slides_class9 - Managerial Economics Class 9 1 Asymmetric...

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Managerial Economics – Class 9 1. Asymmetric information 1. Adverse selection 2. Moral hazard 2. Responses 1. Screening 2. Signaling 3. Incentive contracts 1
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Asymmetric Information Asymmetric information exists if some parties to a transactions (individuals or firms) have better information than others. Classic example: Market for used cars Owner is privy to all sorts of information about the car that potential buyers are not Why is the car being sold? Repair costs too high It was damaged in an accident then repaired
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Two common scenarios that give rise to asymmetric information Hidden characteristics One party to a transaction knows something about itself that the other party doesn’t. This raises possibility of adverse selection. Example: Health Insurance Some individuals will not buy insurance until they get sick. This is why there are exclusions for preexisting conditions. Hidden actions One party to a transaction takes actions that cannot be observed by the other party. This raises the possibility of moral hazard . Example: Auto Insurance Some individuals with zero deductible policies may drive less carefully than they otherwise would because they bear no financial responsibility for an accident
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Possible responses to adverse selection 1. Screening Uninformed party attempts to sort individuals according to their unobserved characteristics. Often accomplished through a self-selection device Informed parties presented with a set of options, and the option that they choose reveals their hidden characteristics. Example: Second-degree price discrimination (volume discounts) 2. Signaling Informed party attempts to send an observable indicator of his or her hidden characteristics to an uninformed party. To work, the signal must not be easily mimicked by other types. Example: Higher education (MBA degree)
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Possible response to moral hazard 1. Use of incentive contracts Uninformed party designs a contract that incentivizes informed party to take the desired action. Example: Employment contracts (base pay plus year-end bonus that is based on performance)
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Decisions under uncertainty Need to know risk preferences to understand how individuals make decisions under uncertainty We will assume individuals are risk averse A sure payoff $X is always preferred to an uncertain payoff that has an expected value of $X Example: Toss a fair coin. “Head” => receive $6400. “Tails” => receive $0. Risk averse individual prefers $3200 for sure. Expected Utility The intrinsic value that an individual places on have wealth of any given level Risk averse individual has a concave utility function Example: E[U(W)]= E[W 1/2 ]
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Calculating expected utility Consider coin tossing example from the previous slide Suppose individual’s initial wealth is $3600 E[U(W)]= E[W 1/2 ] We have Gamble => E[U(W)]= 0.5(3600+6400) 1/2 +0.5(3600) 1/2 = 80 Sure thing => E[U(W)]= (3600+3200) 1/2 = 82.5 Implicit assumption is that individuals will always choose option that offers highest expected utility 7
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