chapter 11: the economics of information

©2012 The McGraw-Hill Companies, All Rights Reserved

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Chapter 11: The Economics of Information


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Learning Objectives

1. Explain how middlemen add value to market transactions

2. Use the concept of rational search to find the optimal amount of information market participants should obtain

3. Define asymmetric information and describe how it leads to the lemons problem

4. Discuss how advertising, conspicuous consumption, statistical discrimination, and other devices are responses to asymmetric information


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Information and the Invisible Hand

Adam Smith’s invisible hand theory presumes that buyers are fully informed about the countless ways in which they might spend their money What goods and services are available What prices they sell for How long they last How frequently they break down But, of course, no one is ever really fully

informed about anything Sometimes people are completely ignorant of

even the most basic information


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Information and the Invisible Hand

All parties have all relevant information Without free information, market results

are not efficient Bargaining for a carpet in Blue Souk Sharjah

• Did you pay a much higher price than the seller ever hoped for?

Parties must decide how much information to gather Information gathering strategies differ

Read reports / talk to friends / visit stores etc…


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The Middleman Adds Value

Buyers sometimes choose among several versions of a product Each has complex features that buyers

do not fully understandResearch options

Company web site Ask friends and family Consumer Reports, online product

reviews Visit stores, ecommerce sites


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How should a consumer decide which smart phone to buy?

Smart Gadgets R Us recommends $600 Nokia X500 Pro Sales representative “seems” knowledgeable

You buy one for $600, then head back to your apartment

Your roommate says that you could have bought it on the internet for only $400 How do you feel about your purchase? Are the different prices charged by the two

suppliers related to the services they offer? Were the extra services you got by shopping

at Smart Gadgets R Us worth the extra $200?


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The Value of the Middleman

Internet retailers can sell for less because their costs are much lower than those of full-service retail stores

Those stores hire salespeople, put their merchandise on display, rent space in expensive shopping malls Internet retailers, by contrast, typically employ

unskilled telephone clerks, and store their merchandise in cheap warehouses.

Sales representatives supply information to buyers Manufacturers can offer direct sales to bypass

middlemen How does better information affect

economic surplus?


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How does better information affect economic surplus?

Elias has just inherited a rare Egyptian gold coin minted in 1923 during the ruling of King Fuad He would like to keep it but reluctantly

decided to sell it to pay his billsHis reservation price is $300 but is

hoping to get much more He has two ways of selling it:

Place an ad in the local newspaper cost $5 List the coin on souq.com for a fee of 5% of

the Internet winning bid


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Because Elias lives in a small town, the maximum price in the local market is $400

If he lists it on souq.com, two online shoppers have secret reservation prices of $800 and $900, respectively Note: In an souq.com auction, each bidder

reports his or her reservation price for an item. When the auction closes, the bidder with the highest reservation price wins, and the price he or she pays is the reservation price of the second highest bidder


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Benefits of souq.com Coin sells for $800 on souq.com less

$40 commission Elias nets $760, $460 above his

reservation price• CS = $460

Buyer surplus is $100• PS = $100 = $900 – $800

TS = $460 + $100 = $560


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Local option is inferior Coin sells for $400 less $5 cost of ad Elias nets $395, $95 more than his

reservation price CS = $95

Buyer surplus is $0 PS = $0 = $400 – $400

TS = $95 + $0 = $95 <<< $560

Economic surplus is increased when a product goes to the person who values it the most Role of middleman to do just that


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$/u

nit

Units of information

MB

The Optimal Amount of Information

No doubt, more information is better than less But information is generally costly to acquire

Just like the Low-Hanging Fruit Principle People tend to gather information from the cheapest

sources first before turning to more costly ones

MC

I *

Optimal

Marginal benefit starts high, then falls rapidly

Marginal cost starts low, then increases

Optimal amount of information: I* where MC = MB


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Free Rider Problem

Does the invisible hand assure that the optimal amount of advice will be made available to consumers in the marketplace?

