1. I MPERFECT M ARKET IMBA NCCU Managerial Economics Jack Wu

2. IMPERFECT MARKET Externality Asymmetric Information

3. E XTERNALITY

4. E XTERNALITIES one party directly conveys benefit or cost to others  positive  Negative

5. 0 0.8 1 3.6 4 15 13.4 10 9 159 group marginal benefit Sak’s marginal benefit florist’s marginal benefit profit gain from additional investment marginal cost shoe store’s marginal benefit Hundred thousand dollars of investment Marginal benefit/cost (Hundred thousand dollars ) SAK ’ S POSITIVE EXTERNALITIES

6. 0 1 2 10 57.5910 a b c marginal benefit group marginal cost Sol’s marginal cost Sak’s marginal cost Hundred thousand dollars of investment Marginal benefit/cost (Hundred thousand dollars) SAK ’ S NEGATIVE EXTERNALITIES profit gain from reducing investment

7. R ESOLVING E XTERNALITIES Economic inefficiency  opportunity for profit merger collective action

8. I NTEL I NSIDE Cooperative advertising resolves positive externality from one retailer to other retailers Externalities 8 (c) 1999-2001, Ivan Png

9. N ETWORK E XTERNALITY Externality where benefit/cost depends on total number in network English language Internet email 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

11. C RITICAL M ASS definition: number of users at which demand becomes positive

12. N ETWORK E FFECTS : D EMAND E LASTICITY highly elastic around tipping point highly inelastic at low demand levels

13. A SYMMETRIC I NFORMATION

14. C ASE : NTUC I NCOME : P REMIUMS FOR $200,000 L IFE I NSURANCE femalemale civil servant group policy maximum coverage limit no medical exam $240 individual policy no maximum coverage medical exam required $991$1849

15. I MPERFECT /A SYMMETRIC I NFORMATION 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

16. R ISK 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

17. 0 2 3 5 7 8 1238 supply of good vintage combined supply of good and bad vintage actual demand (marginal benefit) demand (marginal benefit) for good vintage Quantity (Thousand cases a month) Price (Hundred $ per case) WINE MARKET EQUILIBRIUM, I

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

19. A DVERSE S ELECTION economic inefficiency possible market failure

20. 0 2 8 F8 c d combined supply of good and bad vintages actual demand (marginal benefit) demand (marginal benefit) for good vintage Quantity (Thousand cases a month) Price (Hundred $ per case) MARKET FAILURE, I

21. M ARKET F AILURE, 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

22. L IFE I NSURANCE, 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)$1849$1120

23. L IFE I NSURANCE, II group policy avoids adverse selection individual policy attracts adverse selection no maximum policy coverage medical examination required

24. A PPRAISAL characteristic is objectively verifiable potential gain covers appraisal cost

25. less informed party indirectly elicits other party’s characteristic through structured choice better informed party must be differentially sensitive to the choice S CREENING

26. W HO ’ 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. ”

27. I NDIRECT S EGMENT D ISCRIMINATION restricted vis-a-vis unrestricted air fares separate cable channels vis- à -vis bundle cents-off coupons

28. M ULTIPLE A SYMMETRIES screening mechanisms may conflict example -- auto insurance policy: higher deductible screens out bad drivers screens out more risk-averse

29. A UCTION 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

30. A UCTION M ETHODS open/sealed bidding discriminatory/non-discriminatory pricing reserve price

31. W INNER ’ S C URSE 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

32. better informed party communicates characteristic through signal cost of signal differs according to characteristic  self-selection  signal is credible S IGNALING

33. S IGNALING : E XAMPLES auto manufacturers – extended warranty U.S. publicly-listed companies -- dividends

34. M ORAL H AZARD asymmetric information about action conflict of interest

35. M ORAL HAZARD : D OCTORS 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. M ORAL H AZARD IN E MPLOYMENT worker’s marginal cost employer’s marginal benefit worker’s marginal benefit Quantity (units of effort) Marg. cost/benefit (cents per unit) efficient effort

37. RESOLVING MORAL HAZARD incentive scheme conditional payment quota monitoring system incentives must be based on observables

38. R ELATIVE P ERFORMANCE employment -- promote the best worker sports -- gold, silver, bronze examination – grade on a curve

39. M ULTIPLE R ESPONSIBILITIES strong incentive more effort on that dimension less effort on other dimensions

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