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Managerial Economics: Applying the Tools Topic 10, Part 2 Good s with different quality: Adverse selection Signaling equilibria Pooling equilibria Paul Kerin & Sam Wylie MBS: Term 3, 2004 Mass markets with quality problems We’re considering mass markets for apparently homogenous goods

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Managerial economics applying the tools topic 10 part 2 l.jpg

Managerial Economics: Applying the ToolsTopic 10, Part 2

Goods with different quality: Adverse selection

Signaling equilibria

Pooling equilibria

Paul Kerin & Sam WylieMBS: Term 3, 2004


Mass markets with quality problems l.jpg
Mass markets with quality problems

We’re considering mass markets forapparently homogenous goods

= everyone produces goods that look the same

BUT

are not necessarily of the same quality

COMPETITORS

COMPANY

MASS MARKET CUSTOMERS


Goods that differ in quality l.jpg
Goods that differ in quality

  • In Strategy class: Competing firms will offer products differentiated by quality (Ferraris versus Corollas), just to reach different customer groups

  • In Man Ec: We look at products differentiated by quality, to talk about information problems:

    • Low quality goods and high quality goods in the market, but customers can’t tell them apart!

    • Low quality goods have a cost advantage

    • Producers of high-quality goods want to signal their quality


Example the market for lemons l.jpg
Example: The market for ‘lemons’

  • You want to buy a used car

  • Apart from imperfect information, it’s a perfectly competitive market: there are lots of buyers and lots of sellers

  • To simplify, there is only one kind of used car on the market: three-year-old Holden Barinas

  • There is just one going price in the market: no one will pay more or sell for less than the going price

  • Buyers and sellers see the going price, and decide if they want to participate in the market

  • Unfortunately, there are really 2 qualities of cars on the market: good cars and lemons


Who knows what l.jpg
Who knows what?

The seller knows what type of car she is selling. (This is a generalisation.)

What happens in the market depends on whether buyers can also tell the type of car


The market for lemons case 1 symmetric and perfect information buyers know what type the car is l.jpg
The market for ‘lemons’ – case 1: symmetric and perfect information= buyers know what type the car is


The market for lemons case 2 asymmetric information buyers don t know what type the car is l.jpg
The market for ‘lemons’ – case 2: asymmetric information= buyers don’t know what type the car is


The market for lemons case 2 asymmetric information p 8k l.jpg
The market for ‘lemons’: case 2 – asymmetric information – P>$8K?

  • Suppose the buyer cannot tell a good car from a lemon before they buy

  • Will you buy if the price is at least $8,000?

  • NO!

  • At this price, every seller will want to sell. But this means that if you buy a car it has a 60% chance of being a lemon (worth $6,000 to you) and a 40% chance of being good (worth $10,000 to the buyer). So the expected value of a car to the buyer is $7,600. So you will not pay more than $8,000 for a car with an expected value of $7,600!


The market for lemons case 2 asymmetric information 6k p 8k l.jpg
The market for ‘lemons’: case 2 – asymmetric information – $6K<P<$8K?

  • Suppose the buyer cannot tell a good car from a lemon before they buy

  • Will you buy if the price is between $6,000 and $8,000?

  • NO!

  • At this price, only the sellers of ‘lemons’ will want to sell. Every car being offered is a lemon and you will not pay more than $6000

  • So we expect that the market will have a price of between $3,000 and $6,000, with only lemons sold



Adverse selection a lower price means a lower quality of cars in the market l.jpg
information – outcomesAdverse selection” = a lower price means a lower quality of cars in the market

The problem of adverse selection can lead to the complete collapse of the market for good cars

Any evidence of such problems in the used car market? (Dutta, Strategies and Games)

  • The average car depreciated 37% in the first year. By the end of the second year it had depreciated 50%. (If you tried to sell your 1994 car in 1996, you would get only half the price that you had paid for it a mere two years before.)

  • Only about 1% of new (1 or 2 year old) cars are lemons, so most sales should be from people with changed circumstances.

     Suppose you would pay 80% of new if there were no adverse selection

  • But if the price is only 80% of new, some people with changed circumstances decide to keep the car (give it to kids, drive it to their new home,…)  now cars for sale only worth 70%.

  • But if the price is only 70%, …


Slide12 l.jpg
The Asian Fire sale and the market for “lemons” information – outcomesKhanna and Palepu, Harvard Business Review July-August 1999, 125-134

Asian crisis led to a serious liquidity crisis for many Asian firms

  • Created the need to sell off assets

  • large market for assets arose at the time of the crisis

  • However, in many of the countries experiencing crisis (especially Thailand and Indonesia) there is insufficient reliable public information on the value of an asset.

    (Inadequate accounting practices, inadequate government supervision, lack of transparency in record-keeping.)

  • buyer cannot know the true value of the asset, only the average value in market

  • certain assets that are worth more than average are pulled off the market, and average value keeps falling = market breakdown

  • “The few companies that have been buying in Asia, such as GE Capital in Thailand, are the ones that chose to build a direct understanding of the local markets in the years before the crisis.”


