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Managerial Economics

Solution to Problem Set


Asymmetric Information

1.

A four year old Zagoxl car has a value to the owner which is uniformly
distributed between 3800 and 5800. Whatever the value to the owner, the
car is worth 200 more to a potential buyer. There are many potential buyers
for a 4-year old Zagoxl. Find the equilibrium price. (Hint: at a price p which
cars are offered for sale? What is the expected value of cars offered for sale to
a buyer?)

Solution: Let p be the selling price of a four-year-old Zagoxl. Begin by considering


potential sellers. A potential seller will sell at price p if the value to the seller
does not exceed p. So sellers valuations of four-year-old Zagoxl which they
are prepared to sell at price p will be uniformly distributed in the range 3800
to p. The mean sellers valuation will be (3800 + p)/2.
As there are many potential buyers, we assume there is no surplus to buyers.
So the expected value to buyers will be p. But we know also that the expected
value to a buyer is 200 more than the expected value to a seller. So
Expected value to buyer = p = 200 + (3800 + p)/2
This gives p = 4200

2.

Travel agents sell holidays to the Cayman Islands. Consumers are willing to
pay 1400 if the holiday is excellent and 800 if the holiday is mediocre. A
travel agent knows the quality of the holidays she sells but the consumer does
not. There are many travel agents and they operate in a competitive market.
(a)
If a fraction x of travel agents sell excellent holidays, and the
remainder sell mediocre holidays, what is the maximum amount that a
risk-neutral consumer would be willing to pay for a holiday?
(b)
Suppose that only mediocre holidays exist and it costs a travel agent
1000 to book a mediocre holiday. Is there an equilibrium in which
any holidays are sold?
(c)
Suppose it costs a travel agent 1000 to book a mediocre holiday and
1100 to book an excellent holiday. Is there an equilibrium in which
any holidays are sold?
(d)
Suppose it costs a travel agent the same amount, 1000, to book a
mediocre or an excellent holiday. Find the market
equilibrium(equilibria). How much consumer surplus is generated at
the equilibrium(equilibria)?
(e)
How in practice (i.e. in the real travel market) are inefficiencies arising
from asymmetric information mitigated?

Solution:
(a)

Maximum (in pounds) = 1400x + 800(1 x) = 800 + 600x

(b)

Under perfect competition price will be driven down to cost, i.e. to


1000. But customers are only willing to pay up to 800. So no
holidays are sold at equilibrium.

(c)

If there were no mediocre holidays and all holidays were excellent,


customers would be willing to pay up to 1400 for a holiday; this
exceeds the supply cost of 1100. Unfortunately, however, it is always
in the interests of a travel agent to supply a mediocre holiday as this
increases net earnings by 100 per holiday sold, whereas an individual
travel agents effect on x is negligible. So each travel agent will do the
individually rational thing and sell mediocre holidays. The market will
therefore break down as in (b), and no holidays will be sold at
equilibrium.

(d)

Competition will drive the price down to 1000. An individual travel


agent will be indifferent between supplying good or mediocre holidays.
Consumers will be willing to buy holidays at 1000 as long as 800 +
600x 1000, i.e. x 1/3.
So equilibria in which holidays are sold occur at 1/3 x 1, giving a
price of 1000.
A consumers surplus (i.e. the surplus of an individual consumer) is the
difference between a consumers valuation and the price paid, and is
given by 800 + 600x - 1000 = 600x - 200, for x 1/3. The total
consumer surplus for the population (say N consumers) is N(600x 200)
For x < 1/3 no holidays are sold. A consumers surplus is zero. The
total consumer surplus for the population is zero.

(e)

Part of the answer is that travel agents care about repeat business and
their reputation. Part of the answer is that travel agents may be able to
signal the quality of their holidays. Part of the answer is that
consumers may seek out information from independent sources
(screening)
Alternatively, travel agents could self-regulate by forming a trade
association which awards a seal of approval only to those agents which
consistently offer excellent holidays for sale. The Association of
British Travel Agents (ABTA) may (arguably) fulfil this role to some
extent.

3.

