The Economics
of Information
MB
MC
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Introduction

The invisible hand theory assumes that
buyers are fully informed.


People who don’t know what they are buying.
Given that consumers are not fully
informed, they must employ strategies for
gathering information.
Consumer report
 Amazon.com review
 Talk to family and friends

Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 2
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
Example


How the Middleman
Adds Value
How should a consumer decide which pair of skis
to buy?
 Skis R Us has a.......
knowledgeable sales staff
and a large inventory
 They Recommend Salomon X-Scream 9 skis
for $600
 The skis can be purchased on the Internet for
$400
Question facing the buyer

Is spending $600 on the right skis better than
$400 on the wrong ones?
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
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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.
The maximum price in the local market is $400.
eBay cost is 5% of the Internet auction price.
The maximum prices in the eBay market is $900
and $800.
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
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
How the Middleman
Adds Value
Example

How does better information affect economic
surplus?
 Notice that winning bidder pay the second price
on eBay.
 Economic surplus: = Price paid - transaction
costs - reservation price
Local market = $400 - $5 - $300 = $95
eBay = $800 - $40 - $300
= $460 + $100 = $560
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
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
How the Middleman
Adds Value
How does better information affect
economic surplus?

Economic surplus is increased when a
product goes to the person who values it
the most.

Sales agents and other middlemen help
add economic value.
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 6
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 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 7
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
The Free Rider Problem


The Optimal Amount
of Information
An incentive problem in which too little of a good
or service is produced because nonpayers cannot
be excluded from using it
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?
Get advice/preview from salesclerk/bookstore
Buy the stuff on line for a cheaper price.
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
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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 may be higher when the cost of
a search is higher


When to search
Expensive items
 Lower cost in searching

Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 9
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
Example


The Optimal Amount
of Information
Should a person living in Paris, TX, spend more or
less time searching for an apartment than
someone living in Paris, France?
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 2006 by McGraw-Hill
Chapter 13: The Economics of Information
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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 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 11
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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

Fair Gamble
 Coin flip: Heads win $1, Tails lose $1
 Probabilities: 50% for head and 50% for tail.
 Expected value = (.5)($1) + (.5)(-$1) = 0
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 12
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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
 Risk-neutral person
Will accept any gamble that is fair or
better
 Risk-averse person
Will refuse any fair gamble

Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 13
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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 fo $400 & $360
Of the vacant apartments, 80% rent for
$400 and 20% rent for $360
You must visit the apartment to get to
rental rate
You are risk neutral.
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 14
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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:
 Find one $360 apartment: save $40 and pay $6
 Find another $400 apartment: pay $6
 (.2)($34) + (.80)(-$6) = $2
 What is your decision given that you are risk
neutral? What if you are risk averse?
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
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
The Optimal Amount
of Information
The Commitment Problems When
Search is Costly
Since searching is costly, you may just
take whatever is available for good. But…
 What happens when, by chance, a more
attractive option comes along after the
search has ceased?
 When information is costly and the search
must be limited, a relationship may stay for
a while then may dissolve.

Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
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
The Optimal Amount
of Information
The Commitment Problems When Search is Costly
 Commitment agreements
 Lease agreements
binding the landlords/tenants for a specified
period
 Employment contracts
Honor obligations under normal situations
 Marriage contracts
Penalizes whose who abandon their
spouses, big wedding etc.
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
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The Optimal Amount of Information

Marriage contract and Prenup
 Searching for a perfect match is costly
 In an imperfect match, one side may have
disadvantage when the match breaks up.
 To induce the disadvantaged party to enter
the marriage contract, a break up cost
upon the party with advantage is imposed.
 If the imposed break up cost is too high for
the advantaged party, a prenup is used to
lower that cost to induce the advantaged
party enter into marriage.
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 18
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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 2006 by McGraw-Hill
Chapter 13: The Economics of Information
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Asymmetric Information

Example


Will Jane sell her car to Tom?
Assume

Jane wants to sell a 2000 Miata
70,000 highway miles
Complete maintenance
Excellent condition
Average price is $8,000
Jane’s reservation price is $10,000
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
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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
cannot tell the quality of the car even by
a mechanic, so treat Jane’s as average.
Tom buys an average car at $8,000
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
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Asymmetric Information

