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Managerial EconomicsJack Wu
NTUC Income: Premiums for $200,000 Life Insurance
female male
civil servant group policy• maximum coverage limit• no medical exam
$240 $240
individual policy• no maximum coverage• medical exam required
$991 $1849
Imperfect/Asymmetric Informationimperfect 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
Riskuncertainty about benefit or costarises from imperfect informationrisk-averse person prefers certain payment to
uncertain payments with same expected value
risk-averse person will buy insurance
0
2
3
5
7
8
1 2 3 8
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)
Pri
ce (
Hun
dre
d $
per
case
)
Wine Market Equilibrium, I
Wine Market Equilibrium, IIactual demand = combined supply of good
and badat equilibrium price
actual marginal benefit (adjusted for prob of getting bad vintage) = price
actual marginal cost (of good vintage) = price
Adverse Selectioneconomic inefficiencypossible market failure
0
2
8
F 8
c
d
combined supply of good and bad vintages
actual demand(marginal benefit)
demand (marginal benefit)for good vintage
Quantity (Thousand cases a month)
Pri
ce (
Hun
dre
d $
per
case
)
Market Failure, I
Market Failure, IIconventional market: when supply exceeds
demand, lower price restores equilibriumwine 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 IncomeSingapore
Pacific CenturyHong Kong
Group policy $240 $212
Individual (non-smoker)
$1849 $466
Individual (smoker) $1849 $1120
Life Insurance, IIgroup policy avoids adverse selectionindividual policy attracts adverse selection
no maximum policy coveragemedical examination required
Appraisalcharacteristic is objectively verifiablepotential gain covers appraisal cost
• less informed party indirectly elicits other party’s characteristic through structured choice
• better informed party must be differentially sensitive to the choice
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.”
Indirect Segment Discriminationrestricted vis-a-vis unrestricted air faresseparate cable channels vis-à-vis bundlecents-off coupons
Multiple Asymmetriesscreening mechanisms may conflictexample -- auto insurance policy: higher
deductible screens out bad drivers screens out more risk-averse
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
Auction Methodsopen/sealed biddingdiscriminatory/non-discriminatory pricing reserve price
Winner’s CurseIn auction to buy: winning bidder over-
estimates the true valueIn auction to sell: winning bidder under-
estimates the true costMore severe where
more bidderstrue value/cost more uncertainsealed-bid auction
• better informed party communicates characteristic through signal
• cost of signal differs according to characteristic self-selection signal is credible
Signaling
Signaling: Examplesauto manufacturers – extended warrantyIntuit – money-back guarantee on QuickenU.S. publicly-listed companies -- dividends
Advertising as a signaladvertising expenditure must be sunkbuyers must be able to detect poor qualityinformation about poor quality must quickly
spread and cut into seller’s future business
Contingent ContractPayment is contingent on realized characteristic:
international trade -- buyback (supplier of technology must buy future product)
mergers and acquisitions – payment in shares
Contingent FeeLawyer has better information about likelihood of success at trial contingent fee time-based fee
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