Week 12 A

Week 12 A - COMM 295 November 23, 2010 Asymmetric...

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COMM 295 November 23, 2010 Asymmetric Information More Detail and Solutions Added to Select Slides
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Self Selection Self selection: hidden characteristics are revealed through a person’s choice of action There are two types of workers (50% of each type): good workers, worth $20/hour to your firm, and bad workers, worth $10/hour to your firm. If you can’t distinguish workers when hiring, what is the most you are willing to offer a randomly chosen worker? How would your answer change if you knew that good workers would choose to be self-employed rather than working for less than $18/hour, whereas bad workers have no other options? Good workers self-select away from applying for your job and bad workers self select toward applying for your job. You must account for self-selection when setting wages
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Solution • If both types of workers automatically apply (i.e., zero opportunity cost), and employer can’t distinguish between them, then offer worker: Expected Value = 0.5(10) + 0.5*(20) = $15/hour • If good workers select away from applying if wage is below $18/hour, then only low quality workers will apply • Employer knowing that only low apply will offer wage of $10 hour instead of $15 • DWL because good worker earns $18; not $20
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Self Selection Example An auto insurance company realizes there are an equal number of three types of indistinguishable drivers : good (5% chance of $1000 claim); medium (10% chance of $1000 claim); and bad (18% chance of $1000 claim) (a) Assuming zero fixed costs, what is the lowest price of insurance that would be set if insurance was mandatory? How is each type of driver impacted by the asymmetric information? Is there a net social loss in the equilibrium? (b) What is the lowest price if insurance wasn’t mandatory, and if drivers chose not to buy insurance if the price was more than double the expected sized of the claim? Is there a net social loss in the equilibrium?
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Solution • With mandatory insurance, and a 1/3 chance of each type, the expected claim is E{Claim} = [(1/3)(.05)+ (1/3)(.1)+ (1/3)(.18)](1000) = 0.33*1000/3 = 110 • To break even insurance company sets insurance price equal to $110 • The high risk drivers pay less than their “fair” rate • The low & medium drivers pay more than their “fair” rate cross subsidy, but no mkt failure
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This note was uploaded on 01/03/2011 for the course COMM 290 taught by Professor Brian during the Winter '09 term at UBC.

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Week 12 A - COMM 295 November 23, 2010 Asymmetric...

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