Target Ltd. is worth v to its current owners, and v is known exactly by the
current owners. Take Ltd. does not know the exact value of v, but it knows
that v lies between 3million and 4million, all values equally likely.
Whatever the value of v, Target Ltd. would be worth 1.5v - 1.5million to the
Take Ltd.
(a)
Show that Target Ltd. is always worth more to Take Ltd than to its
current owners. (You may give a formal mathematical argument. Or, if
you prefer, show it by graphing value to Take Ltd against value to
Target Ltd..)
(b)
The Take Ltd makes a take-it-or-leave it offer of 3.5 million to Target
Ltd.s owners. What is the expected gain to the Take Ltd? (Hint: for
which values of v will Target Ltd.s owners accept?)
(c)
Is there any take-it-or-leave-it takeover bid which would generate an
expected positive gain for the Take Ltd.?

Solution:
(a)

Let us work in units of millions of pounds: (value to Take) (value to


Target owners) = (1.5v 1.5) (v) = 0.5v 1.5.
As v is uniformly distributed between 3 and 4 we have that 0.5v 1.5is
always larger than zero (or exactly equal to zero for v=3), i.e. the value
to the Take Ltd is greater than the value to Target.
Here is a sketch. The solid line is the value to the Take Ltd (y) plotted
against the value to Target current management (v). The dashed line is
the line y = v, representing the locus of points for which the two values
are the same. The solid line is always above the dashed line except at v
= 3, where they are equal, but v = 3 will occur with probability zero.

4.5
4
y = value to Take
Ltd

3
3

(b)

v = value to Target

Take Ltds offer of 3.5 will be accepted if v < 3.5, and rejected if v >
3.5.
There are now two ways we can proceed. Method 1 is to calculate the
overall expected gain by averaging Take Ltds gain for all possible

values of v. Method 2 is to consider the gain to Take Ltd conditional


on the offer being accepted. There is also a shortcut which makes use
of the fact that value to Take Ltd is a linear function of v.
Method 1. The probability density function for v is given by:
f(v) = 1
for 3 < v < 4
f(v) = 0
otherwise
Now let g(v) be Take Ltds gain as a function of v. Then Take Ltds
expected gain is given by:
4

All v

f (v) g (v)dv = 1 g (v)dv


3

Now we must write down an expression for g(v). If v > 3.5,


Stronnfellows current management will not sell and so the gain to
Take Ltd is zero. If v < 3.5, Target current management will sell; the
expected value to Take Ltd is 1.5v 1.5, and Take Ltd is paying 3.5,
so the gain is 1.5v 1.5 3.5 = 1.5v 5
Thus we have:

g(v) = 1.5v 5
g(v) = 0

(for 3 < v < 3.5)


(for 3.5 < v < 4)

So Take Ltds expected gain is:

3.5

(1.5v 5)dv + 0 dv
3.5

= [0.75v 5v]
2

3.5
3

0 = ((0.75 12.25) (5 3.5)) ((0.75 9) (5 3)) = 0.0625

i.e. Take Ltd has an expected loss of 0.0625Million = an expected


loss of 62,500.

Method 2. The mean value to the Take Ltd if the offer is accepted is
equal to the mean value to the Take Ltd conditional on v being less
than 3.5,

3.5

(1.5v 1.5)dv

3.5

dv

[0.75v 2 1.5v]33.5
= 3.375
[v]33.5

The mean gain to Take Ltd if the offer is accepted is this expected
value of 3.375 minus the price of 3.5, i.e. -0.125. The offer is accepted
with probability 0.5, so the overall expected gain is 0.5(0.125Million) = -0.0625Million = expected loss of 62,500.
A shortcut
If you dont like integration there is, for this particular example, a
shortcut. If the offer is accepted, v will be between 3 and 3.5. Because
the probability distribution for v is uniform in the range 3 to 3.5, and
because the value to the Take Ltd is a linear function of v, the mean
value to the Take Ltd will be equal to
[(value to Take Ltd if v = 3) + (value to Take Ltd if v = 3.5)]/2

= [(4.5 1.5) + (5.25 1.5)] / 2 = [(3) + (3.75)]/2 = 3.375


On those occasions when the offer is accepted, the expected gain to the
Take Ltd is 3.375 3.5 = -0.125, i.e. on these occasions there is a
mean loss of 0.125. The offer is accepted with probability 0.5 (this is
the probability that v < 3.5), so the mean gain to the Take Ltd arising
from the offer is -0.125/2 = -0.0625.
(c)