The market would provide the optimal level of retail service except for one practical problem: consumers can make use of the services offered by retail stores without paying for them

After benefiting from the advice of informed salespersons and after inspecting the merchandise, the consumer can return home and buy the same item from an internet retailer or mail-order house


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Free Rider Problem

A free-rider problem exists when non-payers cannot be excluded from consuming a good Interferes with incentives Market quantity is below social optimum

Because retail stores have difficulty recovering the cost of providing information, private incentives are likely to yield less than the socially optimal level of retail service


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Two Guidelines For Rational Search

In practice, the exact value of additional information is difficult to know

The amount of time and effort one should invest in acquiring it is not always obvious

But as always, the Cost-Benefit Principle provides a strong conceptual framework for thinking about this problem


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Rational Search Guidelines

Additional search time is more likely to be worthwhile for expensive items than cheap ones Visiting additional apartments entails a cost The more apartments someone visits, the more

likely it is that he or she will find one near the lower end of the rent distribution

Example: Rent in Tangier, Virginia vary between $300

and $500 per month, with an average rent of $400 per month

Rent in Tangier, Morocco vary between $2,000 and $3,000 per month, with an average rent of $2,500


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The expected saving from further time spent searching will be greater in Morocco than in Virginia

A rational person will expect to spend more time searching for an apartment in Morocco People typically hire real estate agents to

help them find a house They seldom hire agents to help them buy a

liter of milk


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Tamim and Tamam are shopping for a used piano Tamim has a car / Tamam does not

Which one should expect to examine fewer pianos before making the purchase?

• Buyer with a car will look at more pianos before buying

When searching becomes more costly, we should expect to do less of it As a result, the prices we expect to pay

will be higher when the cost of a search is higher


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Gamble Inherent in Search

Suppose you are in the market for a one-bedroom apartment and have found one that rents for $400 per month Should you rent it or search further in hopes

of finding a cheaper apartment? Even in a large market with many vacant

apartments, there is no guarantee that searching further will turn up a cheaper or better apartment

Searching further entails a cost, which might outweigh the gain between certain cost and unknown benefit Thus, further search invariably carries an

element of risk


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Additional search has elements of a gambleA gamble has a number of possible

outcomes Each outcome has a probability that it will occur

1st step: to compute the expected value—the average amount you would win (or lose) if you played that gamble an infinite number of times The expected value of a gamble is the sum of

the possible outcomes times their respective probability


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For Example: Suppose you win $1 if a coin flip

comes up heads Lose $1 if it comes up tails Since 1/2 is the probability of heads

(and also the probability of tails) The expected value of this gamble is

(1/2)($1) + (1/2)( $1) = 0 A fair gamble has an expected value of

zero


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Risk Preferences

A better-than-fair gamble has a positive expected value For instance, a coin flip in which you

win $2 for heads and lose $1 for tails is a better-than-fair gamble

A risk-neutral person would accept any gamble that is fair or better-than-fair A risk-averse person would refuse

any fair gamble


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Istanbul Apartment Search

You need a one-month sublet in Istanbul There are only two kinds of one-bedroom

apartments in the neighborhood in which you wish to live

One type of apartment rents for $400 The other type rents for $360

Of the vacant apartments in this neighborhood, 80% are of the 1st type and 20% are of the 2nd type

You must visit the apartment to get the rental rate

Cost per visit is $6 and you are risk-neutral Assume you visited the 1st type apartment

Should you visit another apartment or rent the one you’ve found?


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Istanbul Apartment Search

The 1st apartment you visit is the $400 version Look at the next apartment if the gamble is at

least fair Two outcomes to the gamble

You find a lower-priced apartment and your net benefit is $40 – $6 = $34 with 20% probability

You find another $400 apartment and your net benefit is – $6 with 80% probability

Expected value of the gamble is (34) (0.20) + (– 6) (0.80) = $2

Visiting another apartment is a better-than-fair gamble, and since you are risk-neutral, you should take it


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Commitment Problems and Search

Some searches are for circumstances requiring commitment over some period of time Leasing an apartment Taking a job Getting married

Search is costly and therefore limited People end their searches when the

marginal cost of searching exceeds the marginal benefit

BUT… what if you fall into a better option after the search has ended?


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The difficulty in maintaining stable matches between partners would not arise in a world of perfect information In such a world, everyone would end up in the

best possible relationship, so no one would be tempted to renege

But when information is costly and the search must be limited, there will always be the potential for existing relationships to dissolve

People solve this problem by committing themselves to remain in a relationship once a mutual agreement has been reached to terminate the search


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Commitment to solve the problem Contracts are used to bind parties together

AND Contracts carry penalties for breaking the

arrangement

People terminate their search because information gathering is costly

Even under some circumstances, one party may rationally choose to terminate the agreement and pay the penalties


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Asymmetric Information

Asymmetric information occurs when either the buyer or seller is better informed about the goods in the market Mutually beneficial trades

may not occur A seller might know that

a murder was committed in a house offered for sale

Buyer does not know


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Private Sale of a Used Car

On average, a Miata sells for $8,000 but Abir's Miata is in excellent condition so her reservation price is $10,000

Jabir wants to buy a used Miata His reservation price is $13,000 for one in

excellent condition and $9,000 for one in average condition

Determining the condition of Abir's car has a cost and the results are uncertain

Jabir cannot verify that Abir's Miata is superior

Will Jabir buy Abir’s car?


