1. IMBA NCCU Managerial Economics Jack Wu
Imperfect Market
IMBA NCCU
Managerial Economics
Jack Wu

2. Imperfect Market
Externality
Asymmetric Information

3. Externality

4. Externalities one party directly conveys benefit or cost to others
positive
Negative

5. Sak’s Positive Externalities15
13.4
group marginal benefit 10
Sak’s marginal benefit
(Hundred thousand dollars)
Marginal benefit/cost 9
florist’s marginal
benefit 4
profit gain from
additional investment
3.6
marginal
cost 1
0.8 1 5 9 10
shoe store’s
marginal benefit
Hundred thousand dollars of investment

6. Sak’s Negative Externalities10
marginal benefit
profit gain from
reducing investment
(Hundred thousand dollars)
Marginal benefit/cost
group marginal cost b a 2
Sol’s marginal cost 1
Sak’s marginal cost c 5
7.5 9 10
Hundred thousand dollars of investment

7. Resolving Externalities
Economic inefficiency ® opportunity for profit
merger
collective action
When the sum of the marginal benefits is not equal to the sum of the marginal costs
a profit can be made by resolving an externality
profit opportunity disappears when externality is resolved (sum of the marginal benefits equals the sum of the marginal costs)
Merger: doesn’t matter whether source buys recipient of externality, or vice versa
Example: Disneyland
Anaheim: bought hotels around theme park;
Hong Kong: theme park will have authority to exclude aircraft and ships from peeking at fireworks.
Collective action: standards for telecoms and Internet
GSM --> 3rd generation
IEEE standards committees

8. Intel Inside
Externalities
Cooperative advertising resolves positive externality from one retailer to other retailers
(c) , Ivan Png
Compaq frequently advertises its products with the “Intel Inside” label;
potential generates externality for other PC manufacturers using Intel microprocessors
Intel resolves the positive externality through cooperative advertising.
Another example: advertisements by travel agents featuring airlines -- Cathay Pacific, Singapore Airlines, British Airways;
these advertisements benefit other travel agents and also the airlines
airlines should provide cooperative advertising payment to resolve the externality

9. Network Externality
Externality where benefit/cost depends on total number in network
English language
Internet
international telephone service
Network externality need not necessarily be related to service provided through network;
English language: Why is it so useful to learn English? Because so many other people speak and use it -- size of benefit/cost depends on total number in network;
Similarly with Internet and international telephone service

10. Network Effect benefit/cost depends on total number in network
through market, not directly conveyed
resolved by producer or service provider
Network effect
If you are the only person in the world with a telephone, who do you call?
Similarly with MSN Messenger
Difference from network externality: in case of network effect, someone resolves the externality -- the market achieves economic efficiency or approximates
Telephone service: service is concentrated, as of Feb 2001, only 3% of US users had choice of telephone service provider; provider will price relatively low, to stimulate subscribers and hence network effects, because it will capture the additional subscribers
Microsoft resolves network effect surrounding MS-Excel: prices relatively low so that more will use and generate benefit to other users
Similarly, AOL, Yahoo and others provide free Instant Messenger service
Contrast network externality – unresolved by market, so possible role for government
Example -- Internet access. Provision of service is fragmented. If one provider prices low to stimulate demand, the the additional subscribers may join other providers – original price cutter is just generating an externality for other providers.

11. Critical Mass
definition: number of users at which demand becomes positive
Critical mass: examples
Telephone service – Telephone companies understand the importance of critical mass. Long ago, AT&T advocated the concept of “universal service”
MSN Messenger – Little demand because so few people have this service; most people subscribe to AOL Instant Messenger, which is incompatible.

12. Network Effects: Demand Elasticity
highly elastic around tipping point
highly inelastic at low demand levels
Consider history of Microsoft Word vs WordPerfect:
Microsoft invested heavily to achieve critical mass of users – demand very inelastic when MS user base was low
after long and expensive investment, MS got close to tipping point
WordPerfect missed transition from DOS to Windows, then quickly collapsed – demand very elastic around tipping point
Tipping: tendency for the market demand to shift toward a product that has gained a small initial lead
Contrast demand for office productivity software like MS-Word and conventional products, eg, car stereo systems:
demand for car stereos is conventional – no tipping point between brands, competing brands can co-exist for long period of time

13. Asymmetric Information

14. Case: 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?

15. 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

16. 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

17. Wine Market Equilibrium, I8
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: 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)

18. 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

19. 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

20. Market Failure, I combined supply of good and bad vintages8
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)

21. 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

22. 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?

23. 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?

24. 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

25. 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?

26. 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

27. 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?

28. 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

29. 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

30. 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

31. 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).

32. 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

33. Signaling: Examples auto manufacturers – extended warranty
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

34. Moral Hazard
asymmetric information about action
conflict of interest

35. Moral hazard: Doctors
Brazil: among pregnant women, rate of cesarian section
30% (81 of 269) in public hospitals
66% (117 of 177) in private hospitals
Happy coincidence?

36. Moral Hazard in Employment
employer’s marginal benefit
worker’s marginal cost
worker’s marginal benefit
Marg. cost/benefit (cents per unit)
efficient effort
Quantity (units of effort)

37. Resolving Moral Hazard
incentive scheme
conditional payment
quota
monitoring system
incentives must be based on observables

38. Relative Performance employment -- promote the best worker
sports -- gold, silver, bronze
examination – grade on a curve

39. Multiple Responsibilities
strong incentive
more effort on that dimension
less effort on other dimensions

40. Discussion
Fixed Salary
Commission rises from $1000 to $2000
Quota