Asymmetric Information. 2 (c) 1999-2007, I.P.L. Png & D.E. Lehman Outline imperfect information ...

Asymmetric Information

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

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imperfect information adverse selection appraisal screening signaling


Imperfect vis-à-vis Asymmetric Information

imperfect information – absence of certain knowledge (uncertainty)


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.


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


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Adverse Selection

economic inefficiency possible market failure


Adverse selection

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

Consequences economic inefficiency possible market failure


Adverse Selection Genuine and Fake Genuine and Fake AntiquesAntiques


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


Adverse Selection: Market FailureMarket Failure


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


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


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)


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?


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Appraisal

Directly resolving information asymmetry

Unknown attribute must be objectively verifiable

Potential gain must cover appraisal cost


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%


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


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.


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


Sampling: Examples

wines foodbooks, movies,

musicsoftwarepharmaceuticalscosmeticscars (test-drive)resorts


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Screening

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

Better informed party must be differentially sensitive to the choice


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.”


Screening: Indirect Segment Indirect Segment DiscriminationDiscrimination

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


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


Screening: Multiple AsymmetriesMultiple Asymmetries

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

deductible screens out bad drivers screens out more risk-averse


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Dividend policy

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

taxation (corporate and shareholder levels).

Why pay dividends?


Signaling

Better informed party communicates attribute through signal

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


Signaling: ExamplesExamples

auto manufacturers – extended warranty

Intuit – money-back guarantee on Quicken

U.S. publicly-listed companies -- dividends


Signaling:

Sellers offer Rebate to encourage credit rating in internet shopping


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


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imperfect information adverse selection appraisal screening signaling contingent contract


Contingent Contract

Payment is contingent on realized characteristic:

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

mergers and acquisitions – payment in shares


Contingent Contract: Contingent Contingent FeeFee

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


Resolving Information Asymmetry

direct methods appraisal sampling

indirect methods screening signaling contingent payment


Multiple information asymmetries: Personnel selection

appraisal – interview, test

sampling – summer job

screening – performance-based compensation

signaling – education (“resume building”)


Applicability

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

Asymmetric Information. 2 (c) 1999-2007, I.P.L. Png & D.E. Lehman Outline imperfect information ...

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