Asymmetric Information:
 
Chapter Summary:

In conditions of asymmetric information, the allotment of resources will not be economically proficient. The asymmetry can be solved directly via appraisal or indirectly via screening, signaling, or contingent payments. The indirect techniques based on inducing self-selection among parties with various characteristics.

Screening is an initiative of the party with less information, whereas signaling is an initiative of the party with enhanced information.

The key business application of screening is indirect segment discrimination in pricing. An associated application is auctions that exploit strategic interaction between competing bidders to force bidders with high values to pay high prices.

Whenever the distribution of information is asymmetric, one or more parties will contain imperfect information and therefore bear risk. The distribution of risk might conflict with the self-selection required to solve the asymmetric information.
 
Key Concepts:

General Chapter Objectives:

A) Discuss the perceptions of imperfect information, risk aversion and asymmetric information.

B) Appreciate the managerial implications of adverse selection and particularly, the prospect of market failure.

C) Examine how asymmetric information can be solved via appraisal.

D) Examine how asymmetric information can be solved via screening.

E) Discuss two particular applications of screening: auctions and indirect segment discrimination.

F) Examine how asymmetric information can be solved via signaling.

G) Examine how asymmetric information can be solved via contingent payment.

H) Apply the theory of asymmetric information to lending and the insurance markets.
 
Notes:

1) Asymmetric information:

a) Imperfect information: the deficiency of certain knowledge by a single person or by more than one party.

i) Risk (or uncertainty regarding benefits or costs) occurs whenever there is imperfect information regarding something which affects costs or benefits.

Note: a person can contain imperfect information regarding something, however if that thing doesn’t affect her/his costs or benefits, it doesn’t impose any risk on her/him.

• A risk averse person is one who favors a certain amount to risky amounts with similar expected value.
• A risk-neutral person is indifferent.
• Insurance is the business of taking some payments in exchange for removing risk.

ii) A market could be perfectly competitive even whenever sellers and buyers have imperfect information, as long as they all have similar imperfect information.

b) Asymmetric information: one party has enhanced information than the other, example: insurance, antiques and lending markets.

i) Whenever the distribution of information is asymmetric, one or more parties will encompass imperfect information and therefore bear risk.

ii) Can’t be a perfectly competitive market.

iii) In an imperfectly competitively market, when sellers and buyers can solve the information asymmetries, they can raise benefits by more than their costs.
 
2) Equilibrium in the market with asymmetric information:

a) The equilibrium in a market with asymmetric information might not be economically proficient. For illustration, whenever fakes are introduced in an antiques market:

i) Each buyer purchases up to the point where its real marginal benefit (that is, adjusted down for the probability of getting a fake) balances the market price. Each and every legitimate seller supplies up to the point where its marginal cost balances the market price.

ii) Buyers who get genuine items encompass a marginal benefit greater than the legitimate seller’s marginal cost. Buyers who get fakes encompass a marginal benefit less than the legitimate seller’s marginal cost.

iii) At equilibrium, marginal benefit doesn’t equivalent marginal cost:

• The quantity traded is not economically proficient.
• Consequence on buyer’s excess is ambiguous. Buyer surplus drops as certain buyers get fakes. Buyer surplus increases as market price drops and whenever sales are higher.
• Legitimate sellers obtain a lower price and sell some units. Sellers of fakes are the only one which is better off.

iv) Sellers of fakes entail a negative externality on the buyers and legitimate sellers.

v) By solving the negative externality (that is, information asymmetry), benefits will rise by more than costs, and a gain can be made.

b) Adverse selection occurs in conditions of asymmetric information. In adverse selection, the party with comparatively poor information draws a choice with comparatively less attractive characteristics. Rigorous adverse choice can cause a market to fail, and price modifications do not aid to restore equilibrium. For illustration: when fakes are mentioned in an antiques market:

i) Antiques buyers with less information draw a mixture of fakes and authentic antiques that is an adverse choice of items.

ii) Since market price drops, legitimate sellers supply the smaller quantity.
Quantity of fakes is not influenced, rising the proportion of fakes, leaving buyers with a worse adverse choice. Price reductions cuts demand and supply and doesn’t essentially restore the equilibrium.

iii) In extreme, too many fakes flood the market which actual demand curve drops to zero and the market fails (that is, there is no sale at all).
 
3) Appraisal:

a) Appraisal (comprising credit checks, employment records in the lending market) can directly solve asymmetric information, example: Moody’s appraisals.

b) Appraisal works only when:

i) The feature about which information is asymmetric is objectively confirmable.

ii) The potential profit (for buyer: difference between the marginal benefit and market price; for seller: difference between the market price and marginal cost) covers the cost of appraisal.

c) Procuring the appraisal: Seller must obtain the appraisal if:

i) There are lots of potential buyers; this is more economical for the seller to receive the appraisal that is like a public good.
ii) Different potential buyers seek similar information.
 
