1. Asymmetric Information
Managerial Economics
Jack Wu

2. 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?

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
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

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
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

5. 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)

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
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

7. 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

8. 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)

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
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

10. 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?

11. 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?

12. 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

13. 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?

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.”
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

15. 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?

16. 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

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

18. 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

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
Illustrate with class experiment: auction jar of pennies (See Instructor’s Manual for instructions).

20. 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

21. 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

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
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.

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
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

24. 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

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.