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IMPERFECT MARKETIMBA NCCU
Managerial Economics
Jack Wu
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IMPERFECT MARKET
Externality Asymmetric Information
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EXTERNALITY
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EXTERNALITIES
one party directly conveys benefit or cost to others� positive� Negative
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0
0.81
3.64
15
13.4
10
9
1 5 9 10
group marginal benefit
Sak’s marginal benefit
florist’s marginalbenefit
profit gain fromadditional investment
marginalcost
shoe store’smarginal benefit
Hundred thousand dollars of investment
Marg
inal benefit/
cost
(Hundre
d t
housa
nd d
olla
rs)
SAK’S POSITIVE EXTERNALITIES
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0
1
2
10
5 7.5 9 10
ab
c
marginal benefit
group marginal cost
Sol’s marginal cost
Sak’s marginal cost
Hundred thousand dollars of investment
Marg
inal benefit/
cost
(H
undre
d t
housa
nd
dolla
rs)
SAK’S NEGATIVE EXTERNALITIES
profit gain fromreducing investment
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RESOLVING EXTERNALITIES
Economic inefficiency opportunity for profit merger collective action
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INTEL INSIDE
Cooperative advertising resolves positive externality from one retailer to other retailers
Exte
rna
lities
8
(c) 19
99
-20
01
, Ivan
Pn
g
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NETWORK EXTERNALITY
Externality where benefit/cost depends on total number in network English language Internet email international telephone service
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NETWORK EFFECTbenefit/cost depends on total number in network through market, not directly conveyed resolved by producer or service provider
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CRITICAL MASS
definition: number of users at which demand becomes positive
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NETWORK EFFECTS: DEMAND ELASTICITY
highly elastic around tipping pointhighly inelastic at low demand levels
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ASYMMETRIC INFORMATION
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CASE: NTUC INCOME: PREMIUMS FOR $200,000 LIFE INSURANCE
female male
civil servant group policy• maximum coverage limit• no medical exam
$240 $240
individual policy• no maximum coverage• medical exam required
$991 $1849
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IMPERFECT/ASYMMETRIC INFORMATION
imperfect information – absence of certain knowledge (uncertainty)
asymmetric information -- one party has better information than the other party with worse information also suffers from
imperfect information
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RISK
uncertainty about benefit or cost arises from imperfect information risk-averse person prefers certain payment
to uncertain payments with same expected value
risk-averse person will buy insurance
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0
2
3
5
7
8
1 2 3 8
supply of good vintage
combined supply of good and bad vintage
actual demand(marginal benefit)
demand (marginal benefit)for good vintage
Quantity (Thousand cases a month)
Pri
ce (
Hun
dre
d $
per
case
)
WINE MARKET EQUILIBRIUM, I
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WINE MARKET EQUILIBRIUM, II
actual demand = combined supply of good and bad
at equilibrium price actual marginal benefit (adjusted for prob of
getting bad vintage) = price actual marginal cost (of good vintage) = price
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ADVERSE SELECTION
economic inefficiency possible market failure
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0
2
8
F 8
c
d
combined supply of good and bad vintages
actual demand(marginal benefit)
demand (marginal benefit)for good vintage
Quantity (Thousand cases a month)
Pri
ce (
Hun
dre
d $
per
case
)
MARKET FAILURE, I
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MARKET FAILURE, II
conventional market: when supply exceeds demand, lower price restores equilibrium
wine market with adverse selection: lower price drives out better vintages, leaving even worse adverse selection
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LIFE INSURANCE, I
Coverage = $200,000 for 43 year-old male
NTUC IncomeSingapore
Pacific CenturyHong Kong
Group policy $240 $212
Individual (non-smoker)
$1849 $466
Individual (smoker) $1849 $1120
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LIFE INSURANCE, II
group policy avoids adverse selection individual policy attracts adverse selection
no maximum policy coverage medical examination required
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APPRAISAL
characteristic is objectively verifiable potential gain covers appraisal cost
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• less informed party indirectly elicits other party’s characteristic through structured choice
• better informed party must be differentially sensitive to the choice
SCREENING
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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.”
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INDIRECT SEGMENT DISCRIMINATION
restricted vis-a-vis unrestricted air fares separate cable channels vis-à-vis bundle cents-off coupons
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MULTIPLE ASYMMETRIES
screening mechanisms may conflict example -- auto insurance policy: higher
deductible screens out bad drivers screens out more risk-averse
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AUCTION
auctions to sell: seller doesn’t know buyers’ valuations
auctions to buy: buyer doesn’t know sellers’ costs
use competitive pressure to force bidders to reveal their information
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AUCTION METHODS
open/sealed bidding discriminatory/non-discriminatory pricing reserve price
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WINNER’S CURSE In auction to buy: winning bidder over-
estimates the true value In auction to sell: winning bidder under-
estimates the true cost More severe where
more bidders true value/cost more uncertain sealed-bid auction
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• better informed party communicates characteristic through signal
• cost of signal differs according to characteristic self-selection signal is credible
SIGNALING
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SIGNALING: EXAMPLES
auto manufacturers – extended warranty U.S. publicly-listed companies -- dividends
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MORAL HAZARD
asymmetric information about action conflict of interest
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MORAL HAZARD: DOCTORS
• Brazil: among pregnant women, rate of cesarian section– 30% (81 of 269) in public
hospitals– 66% (117 of 177) in private
hospitals
• Happy coincidence?
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MORAL HAZARD IN EMPLOYMENT
worker’s marginal cost
employer’s marginal benefit
worker’s marginal benefit
Quantity (units of effort)
Marg
. co
st/b
enefit
(cents
per
unit
)
efficient effort
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RESOLVING MORAL HAZARD
incentive scheme conditional payment quota
monitoring system incentives must be based on observables
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RELATIVE PERFORMANCE
employment -- promote the best worker sports -- gold, silver, bronze examination – grade on a curve
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MULTIPLE RESPONSIBILITIES
strong incentive more effort on that dimension less effort on other dimensions
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DISCUSSION
Fixed Salary Commission rises from $1000 to $2000 Quota