The Economics
of Information
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MC
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Introduction

The invisible hand theory assumes that
buyers are fully informed.

Given that consumers are not fully
informed, they must employ strategies
for gathering information.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 2
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
How the Middleman
Adds Value
Example

How should a consumer decide which pair
of skis to buy?
 Skis
R Us has a.......
o knowledgeable sales staff
o and a large inventory
 They
Recommend Salomon X-Scream 9 skis
for $600
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 3
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
How the Middleman
Adds Value
Example

How should a consumer decide which pair
of skis to buy?
 The
skis can be purchased on the Internet for
$400

Question

Is spending $600 on the right skis better
than $400 on the wrong ones?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 4
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
How the Middleman
Adds Value
How does better information affect
economic surplus?

Ellis wants to sell a Babe Ruth baseball
card.
 His
reservation price is $300.
 An ad in the local newspaper cost $5.
 eBay cost is 5% of the Internet auction price.
 The maximum price in the local market is $400.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 5
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
How the Middleman
Adds Value
Example

How does better information affect
economic surplus?
 The
maximum prices in the eBay market is
$900 and $800.
 Economic surplus:
o Local market = $400 - $5 - $300 = $95
o eBay = $800 - $40 - $300
= $460 + $100 = $560
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 6
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
How the Middleman
Adds Value
Example

How does better information affect
economic surplus?
 Economic
surplus is increased when a product
goes to the person who values it the most.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 7
The Optimal Amount
of Information
MB MC
$/unit
Marginal cost
of information
The optimal amount of
information (ignorance)
occurs where MC = MB
Marginal benefit
of information
I*
Units of information
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 8
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
The Optimal Amount
of Information
The Free Rider Problem

An incentive problem in which too little
of a good or service is produced
because nonpayers cannot be excluded
from using it
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 9
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
The Optimal Amount
of Information
Economic Naturalist

Why is finding a knowledgeable salesclerk
often difficult?

Why did Rivergate Books, the last
bookstore in Lambertville, NJ, recently go
out of business?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 10
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
The Optimal Amount
of Information
Two Guidelines for Rational Search

Additional search time is more likely to be
worthwhile for expensive items than cheap
ones

Prices paid will be higher when the cost of
a search is higher
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 11
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
The Optimal Amount
of Information
Example

Should a person living in Paris, Tx, spend
more or less time searching for an
apartment than someone living in Paris,
France?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 12
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
The Optimal Amount
of Information
Example

Tom and Tim are shopping for a used
upright piano.

Tom has a car & Tim does not.

Which one should expect to examine fewer
pianos before making a purchase?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 13
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
The Optimal Amount
of Information
The Gamble Inherent in Search

When engaging in further search there are
additional costs and uncertain benefits
and, therefore, there is a degree of risk or
gamble from the search.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 14
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
The Optimal Amount
of Information
Determining whether or not to take the
gamble:

Compute the expected value of the gamble
 The
sum of the possible outcomes multiplied by
their respective probabilities
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 15
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
The Optimal Amount
of Information
Determining whether or not to take the
gamble:

Fair Gamble
 Coin
flip: Heads win $1, Tails lose $1
 Expected value = (.5)($1) + (.5)(-$1) = 0
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 16
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
The Optimal Amount
of Information
Determining whether or not to take the
gamble:

Better-than-fair-gamble
 Coin
flip: Heads win $2, Tails lose $1
 Expected value = (.5)($2) + (.5)(-$1) = .5
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 17
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
The Optimal Amount
of Information
Determining whether or not to take the
gamble:

Risk-neutral person
 Will

accept any gamble that is fair or better
Risk-averse person
 Will
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
refuse any fair gamble
Chapter 13: The Economics of Information
Slide 18
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
The Optimal Amount
of Information
Example

Should you search further for an
apartment?
 Searching
for an apartment in a neighborhood
where identical apartments rent for $400 &
$360
 Of the vacant apartments, 80% rent for $400
and 20% rent for $360
 You must visit the apartment to get the rental
rate
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 19
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
The Optimal Amount
of Information
Example

Should you search further for an
apartment?
 The
first visit is a $400 apartment.
 The opportunity cost of an additional visit is $6.

