1. Asymmetric Information

2. 2 (c) 1999-2007, I.P.L. Png & D.E. Lehman Outline  imperfect information  adverse selection  appraisal  screening  signaling

3. 3 (c) 1999-2007, I.P.L. Png & D.E. Lehman Imperfect vis-à-vis Asymmetric Information  imperfect information – absence of certain knowledge (uncertainty)

4. 4 (c) 1999-2007, I.P.L. Png & D.E. Lehman Risk  Imperfect information (uncertainty) regarding your benefit or loss  Risk neutral: you only care about expected payoff  Risk averse: you don’t like uncertainty. Even if the expected payoff is the same, you will prefer the situation with lower degree of uncertainty.

5. 5 (c) 1999-2007, I.P.L. Png & D.E. Lehman Asymmetric information  asymmetric information – it involves two or more parties, while one party has better information than the other  party with worse information also suffers from imperfect information

6. 6 (c) 1999-2007, I.P.L. Png & D.E. Lehman Outline  imperfect information  adverse selection  appraisal  screening  signaling

7. 7 (c) 1999-2007, I.P.L. Png & D.E. Lehman Adverse Selection  economic inefficiency  possible market failure

8. 8 (c) 1999-2007, I.P.L. Png & D.E. Lehman Adverse selection  Definition: Party with less information draws a selection of bad attributes.  Consequences  economic inefficiency  possible market failure

9. 9 (c) 1999-2007, I.P.L. Png & D.E. Lehman Genuine and Fake Antiques Adverse Selection Genuine and Fake Antiques

10. 10 (c) 1999-2007, I.P.L. Png & D.E. Lehman  Actual demand = combined supply of genuine and fake  At equilibrium price  actual marginal benefit (adjusted for probability of getting fake) = price  actual marginal cost (of genuine) = price Adverse selection: Market equilibrium

11. 11 (c) 1999-2007, I.P.L. Png & D.E. Lehman Market Failure Adverse Selection: Market Failure

12. 12 (c) 1999-2007, I.P.L. Png & D.E. Lehman Market Failure Adverse Selection: Market Failure  conventional market: when supply exceeds demand, lower price restores equilibrium  antique market with adverse selection: lower price drives out genuine, leaving even worse adverse selection

13. 13 (c) 1999-2007, I.P.L. Png & D.E. Lehman Adverse selection: Group vis- à -vis individual term life insurance  Group policy avoids adverse selection  covers specific class of people  limits coverage  Individual policy attracts adverse selection  open to everyone, regardless of occupation  no maximum policy coverage

14. 14 (c) 1999-2007, I.P.L. Png & D.E. Lehman Term life insurance premiums Adverse Selection: The Hartford; Term life insurance premiums Massachusetts Group Insurance Commission plan General public (for coverage of less than $500,000) AgeSmokerNon-smokerSmokerNon-smoker Under 35$0.09$0.05$0.10$0.06 35 – 44$0.13$0.06$0.15$0.08 45 – 49$0.24$0.09$0.26$0.13 50 – 54$0.38$0.15$0.35$0.18 55 – 59$0.58$0.23$0.43$0.25 60 – 64$0.88$0.34$0.58$0.36 65 – 69$1.57$0.83$0.89$0.57 70 and over$2.81$1.30$1.16$0.75 (age 70 only) (monthly, per $1,000 of coverage)

15. 15 (c) 1999-2007, I.P.L. Png & D.E. Lehman Life Insurance for Some or for All?  The Hartford offers $5000 of life insurance for all state of Massachusetts employees and optional additional insurance up to 8 times their annual salary  Premiums vary by age and smoking status  Hartford insurance for the general public for premiums which vary by age and smoking status (and which require a physical exam)  Insurance premiums for the general public are considerably higher than for group insurance for State employees  Why?

16. 16 (c) 1999-2007, I.P.L. Png & D.E. Lehman Outline  imperfect information  adverse selection  appraisal  screening  signaling

17. 17 (c) 1999-2007, I.P.L. Png & D.E. Lehman Appraisal  Directly resolving information asymmetry  Unknown attribute must be objectively verifiable  Potential gain must cover appraisal cost

18. 18 (c) 1999-2007, I.P.L. Png & D.E. Lehman Appraisal: Moody ’ s  Charges issuers for rating Rating10-year cumulative default rate Aaa0.40% Aa0.25%-0.33% A0.84%-1.69% Baa2.31%-7.20% Ba12.38%-36.24% B47.43%-62.32% Caa-C78.81%

19. 19 (c) 1999-2007, I.P.L. Png & D.E. Lehman Appraisal: Who procures?  Does seller or buyer procure the appraisal?  Factors:  number of buyers  nature of unknown attributes – common/specific to various less informed parties

20. 20 (c) 1999-2007, I.P.L. Png & D.E. Lehman Appraisal: Who procures?  Usually, the informed party will procure the appraisal  Appraisal is public good – can be supplied to all uninformed parties at no additional cost.  Larger the number of uninformed parties, greater the saving if informed party procures appraisal.

