ManEconCh15 - MANAGERIAL ECONOMICS: THEORY, APPLICATIONS,...

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Unformatted text preview: MANAGERIAL ECONOMICS: THEORY, APPLICATIONS, AND CASES W. Bruce Allen | Keith Weigelt | Neil Doherty | Edwin Mansfield CHAPTER 15 Adverse Selection 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. THE MARKET FOR LEMONS Ackerlofs 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. THE MARKET FOR LEMONS Ackerlofs 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. 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. 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. 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 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...
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This note was uploaded on 03/30/2011 for the course ECON 3020 taught by Professor Lucas during the Spring '10 term at Hawaii Pacific.

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ManEconCh15 - MANAGERIAL ECONOMICS: THEORY, APPLICATIONS,...

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