The expected value of another visit:
 (.2)($34)
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
+ (.80)(-$6) = $2
Chapter 13: The Economics of Information
Slide 20
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
The Optimal Amount
of Information
The Commitment Problems When
Search is Costly

What happens when, by chance, a more
attractive option comes along after the
search has ceased?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 21
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
The Optimal Amount
of Information
The Commitment Problems When
Search is Costly

When information is costly and the search
must be limited, a relationship may
dissolve.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 22
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
The Optimal Amount
of Information
The Commitment Problems When
Search is Costly

Commitment agreements
 Lease
agreements
 Employment contracts
 Marriage contracts
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 23
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Asymmetric Information

Asymmetric Information

Situations in which buyers and sellers are
not equally well informed about the
characteristics of goods and services for
sale in the marketplace.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 24
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Asymmetric Information

Example

Will Jane sell her car to Tom?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 25
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Asymmetric Information

Example


Will Jane sell her car to Tom?
Assume

Jane wants to sell a 2001 Miata
 70,000
highway miles
 Complete maintenance
 Excellent condition
 Average price is $8,000
 Jane’s reservation price is $10,000
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 26
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Asymmetric Information

Tom

Reservation price
 $13,000
if in excellent condition
 $9,000 if not in excellent condition

Will not pay $10,000 because he cannot
tell if Jane’s car is an excellent buy
 Tom
Copyright c 2007 by The McGraw-Hill
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buys an average car
Chapter 13: The Economics of Information
Slide 27
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Asymmetric Information

Example

There is a loss in economic surplus
 Assuming
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Tom had paid Jane $11,000
Chapter 13: The Economics of Information
Slide 28
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Asymmetric Information

Example

Tom
 Pays
$8,000 and has a gain of $1,000 ($9,000 $8,000)
 Tom’s Loss
o $13,000 - $11,000 = $2,000 - $1,000 = $1,000

Jane’s loss is $1,000

Total loss is $2,000
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 29
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Asymmetric Information

The Lemons Model

Asymmetric information tends to reduce
the average quality of goods offered for
sale.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 30
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Asymmetric Information

The Lemons Model

People who have below average (lemons)
cars, are more likely to want to sell them.

Buyers know that below average cars are
likely to be on the market and lower their
reservation prices.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 31
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Asymmetric Information

The Lemons Model

Because used car prices are low, people
with good cars keep them longer.

The average quality of used cars falls even
further.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 32
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Asymmetric Information

Example

Should you buy your aunt’s car?
 4-year
old Accord
 The asking price of $10,000 is the blue book
value.
 You believe the car is in good condition.
 It is a good deal because the blue book value is
the equilibrium price for below average cars.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 33
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Asymmetric Information

Example

How much will a naïve buyer pay for a
used car?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 34
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Asymmetric Information

Assume

There are only good cars and lemons.

10% of all new cars are lemons.

Good used cars are worth $10,000 and
lemons are worth $6,000.

The used car market is 90% good cars and
10% lemons.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 35
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Asymmetric Information

Example

Calculating the expected value:
 (.90)($10,000)
+ (.10)($6,000) = $9,600
o Reservation price for a risk-neutral buyer
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 36
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Asymmetric Information

Example

Who will sell a used car for what the naïve
buyer is willing to pay?
 Would
not sell a good car that is worth $10,000
 Would sell a lemon that is worth $6,000
 Only lemons will be on the market
 Price will fall to $6,000
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 37
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Asymmetric Information

What Do You Think?

If you have a good used car for sale, how
can you get a higher price?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 38
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Asymmetric Information

The Credibility Problem In Trading

People tend to interpret ambiguous
information in ways that promote their own
interests.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 39
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Asymmetric Information

The Costly-to-Fake Principle

To communicate information credibly, a
signal must be costly or difficult to fake.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 40
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Asymmetric Information

Economic Naturalist

Why do firms insert the phrase “As
advertised on TV” when they advertise
their products in magazines and
newspapers?

Why do many companies care so much
about elite educational credentials?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 41
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
Conspicuous Consumption
as a Signal of Ability
Economic Naturalist

Why do many clients seem to prefer
lawyers who wear expensive suits?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 42
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Asymmetric Information

Statistical Discrimination

The practice of making judgments about
the quality of people, goods, or services
based on the characteristics of the groups
to which they belong.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 43
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Asymmetric Information

Economic Naturalist

Why do males under 25 years of age pay
more than other drivers for auto insurance?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 44
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Asymmetric Information

Adverse Selection

The pattern in which insurance tends to be
purchased disproportionately by those who
are most costly for companies to insure
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 45
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Asymmetric Information

Adverse Selection

Raises premiums

Reduces the number of low-risk policy
holders

Increases the risk level of the insured
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 46
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Asymmetric Information

Moral Hazard

The tendency of people to expend less
effort protecting those goods that are
insured against theft or damage
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 47
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Asymmetric Information

Moral Hazard

Deductibles are used to reduce moral
hazard and adverse selection.
 Lower
rates
 Increase the incentive to drive safely
 Reduce the number of claims, which lowers
cost and premiums
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 48
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Disappearing Political Discourse

Economic Naturalist

Why do opponents of the death penalty
often remain silent?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 49
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Disappearing Political Discourse

Economic Naturalist

Why do proponents of legalized drugs
remain silent?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 13: The Economics of Information
Slide 50
End of
Chapter
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MC