Consider a take-it-or-leave-it offer of X, where 3 X 4. Then the


offer will be accepted if v < X. Using the same shortcut as before
(because value to Take Ltd is a linear function of v), the mean value to
the Take Ltd if its offer is accepted is
[(4.5 1.5) + (1.5X 1.5)] / 2 = [1.5X + 1.5]/2 = 0.75X + 0.75
Mean gain to Take Ltd if offer is accepted = (0.75X + 0.75) (X) =
0.75 0.25X. This is zero if X = 3, otherwise negative. So there is no
take-it-or-leave-it offer which will result in a positive mean gain to the
Take Ltd.
(You can also apply method 1 or method 2, replacing 3.5 with X in
your calculation.)

4. An insurance firm wishes to take on a temporary salesman for a week. Both are
risk-neutral. The salesmans effort level y is a continuous variable, with 0 y 1. The
firm pays the salesman basic pay of zero, plus a commission X if a policy is sold. A
policy sale is worth 1000 to the firm. The salesman will sell one policy at most. The
probability of a sale is 0.3 + 0.4y. The recruit has a disutility for effort (i.e. putting in
more effort is equivalent to a monetary cost to him). The monetary equivalent of the
salesmans disutility for an effort of y is 80(1 + y). What value of X will maximise
the firms expected surplus? What will be the salesmans effort level at this value of
X?

Solution:
First, we should recognise that this is a principal-agent problem in which the
insurance firm is the principal and the salesman is the agent. The salesman will
maximise his own utility, which means that, given X, he will choose his preferred
effort level y. The insurance firm knows the salesmans utility function and so can
anticipate what the salesmans effort level will be in response to X. Making use of this
information, the firm chooses X to maximise expected profit.
If you prefer to think about this problem in game theory terms, we have a sequential
game in which the insurance firm goes first (by choosing X) and the salesman goes
second (by choosing y). Think of it as being like a Stackelberg game. We solve the
game by backward induction: find y as a function of X, and then substitute this into
the firms profit function.
So we can start by finding the salesmans effort y, given X. The salesmans expected
surplus, as a function of X and y, is given by expected payment to the salesman minus
the disutility of his effort. So the salesmans expected surplus is:
X(0.3 + 0.4y) - 80(1 + y)
(1)

Only y is under the control of the salesman. The salesman will choose the value of y
which maximises his surplus, with X taken as given. Differentiating partially with
respect to y, and setting this derivative to zero, the optimal effort y* is given by
y* = X/400
(2)
Now consider the firm. The firms expected profit, as a function of X and Y, is
= (0.3 + 0.4y) (1000 X)
(3)
Substituting from (2) into (3), the firms expected profit as a function of X is
= (0.3 + 0.4X/400) (1000 X)
We can write /1000 = (300 + X) (1000 X) = -X2 + 700X + 300,000
The firm wants to maximise this. It is maximised at X = 350 (Differentiate with
respect to X and set the derivative to zero to show this.)
We can now find the effort level from (2). We get y* = 350/400, giving y* = 49/64 =
0.766

Appendix: expectations of functions of random variables

Suppose X is a random variable. Let f(X) be a function of X. Let E[...] denote


the expected value of the thing in square brackets.
Is E[f(X)] the same as f(E[X])?
In general they are not the same

Suppose X can equal -1, 0 or 1, each with probability 1/3. Suppose that f(X) =
X2 . Then
E[f(X)] = 1/3{(-1)2 + 02 + 12}= 2/3
Whereas
f(E[X]) = {(-1 + 0 + 1)/3}2 = 02 = 0.
So they are different.
But E[f(X)] will be equal to f(E[X]) if f() is a linear function, i.e. f(X) = aX + b.
See for example MN203, Michaelmas Term, lecture handout 3, expression
(3.1) (available on the public folders).
Now look at question 3. You are asked to calculate the mean gain to DoS if
the offer of 3.5million is accepted. So you are calculating E[f(v)], where f(v) is
value to DoS as a function of value to Strongfellows. The correct way to do
this is to integrate over all possible values of v for which the offer is accepted.

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