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