Professional Documents
Culture Documents
male
$240
$991
$1849
IMPERFECT/ASYMMETRIC INFORMATION
imperfect information absence of certain knowledge (uncertainty) asymmetric information -- one party has better information than the other
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
3 2
actual marginal benefit (adjusted for prob of getting bad vintage) = price actual marginal cost (of good vintage) = price
ADVERSE SELECTION
economic inefficiency possible market failure
MARKET FAILURE, I
8 Price (Hundred $ per case)
2 0
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
LIFE INSURANCE, I
Coverage = $200,000 for 43 year-old male
NTUC Income Singapore Group policy $240 Pacific Century Hong Kong $212
Individual (nonsmoker)
Individual (smoker)
$1849
$1849
$466
$1120
LIFE INSURANCE, II
group policy avoids adverse selection individual policy attracts adverse selection
APPRAISAL
characteristic is objectively verifiable potential gain covers appraisal cost
SCREENING
less informed party indirectly elicits other partys characteristic through structured choice better informed party must be differentially sensitive to the choice
MULTIPLE ASYMMETRIES
screening mechanisms may conflict example -- auto insurance policy: higher deductible
AUCTION
auctions to sell: seller doesnt know buyers valuations auctions to buy: buyer doesnt know sellers costs use competitive pressure to force bidders to reveal their information
AUCTION METHODS
open/sealed bidding discriminatory/non-discriminatory pricing reserve price
WINNERS 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
SIGNALING
better informed party communicates characteristic through signal cost of signal differs according to characteristic self-selection signal is credible
SIGNALING: EXAMPLES
auto manufacturers extended warranty Intuit money-back guarantee on Quicken U.S. publicly-listed companies -- 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 sellers future business
CONTINGENT CONTRACT
Payment is contingent on realized characteristic:
international trade -- buyback (supplier of technology must buy future product) mergers and acquisitions payment in shares
CONTINGENT FEE
Lawyer has better information about likelihood of success at trial contingent fee time-based fee
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.