Asymmetric Information

2(c) 1999-2007, I.P.L. Png & D.E. Lehman

OutlineOutline

imperfect information adverse selection appraisal screening signaling

3(c) 1999-2007, I.P.L. Png & D.E. Lehman

Imperfect vis-à-vis Asymmetric Information

imperfect information – absence of certain knowledge (uncertainty)

4(c) 1999-2007, I.P.L. Png & D.E. Lehman

Risk

Imperfect information (uncertainty) regarding your benefit or loss

Risk neutral: you only care about expected payoff

Risk averse: you don’t like uncertainty. Even if the expected payoff is the same, you will prefer the situation with lower degree of uncertainty.

5(c) 1999-2007, I.P.L. Png & D.E. Lehman

Asymmetric information

asymmetric information – it involves two or more parties, while one party has better information than the other party with worse information also suffers

from imperfect information

6(c) 1999-2007, I.P.L. Png & D.E. Lehman

OutlineOutline

imperfect information adverse selection appraisal screening signaling

7(c) 1999-2007, I.P.L. Png & D.E. Lehman

Adverse Selection

economic inefficiency possible market failure

8(c) 1999-2007, I.P.L. Png & D.E. Lehman

Adverse selection

Definition: Party with less information draws a selection of bad attributes.

Consequences economic inefficiency possible market failure

9(c) 1999-2007, I.P.L. Png & D.E. Lehman

Adverse Selection Genuine and Fake Genuine and Fake AntiquesAntiques

10(c) 1999-2007, I.P.L. Png & D.E. Lehman

Actual demand = combined supply of genuine and fake

At equilibrium price actual marginal benefit (adjusted for

probability of getting fake) = price actual marginal cost (of genuine) = price

Adverse selection:Market equilibrium

11(c) 1999-2007, I.P.L. Png & D.E. Lehman

Adverse Selection: Market FailureMarket Failure

12(c) 1999-2007, I.P.L. Png & D.E. Lehman

Adverse Selection: Market FailureMarket Failure

conventional market: when supply exceeds demand, lower price restores equilibrium

antique market with adverse selection: lower price drives out genuine, leaving even worse adverse selection

13(c) 1999-2007, I.P.L. Png & D.E. Lehman

Adverse selection: Group vis-à-vis individual term life insurance

Group policy avoids adverse selection covers specific class of people limits coverage

Individual policy attracts adverse selection open to everyone, regardless of

occupation no maximum policy coverage

14(c) 1999-2007, I.P.L. Png & D.E. Lehman

Adverse Selection:The Hartford; Term life insurance Term life insurance premiumspremiums

Massachusetts Group Insurance Commission plan

General public (for coverage of less than $500,000)

Age Smoker Non-smoker

Smoker Non-smoker

Under 35 $0.09 $0.05 $0.10 $0.06

35 – 44 $0.13 $0.06 $0.15 $0.08

45 – 49 $0.24 $0.09 $0.26 $0.13

50 – 54 $0.38 $0.15 $0.35 $0.18

55 – 59 $0.58 $0.23 $0.43 $0.25

60 – 64 $0.88 $0.34 $0.58 $0.36

65 – 69 $1.57 $0.83 $0.89 $0.57

70 and over $2.81 $1.30 $1.16 $0.75

(age 70 only) (age 70 only)(monthly, per $1,000 of coverage)

15(c) 1999-2007, I.P.L. Png & D.E. Lehman

Life Insurance for Some or for All?

The Hartford offers $5000 of life insurance for all state of Massachusetts employees and optional additional insurance up to 8 times their annual salaryPremiums vary by age and smoking statusHartford insurance for the general public for premiums which vary by age and smoking status (and which require a physical exam)Insurance premiums for the general public are considerably higher than for group insurance for State employeesWhy?

16(c) 1999-2007, I.P.L. Png & D.E. Lehman

OutlineOutline

imperfect information adverse selection appraisal screening signaling

17(c) 1999-2007, I.P.L. Png & D.E. Lehman

Appraisal

Directly resolving information asymmetry

Unknown attribute must be objectively verifiable

Potential gain must cover appraisal cost

18(c) 1999-2007, I.P.L. Png & D.E. Lehman

Appraisal: Moody’s

Charges issuers for rating

Rating 10-year cumulative default rate

Aaa 0.40%

Aa 0.25%-0.33%

A 0.84%-1.69%

Baa 2.31%-7.20%

Ba 12.38%-36.24%

B 47.43%-62.32%

Caa-C 78.81%

19(c) 1999-2007, I.P.L. Png & D.E. Lehman

Appraisal: Who procures?

Does seller or buyer procure the appraisal?

