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IMPERFECT MARKETIMBA NCCU
Managerial Economics
Jack Wu
IMPERFECT MARKET
Externality Asymmetric Information
EXTERNALITY
EXTERNALITIES
one party directly conveys benefit or cost to others� positive� Negative
0
0.81
3.64
15
13.4
10
9
1 5 9 10
group marginal benefit
Sak’s marginal benefit
florist’s marginalbenefit
profit gain fromadditional investment
marginalcost
shoe store’smarginal benefit
Hundred thousand dollars of investment
Marg
inal benefit/
cost
(Hundre
d t
housa
nd d
olla
rs)
SAK’S POSITIVE EXTERNALITIES
0
1
2
10
5 7.5 9 10
ab
c
marginal benefit
group marginal cost
Sol’s marginal cost
Sak’s marginal cost
Hundred thousand dollars of investment
Marg
inal benefit/
cost
(H
undre
d t
housa
nd
dolla
rs)
SAK’S NEGATIVE EXTERNALITIES
profit gain fromreducing investment
RESOLVING EXTERNALITIES
Economic inefficiency opportunity for profit merger collective action
INTEL INSIDE
Cooperative advertising resolves positive externality from one retailer to other retailers
Exte
rna
lities
8
(c) 19
99
-20
01
, Ivan
Pn
g
NETWORK EXTERNALITY
Externality where benefit/cost depends on total number in network English language Internet email international telephone service
NETWORK EFFECTbenefit/cost depends on total number in network through market, not directly conveyed resolved by producer or service provider
CRITICAL MASS
definition: number of users at which demand becomes positive
NETWORK EFFECTS: DEMAND ELASTICITY
highly elastic around tipping pointhighly inelastic at low demand levels
ASYMMETRIC INFORMATION
CASE: 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 INFORMATION
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
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
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, 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
ADVERSE SELECTION
economic inefficiency possible 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, 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 IncomeSingapore
Pacific CenturyHong Kong
Group policy $240 $212
Individual (non-smoker)
$1849 $466
Individual (smoker) $1849 $1120
LIFE INSURANCE, II
group policy avoids adverse selection individual policy attracts adverse selection
no maximum policy coverage medical examination required
APPRAISAL
characteristic is objectively verifiable potential 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 DISCRIMINATION
restricted vis-a-vis unrestricted air fares separate cable channels vis-à-vis bundle cents-off coupons
MULTIPLE ASYMMETRIES
screening mechanisms may conflict example -- 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 METHODS
open/sealed bidding discriminatory/non-discriminatory pricing reserve price
WINNER’S 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
more bidders true value/cost more uncertain sealed-bid auction
• better informed party communicates characteristic through signal
• cost of signal differs according to characteristic self-selection signal is credible
SIGNALING
SIGNALING: EXAMPLES
auto manufacturers – extended warranty U.S. publicly-listed companies -- dividends
MORAL HAZARD
asymmetric information about action conflict of interest
MORAL HAZARD: DOCTORS
• Brazil: among pregnant women, rate of cesarian section– 30% (81 of 269) in public
hospitals– 66% (117 of 177) in private
hospitals
• Happy coincidence?
MORAL HAZARD IN EMPLOYMENT
worker’s marginal cost
employer’s marginal benefit
worker’s marginal benefit
Quantity (units of effort)
Marg
. co
st/b
enefit
(cents
per
unit
)
efficient effort
RESOLVING MORAL HAZARD
incentive scheme conditional payment quota
monitoring system incentives must be based on observables
RELATIVE PERFORMANCE
employment -- promote the best worker sports -- gold, silver, bronze examination – grade on a curve
MULTIPLE RESPONSIBILITIES
strong incentive more effort on that dimension less effort on other dimensions
DISCUSSION
Fixed Salary Commission rises from $1000 to $2000 Quota
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