4) Screening:

a) Screening: the initiative of a less-informed party to indirectly draw the other party’s characteristics, example: points in home mortgages, physical exams for life insurance applicants.

i) An indirect manner to solve asymmetric information.

ii) It works only when the less informed party can recognize and control some variable which the better-informed parties are differentially sensitive too.

iii) The less informed party should design choices or structure a set of alternatives around which variable to induce the self-selection.

iv) In self-selection, parties with various features select dissimilar alternatives.

b) Differentiating variable:

i) Put more emphasis on the more efficient variable: the variable which drives the biggest probable wedge among the better-informed parties with various features.

ii) Use a combination of differentiating variables (example: restrictions, advice booking, and weekend stay-over to screen between leisure in respect of business travelers).

c) Multiple un-observable characteristics:

i) When a party is un-informed regarding several characteristics, then screening based on single differentiating variable might not resolve the asymmetry.

ii) To solve information asymmetries via screening, the less-informed party requires as many differentiating variables (example: a selection of high and low deductible polices) as there are features (example: driver’s carefulness and degree of risk aversion) which it can’t observe.

d) Indirect segment discrimination is an application of the screening. A seller who is less informed regarding how much the buyer is ready to pay for an item employs screening to induce self-selection among buyers with various features.

e) Auctions are the other application of screening. A seller who does not know buyer’s valuations can employ an auction to sell, whereas a buyer does not know seller’s costs can utilize an auction to buy. Auctions exploit strategic interaction between competing bidders to encourage self-selection between the participants accordingly to their respective values for the item (that is, forcing bidders with high values to pay high prices).

i) The differentiating variable is the probability of winning.

ii) An auction might be sealed or open.

• Open bid auctions: higher potential for the collusion among bidders.
• Sellers can counter the collusion by applying reserve price. The reserve price is the price beneath which the seller will not sell the item. Whenever there are lots of bidders, it is more likely that at-least one bidder will surpass the reserve price, and the auction will not fail.

iii) In discriminatory auction, each and every winning bidder pays the price which she or he bid. In a non-discriminatory auction, each and every winning bidder pays the price bid by the marginal winning bidder.

• The bidders make relatively higher bids in non-discriminatory auctions.
• Seller’s revenues in a non-discriminatory auction might or might not be higher.

iv) Uncertainly regarding the value of the item for sale.

• The winner’s curse in an auction to purchase is the phenomenon where the winning bidder over-estimates the correct value of the item for sale, and in auction to sell is the phenomenon where the winning bidder under-estimates the correct cost of providing the item.  
• The winner’s curse is more rigorous if: number of bidders is bigger, correct value of the item is much uncertain, and in a sealed-bid as compared with the open auction.
• Whenever the winner’s curse is much severe, a bidder must bid more conservatively.

5) Signaling:

a) Signaling: an action initiated by better-informed party to communicate its features in a credible manner to the less-informed party.

i) An indirect manner to solve asymmetric information.
ii) Signaling is credible simply if it induces the self-selection among the better-informed parties (example: buy back offers by the sellers of genuine antiques).

b) Costless signaling is not reliable. The cost of signal should be sufficiently lower for parties with superior features than for parties with lower features.

c) Three conditions for advertising to be a reliable signal of product quality:

i) Investment should be sunk: a reversible investment is not reliable (example: reputation built up over a long-time).
ii) The buyers detect poor quality rapidly.
iii) The information should negatively influence the seller (that is, word of poor quality should spread and cut into seller’s future business).
 
6) Contingent payment:

a) Contingent payment: it is a payment made up if a specific event takes place, example: bets.

i) An indirect manner to solve asymmetric information.
ii) Encourages self-selection among the better-informed parties (example: sellers offering products of various qualities).
iii) Might serve as screens or signals (example: selling a tract for sharing of the production).

b) Promises and threats might include contingent payments.

c) Insurance compensation is the contingent payment, example: in the event of illness or death.

Question-Answer:

A life insurance policy gives a payment in case of the death of insured party. Some life insurers need applicants to undergo a medical exam, whereas other insurers do not. Some life insurers set restrictions to the quantity of the insurance coverage.

a) Why do certain life insurers need applicants to undergo a medical exam?

b) Describe the adverse selection trouble which will occur from offers of life insurance with no medical exam.

c) How would the premiums (that is, per dollar of coverage) for insurance with no medical exam compare with such of insurers which need a medical exam?

d) When an insurer does not need a medical exam, must it set a limit to the quantity of the insurance coverage?
 
Answer:

a) A medical examination is a form of screening. The exam permits a life insurer to collect information regarding an applicant’s health, and therefore decrease adverse selection.

b) Offering life insurance devoid of a medical exam will form adverse selection, as this will draw people who are somewhat in poor health and therefore more likely to make claims.

c) Premiums for insurance devoid of medical examinations should take account of adverse choice, therefore will be higher than such for insurance which need medical exams.

d) By setting a limit to the quantity of insurance coverage, the insurer can limit the losses due to the adverse selection.

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