Factors: number of buyers nature of unknown attributes –

common/specific to various less informed parties

20(c) 1999-2007, I.P.L. Png & D.E. Lehman

Appraisal: Who procures?

Usually, the informed party will procure the appraisal Appraisal is public good – can be

supplied to all uninformed parties at no additional cost.

Larger the number of uninformed parties, greater the saving if informed party procures appraisal.

21(c) 1999-2007, I.P.L. Png & D.E. Lehman

Sampling

Directly resolving information asymmetry

Unknown attribute need not be objectively verifiable Sampling can resolve asymmetry about

subjective attributes Potential gain must cover sampling cost

low-cost items, eg, wine tasting some high-cost items, eg, car test drive

22(c) 1999-2007, I.P.L. Png & D.E. Lehman

Sampling: Examples

wines foodbooks, movies,

musicsoftwarepharmaceuticalscosmeticscars (test-drive)resorts

23(c) 1999-2007, I.P.L. Png & D.E. Lehman

OutlineOutline

imperfect information adverse selection appraisal screening signaling

24(c) 1999-2007, I.P.L. Png & D.E. Lehman

Screening

Less informed party indirectly elicits other party’s characteristic through structured choice

Better informed party must be differentially sensitive to the choice

25(c) 1999-2007, I.P.L. Png & D.E. Lehman

Screening: Who’s the real mother?Who’s the real mother?

Solomon: “Divide the living child into two, and give half to the one, and half to the other.”

Woman whose son was alive: “give her the living child, and by no means slay it.”

Other woman: “It shall be neither mine nor yours; divide it.”

26(c) 1999-2007, I.P.L. Png & D.E. Lehman

Screening: Indirect Segment Indirect Segment DiscriminationDiscrimination

restricted vis-a-vis unrestricted air fares separate cable channels vis-à-vis bundle cents-off coupons

27(c) 1999-2007, I.P.L. Png & D.E. Lehman

Screening: Criminal Justice Criminal Justice SystemSystem

Defendant might expose his guilt on witness stand Common Law - right to remain silent Civil Law - court can draw inference from defendant’s silence

28(c) 1999-2007, I.P.L. Png & D.E. Lehman

Screening: Multiple AsymmetriesMultiple Asymmetries

screening mechanisms may conflict example -- auto insurance policy: higher

deductible screens out bad drivers screens out more risk-averse

29(c) 1999-2007, I.P.L. Png & D.E. Lehman

OutlineOutline

imperfect information adverse selection appraisal screening signaling

30(c) 1999-2007, I.P.L. Png & D.E. Lehman

Dividend policy

U.S. publicly-listed companies Dividends are costly – subject to double

taxation (corporate and shareholder levels).

Why pay dividends?

31(c) 1999-2007, I.P.L. Png & D.E. Lehman

Signaling

Better informed party communicates attribute through signal

Cost of signal differs according to attribute: self-selection signal is credible

32(c) 1999-2007, I.P.L. Png & D.E. Lehman

Signaling: ExamplesExamples

auto manufacturers – extended warranty

Intuit – money-back guarantee on Quicken

U.S. publicly-listed companies -- dividends

33(c) 1999-2007, I.P.L. Png & D.E. Lehman

Signaling:

Sellers offer Rebate to encourage credit rating in internet shopping

34(c) 1999-2007, I.P.L. Png & D.E. Lehman

Signaling: AdvertisingAdvertising and and ReputationReputation

advertising expenditure must be sunk buyers must be able to detect poor

quality information about poor quality must

quickly spread and cut into seller’s future business

35(c) 1999-2007, I.P.L. Png & D.E. Lehman

OutlineOutline

imperfect information adverse selection appraisal screening signaling contingent contract

36(c) 1999-2007, I.P.L. Png & D.E. Lehman

Contingent Contract

Payment is contingent on realized characteristic:

international trade -- buyback (supplier of technology must buy future product)

mergers and acquisitions – payment in shares

37(c) 1999-2007, I.P.L. Png & D.E. Lehman

Contingent Contract: Contingent Contingent FeeFee

Lawyer has better information about likelihood of success at trial contingent fee time-based fee

38(c) 1999-2007, I.P.L. Png & D.E. Lehman

Resolving Information Asymmetry

direct methods appraisal sampling

indirect methods screening signaling contingent payment

39(c) 1999-2007, I.P.L. Png & D.E. Lehman

Multiple information asymmetries: Personnel selection

appraisal – interview, test

sampling – summer job

screening – performance-based compensation

signaling – education (“resume building”)

40(c) 1999-2007, I.P.L. Png & D.E. Lehman

Applicability

Corporate finance Foreign direct investment Insurance Auctions and procurement Human resource policy