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ManEconCh15 - MANAGERIAL ECONOMICS THEORY APPLICATIONS AND...

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MANAGERIAL ECONOMICS: THEORY, APPLICATIONS, AND CASES W. Bruce Allen | Keith Weigelt | Neil Doherty | Edwin Mansfield CHAPTER  15 Adverse Selection
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OBJECTIVES Explain how managers can use their  informational advantage to increase  performance and how managers at an  information disadvantage can mitigate the  effect by using creative defenses.
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THE MARKET FOR “LEMONS” Ackerlof’s model Used cars are either gems (which is good) or lemons  (which is bad). Information asymmetry means that sellers have more  information about the quality of the car they are selling  than the buyer does.  Owners of gems are less willing to sell at the average  price because they know that gems are worth more than  the average.
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THE MARKET FOR “LEMONS” Ackerlof’s model (Continued) Owners of lemons are eager to sell at the average price  because they know that lemons are worth less than the  average. As a result, most of the used cars on the market are  lemons. Eventually, the average price of a used car will  be equal to the value of a lemon because no one will  sell a gem. This is a case of adverse selection in that the market  dynamic leads to only lemons being offered for sale on  the used car market.
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ADVERSE SELECTION IN  AUTOMOBILE SELECTION Model Drivers are either high risk or low risk. Both types of drivers start with wealth = 125 and  a loss will reduce wealth to 25. High-risk drivers have a loss with probability  0.75 and their expected loss is therefore (0.75) (100) = 75. Low-risk drivers have a loss with probability  0.25 and their expected loss is therefore (0.25) (100) = 25.
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ADVERSE SELECTION IN  AUTOMOBILE SELECTION Perfect Information Given perfect information, high-risk drivers will  be charged 75 and low-risk drivers will be  charged 25 and, because both are risk averse,  both will buy insurance.
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ADVERSE SELECTION IN  AUTOMOBILE SELECTION Perfect Information (Continued) Assuming that U = (Wealth) 0.5  for both types of drivers, High risk without insurance U = (0.25)(125) 0.5  + (0.75)(25) 0.5  =  6.545 High risk with insurance U = (125 - 75) 0.5  = 7.071 Low risk without insurance U = (0.75)(125) 0.5  + (0.25)(25) 0.5  =  9.635 Low risk with insurance U = (125 - 25) 0.5  = 10 Figure 15.1: Adverse Selection in Automobile Insurance
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ADVERSE SELECTION IN  AUTOMOBILE SELECTION Asymmetric Information If the insurer cannot distinguish between high-  and low risk-drivers, and there are equal  numbers of each, then the average premium  should be 50. High-risk drivers will buy  insurance at this price, but low-risk drivers will  not. Since only high-risk drivers will buy  insurance, the insurance premium must  increase to 75.
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