Information and market failure l.jpg
Information and market failure information – outcomes

  • Why do health insurance companies worry about healthy young married women?

    What is the outcome, if insurance companies raise the price of insurance to that group?

  • Why do insurance companies make you pay the first part of any claim (the deductible)?

  • Why is car insurance sometimes unavailable for younger drivers?

  • Are higher interest rates better for banks?

  • Adverse selection can also lead to ‘statistical discrimination’ and rationing


Gresham s law l.jpg
Gresham’s Law information – outcomes

Imagine an economy in which the currency consists of gold coins. The holder of a coin is able to shave a bit of gold from it in a way that is undetectable without careful measurement; the gold so obtained can then be used to produce new coins. Imagine that some of the coins have been shaved in this fashion, while others have not. Then someone taking a coin in trade for goods will assess positive probability that the coin being given her has been shaved, and thus less will be given for it than if it was certain not to be shaved. The holder of an unshaved coin will therefore withhold the coin from trade; only shaved coins will circulate.

“Bad Money Drives Out the Good”


Bad staplers drive out good l.jpg
Bad staplers drive out good information – outcomes

  • Suppose that there are firms producing good staplers and firms producing bad staplers

  • Customers can’t tell the two types of staplers apart  staplers are all sold for the same price

  • But producers of bad staplers have lower costs than producers of good staplers

  • If it’s a competitive market, firms keep entering so long as positive profits are being earned, and enter until profits are driven to zero

  • Bad stapler producers keep entering until their profits are nearly zero

  • But that means that producers of good staplers are losing money!

  • Firms producing good staplers exit the market (or switch to producing bad staplers)


Responses to adverse selection l.jpg
Responses to adverse selection information – outcomes

  • Note that the problem of adverse selection harms the uninformed parties and some of the informed parties:

    • In the lemons example, it meant that buyers could not buy good cars

    • But also sellers of good cars could not get a reasonable price for their cars (even if the price is still above their WTS, the presence of lemons means they earn less)

  • Uninformed buyers may try to overcome the information asymmetry by ‘search’

  • Informed sellers may try to overcome the problem by

    • Offering warranties

    • Other signaling strategies


Warranties and the market for lemons l.jpg
Warranties information – outcomes and the market for ‘lemons’

Let’s go back to our used car market, and suppose that there are lots more buyers than sellers  the price rises to buyers’ WTP

Sellers of good cars want to offer a warranty—but what kind of warranty?

Ex: Let’s say the warranty is a $2000 payment in the event of a breakdown

But if that warranty makes buyers willing to pay close to $10,000 instead of $6,000, sellers of lemons will want to offer the warranty, too

 Customers shouldn’t assume the warranty means it’s a good car


Warranties l.jpg
Warranties information – outcomes

Let’s return to our car market example

Suppose that good cars never break down. However, a lemon has a high probability of breaking down (that is why it is a lemon). Say lemons break down with an 80% probability. (But cars only break down once)

Fixing a broken down car is expensive – about $5,000.

Suppose now that a car seller offers you the following deal – “Buy the car for $9,000. If it breaks down, the seller will fix your car for free.”

Should you buy the car?


Warranties good seller l.jpg
Warranties: information – outcomesgood seller

So if the buyer knew that it was a good car, she would accept the deal

Don’t buy

(0,0)

Buyer

Offer deal

Breakdown (zero chance)

Good seller

(-$4,000; $?)

Buy

Don’toffer deal

No breakdown (100%)

(0, 0)

($1000,$1000)


Warranties lemon seller l.jpg
Warranties: information – outcomeslemon seller

But the buyer can infer sellers offering the deal are good, the seller of a lemon would not offer the deal

Don’t buy

(3000; 0)

Buyer

Offer deal

Breakdown (80%)

Lemon seller

($1,000;$?)

Buy

No breakdown (20%)

Don’toffer deal

(3000; 0)

($6,000;$?)


Warranties lemon seller cont l.jpg
Warranties: information – outcomeslemon seller (cont’)

Don’t buy

(3000; 0)

Buyer

Offer deal

Breakdown (80%)

Lemon seller

Expected payoff for

lemon seller if buyer

accepts offer is

$2000.

So if the lemon seller

thinks that you will

accept the deal,

they will not offer it!

Buy

No breakdown (20%)

Don’toffer deal

(3000; 0)


Warranties conclusion l.jpg
Warranties: conclusion information – outcomes

  • So the warranty ‘works’

    • Only the good sellers will offer the warranty

    • Buyers can buy the car with the warranty, sure that they are buying a good car (and will never need to use the warranty)

    • But it is not worth while for the sellers of ‘lemons’ to copy the warranty – their cars break down and the warranty costs more than the increased price that they receive for their cars

  • “The dog that didn’t bark:”

    • If good firms are offering a warranty

    • Then if a firm doesn’t offer a warranty, customers correctly infer that it’s a bad firm. Silence is informative!