21. 21 (c) 1999-2007, I.P.L. Png & D.E. Lehman Sampling  Directly resolving information asymmetry  Unknown attribute need not be objectively verifiable  Sampling can resolve asymmetry about subjective attributes  Potential gain must cover sampling cost  low-cost items, eg, wine tasting  some high-cost items, eg, car test drive

22. 22 (c) 1999-2007, I.P.L. Png & D.E. Lehman Sampling: Examples  wines  food  books, movies, music  software  pharmaceuticals  cosmetics  cars (test-drive)  resorts

23. 23 (c) 1999-2007, I.P.L. Png & D.E. Lehman Outline  imperfect information  adverse selection  appraisal  screening  signaling

24. 24 (c) 1999-2007, I.P.L. Png & D.E. Lehman Screening  Less informed party indirectly elicits other party’s characteristic through structured choice  Better informed party must be differentially sensitive to the choice

25. 25 (c) 1999-2007, I.P.L. Png & D.E. Lehman Who’s the real mother? Screening: 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.”

26. 26 (c) 1999-2007, I.P.L. Png & D.E. Lehman Indirect Segment Discrimination Screening: Indirect Segment Discrimination  restricted vis-a-vis unrestricted air fares  separate cable channels vis-à-vis bundle  cents-off coupons

27. 27 (c) 1999-2007, I.P.L. Png & D.E. Lehman Criminal Justice System Screening: Criminal Justice System Defendant might expose his guilt on witness stand  Common Law - right to remain silent  Civil Law - court can draw inference from defendant’s silence

28. 28 (c) 1999-2007, I.P.L. Png & D.E. Lehman Multiple Asymmetries Screening: Multiple Asymmetries  screening mechanisms may conflict  example -- auto insurance policy: higher deductible  screens out bad drivers  screens out more risk-averse

29. 29 (c) 1999-2007, I.P.L. Png & D.E. Lehman Outline  imperfect information  adverse selection  appraisal  screening  signaling

30. 30 (c) 1999-2007, I.P.L. Png & D.E. Lehman Dividend policy  U.S. publicly-listed companies  Dividends are costly – subject to double taxation (corporate and shareholder levels).  Why pay dividends?

31. 31 (c) 1999-2007, I.P.L. Png & D.E. Lehman Signaling  Better informed party communicates attribute through signal  Cost of signal differs according to attribute:  self-selection  signal is credible

32. 32 (c) 1999-2007, I.P.L. Png & D.E. Lehman Examples Signaling: Examples  auto manufacturers – extended warranty  Intuit – money-back guarantee on Quicken  U.S. publicly-listed companies -- dividends

33. 33 (c) 1999-2007, I.P.L. Png & D.E. Lehman Signaling:  Sellers offer Rebate to encourage credit rating in internet shopping

34. 34 (c) 1999-2007, I.P.L. Png & D.E. Lehman Advertisingand Reputation Signaling: Advertising and Reputation  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

35. 35 (c) 1999-2007, I.P.L. Png & D.E. Lehman Outline  imperfect information  adverse selection  appraisal  screening  signaling  contingent contract

36. 36 (c) 1999-2007, I.P.L. Png & D.E. Lehman Contingent Contract Payment is contingent on realized characteristic:  international trade -- buyback (supplier of technology must buy future product)  mergers and acquisitions – payment in shares

37. 37 (c) 1999-2007, I.P.L. Png & D.E. Lehman Contingent Fee Contingent Contract: Contingent Fee Lawyer has better information about likelihood of success at trial  contingent fee  time-based fee

38. 38 (c) 1999-2007, I.P.L. Png & D.E. Lehman Resolving Information Asymmetry  direct methods  appraisal  sampling  indirect methods  screening  signaling  contingent payment

39. 39 (c) 1999-2007, I.P.L. Png & D.E. Lehman Multiple information asymmetries: Personnel selection  appraisal – interview, test  sampling – summer job  screening – performance-based compensation  signaling – education (“resume building”)

40. 40 (c) 1999-2007, I.P.L. Png & D.E. Lehman Applicability  Corporate finance  Foreign direct investment  Insurance  Auctions and procurement  Human resource policy