Example

There is a loss in economic surplus
Assuming Tom had paid Jane $11,000

Tom
Pays $8,000 and has a gain of $1,000
($9,000 - $8,000) if he buys the average
car
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
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Asymmetric Information
Tom’s Gain if he buys at $11,000
$13,000 - $11,000 = $2,000 (bought
from Jane)
 Tom’s Loss=$2,000 - $1,000 = $1,000
(compared to paying $8,000)
 Jane’s loss is $1,000 (=11,000-10,000)
 Total loss is $2,000 ($1,000 for Jane &
$1,000 for Tom)


Asymmetric information costs economic
surplus
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 23
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Asymmetric Information

The Lemons Model

Asymmetric information tends to reduce
the average quality of goods offered for
sale.

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 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 24
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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.

As the average quality of used cars falls,
buyers’ reservation price will fall as well.

And so on and so forth.
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 25
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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 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 26
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Asymmetric Information

Example

How much will a naïve buyer pay for a
used car?
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 27
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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 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 28
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Asymmetric Information

Example

Calculating the expected value:
(.90)($10,000) + (.10)($6,000) = $9,600
Reservation price for a risk-neutral
buyer

A naïve buyer will pay $9,600 for a used
car.
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 29
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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 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 30
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Asymmetric Information

If you have a good used car for sale,
how can you get a higher price?
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 31
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Asymmetric Information

The Credibility Problem In Trading

People tend to interpret ambiguous
information in ways that promote their own
interests.

Sellers: overstate the quality of their
products for higher price.

Buyers: understate the amount they’re
willing to pay to bargain a low price.
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 32
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Asymmetric Information

The Costly-to-Fake Principle

To communicate information credibly, a
signal must be costly or difficult to fake.

Called “signaling” in game theory

Who wants to fake?

Who can signal?
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 33
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Asymmetric Information

Economic Naturalist: common signals
Firms insert the phrase “As advertised on
TV” when they advertise their products in
magazines and newspapers for million
dollars TV ads.
Signal the ability to earn money back
from the profit on the product.
 Many companies care a lot about elite
educational credentials.
High grade: signal for high capability

Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 34
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Asymmetric Information

Economic Naturalist

Many clients seem to prefer lawyers who
wear expensive suits. Expensive personal
items signal the ability to earn money from
winning cases.
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 35
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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.

Use information on groups (statistics)
instead of on individual customer to make
pricing decisions.
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 36
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Asymmetric Information

Economic Naturalist

Why do males under 25 years of age pay
more than other drivers for auto insurance?

The group of males under 25 years old
tends to have more accidents than other
group.

If you belong to that group, you pay higher
premium.

High grades/expensive suits signals which
group an individual belongs to.
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 37
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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
 Raises
premiums
 Reduces
the number of low-risk policy
holders
 Increases
Copyright c 2006 by McGraw-Hill
the risk level of the insured
Chapter 13: The Economics of Information
Slide 38
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Asymmetric Information

Adverse Selection

Happens when the insurance contract is
sold/signed.

High risk individuals would like to pay
higher prices.

Same price looks more attractive to high
risk individuals than people with
average/low risk

Government enforced insurance policy
may lower the premium in the market.
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 39
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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

Happens after the insurance contract is
signed.

Because of insurance, people tend to
choose riskier behavior for lower
potential loss.
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 40
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Asymmetric Information

Moral Hazard

Deductibles are used to reduce moral
hazard and adverse selection.

Benefits from deductibles in the insurance
policy
Lower rates
Increase the incentive to drive safely
Reduce the number of claims, which
lowers cost and premiums
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 41
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Disappearing Political Discourse

Economic Naturalist

Why do opponents of the death penalty
often remain silent? (bad signal)

Why do proponents of legalized drugs
remain silent? (bad signal)

Why did it take Richard Nixon – a diehard
anti-communist – to reestablish normal
diplomatic relations to China – a
communist country at then? (no bad signal)
Copyright c 2006 by McGraw-Hill
Chapter 13: The Economics of Information
Slide 42
End of
Chapter
MB
MC