Evidence on warranties l.jpg
Evidence on warranties information – outcomes

  • From Dutta, Strategies and Games:

  • Of all used cars purchased, 20% are sold through new car dealerships and another 15% are sold through used car dealerships. Dealerships typically offer warranties on the used cars they sell

  • The average price of a used car in 1994 was about $11,500. The average private-party sale price on a used car was about $2,000 less than the average sale price at dealers


Signaling l.jpg
Signaling information – outcomes

  • The warranty is an example of a ‘signal’ that the ‘good’ seller can send to the buyer

  • In our example here the signal had no cost to the ‘good’ seller. This is not generally the case

  • For a signal to ‘work’ it requires three features

    • The cost to the ‘bad’ type must be high enough so that they do not want to pretend to be a ‘good’ type

    • It must be less costly to the ‘good’ type than to the ‘bad’ type.

    • Even given the cost, it must be better for the ‘good’ type to distinguish themselves than be mistaken for a ‘bad’ type


Bargaining revisited l.jpg
Bargaining revisited! information – outcomes

  • Signaling is not just a mass-market concept:

    It applies whenever you need to distinguish yourself from another type of person/firm/group

    Example: Back to bargaining.

  • We assumed complete information = all parties to an agreement know the WTP or WTS of each player

  • Observation: If there is incomplete information, your trading partner knows his WTP/WTS, but you don’t know it for sure

  • Why does that lead to delay?

  • Why might that rule out agreement, in some instances?


Other examples the early career rat race l.jpg
Other examples: the early career rat race information – outcomes

  • Suppose there are ordinary and talented workers

  • Your boss can observe the quality of your work but not how difficult you found the task

  • If everyone spends the same time, the talented workers will be recognised and gain promotion

  • So the ordinary workers work harder to try and ‘appear’ to be talented

  • So to distinguish themselves, the talented workers also have to work hard


The early career rat race potential outcomes l.jpg
The early career rat race: potential outcomes information – outcomes

  • Separating equilibrium. This is where the signal ‘works’. The talented workers work too hard but are recognised. The ordinary workers just give upor

  • Pooling equilibrium. In this situation, the ordinary workers work hard and talented workers work normally. The boss interprets ‘ordinary’ performance as a sure sign of lack of talent. But the boss cannot infer anything from exceptional work – because everyone is doing it!


Signaling lifting the fog l.jpg
Signaling = “ information – outcomeslifting the fog”

  • Signaling can overcome information problems

  • But it’s costly to the ‘good’ type who is trying to distinguish herself from the ‘bad’ type

  • Choosing the wrong signal just means the ‘bad’ type will copy you. Despite the cost of the signal, there is no gain in information

  • So: it is important to carefully choose your signaling strategy. It needs to be low cost to you and high cost to others, so that it will be ‘believed’ and cannot be ‘jammed’ by the bad types


Pooling equilibria preserving the fog l.jpg
Pooling Equilibria = “ information – outcomespreserving the fog”

  • If you’re a bad type (or you might be) you want the bad types and the good types to look the same

  • You mimic the ‘good’ type:

    • Follow the herd: Forecasters try and keep their forecast in line with the others; it’s more costly to make a mistake, if you’re the only one who makes it.

  • You make it harder to get clear information about your quality = ‘signal jamming’

    • Create variability and complexity in performance measures

    • Bury information where possible:

      • If you refused a project, bury it so that no one finds out you might have been wrong (e.g. ET)

      • Refuse to collect more information (e.g. Continental Corporation refusing an extensive due diligence by a buyer)


How to find a credible signaling strategy l.jpg
How information – outcomes to find a credible signaling strategy

  • If the good types send a credible signal, what does that say about the equilibrium?

    • Customers (or business partners) believe you’re the good type when you send the signal  you get the “good deal”

    • Customers assume that if you didn’t send the signal, you’re the bad type  you get treated like a bad type

       Spell out exactly what this will mean, in this situation.

  • What makes the signal credible?

    • Bad types don’t want to send it. (That is, they know they could fool customers by sending the signal, but it’s not worth it.)

    • Draw a decision tree, to find a signal that bad don’t want to send.

  • Last: check that good types are better off than in the pooling equilibrium (where customers can’t distinguish them from bad)


Signaling warranties and the market for lemons l.jpg
Signaling: information – outcomes warranties and the market for ‘lemons’

  • Back to our used car market, but suppose that now there are only 30% lemons

  • There are lots more buyers than sellers  the price rises to buyers’ WTP.

  • What is the pooling equilibrium?

  • If good cars break down with a 5% probability and lemons break down with a 50% probability, what is the signaling equilibrium?

    • (Firms can offer warranties of the following form: If your car breaks down, I pay you $X)

  • Which equilibrium do the good sellers prefer?


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