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