reitman, Rand Journal (1995): stations along highways were 19% more likely to be affiliated with a major brand than stations off highways.

Contingent Contract Payment is contingent on realized characteristic: international trade -- buyback (supplier of technology must buy future product) mergers and acquisitions – payment in shares Buyback: investor in developing country may have inferior information about technology and market for final product buyback requirement ensures that foreign supplier provides appropriate technology, otherwise it will be saddled with goods that cannot be sold. Payment in shares: acquirer has inferior information about the financial condition and resources of target company shares provides payment that is contingent on success of the merger/acquisition

Contingent Fee Lawyer has better information about likelihood of success at trial contingent fee time-based fee Lawyers who accept contingent fee will select only cases with good chance of success

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.