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Surplus Loss and Asymmetric Information

Abir’s car looks like any other Miata Jabir will not pay $10,000 for it

Jabir will buy someone else’s Miata for $8,000 However, this outcome is not efficient

Why? Assume that Jabir had bought Abir’s Miata for, say, $11,000 His surplus would have been $2,000 Abir’s surplus is $1,000 Instead, Jabir ends up buying a Miata that

is in average condition (or worse), and his surplus is only $1,000

Abir gets no economic surplus at all


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The Lemons Model

Economic incentives suggest that most used cars that are put up for sale will be of lower-than-average quality (lemons) 1st: people who mistreat their cars are more

likely than others to want to sell them 2nd: people whose cars were never very good

to begin with are more likely to want to sell them

Buyers know that below average cars are likely to be on the market and therefore they lower their reservation prices


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The Lemons Model

Once used car prices have fallen, the owners of cars that are in good condition have an even stronger incentive to hold onto them

Good quality cars are withdrawn from the market Average quality decreases further and

reservation prices decrease again

The lemons model says that asymmetric information tends to reduce the average quality of goods for sale


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Should you buy your Aunt's Car?

Your aunt offers you her 4-year old Accord

The asking price of $10,000 is also the blue book value

You believe the car is in good condition

Blue book value is the equilibrium price for below average cars

You should buy the car for $10,000 It is in better condition than the average

Accord of the same vintage and mileage


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How much will a naive buyer pay for a used car?

Assume that only 2 kinds of cars: good cars and lemons Owners know what kind they have Buyers can't determine a car's quality Buyers are risk neutral

What would the buyer offer for a used car? Expected value of a car is

(0.90) ($10,000) + (0.10) ($6,000) = $9,600The buyer gets a lemon

Good Cars Lemons

Probability 90% 10%

Value $10,000 $6,000


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How much will a naive buyer pay for a used car?

In practice, owners of good cars will sometimes be forced to sell them, even at a price that does not reflect its condition

The first thing sellers in this situation want a prospective buyer to know is the reason they are selling their cars For example, classified ads often announce,

“Just had a baby, must sell my 2005 Corvette”

Any time you pay the blue book price for a used car that is for sale for some reason unrelated to its condition, you are beating the market


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Credibility Problem

Why can’t someone with a high-quality used car simply tell the buyer about the car’s condition? The difficulty is that buyers’ and sellers’ interests

tend to conflict Sellers have an incentive to overstate the quality

of their cars Buyers have an incentive to understate the

amount they are willing to pay for used carsPeople have a natural tendency to

exaggerate 92% of factory employees surveyed in a study

rated themselves as more productive than the average factory worker


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How can a used car seller signal high quality credibly?

However, parties can often gain if they find a way to communicate information truthfully

If Abir can convince Jabir her Miata is in excellent condition, Jabir will buy But her statements are not credible

But what kind of signal about the car’s quality would Jabir find credible?

Abir offers Jabir a 6-month warranty on the car A warranty for a lemon would cost more than the

economic surplus gained Only sellers of good quality cars would offer the

warranty


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The Costly-to-Fake Principle

To communicate information credibly, a signal must be costly or difficult to fake

If the seller of a defective car could offer an extensive warranty just as easily as the seller of a good car, a warranty offer would communicate nothing about the car’s quality

Buyers value objective information about quality


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Costly Signals

Television advertising is expensive In print advertising, "As seen on TV"

signals a company's commitment to its product

Potential signal of quality Note, however, that the relevant information

lies in the expenditure on the advertising campaign, not in what the ads themselves say

Educational institutions' brands and students' grades signal quality An A student from AUS is more likely to

be offered a job than a C student from Preston University


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Conspicuous Consumption as a Signal of Ability

Some individuals of high ability are not highly paid (Remember the best elementary school teacher you ever had)

And some people earn a lot, yet spend very little

In competitive markets, the people with the most ability tend to receive the highest salaries

The more someone earns, the more he or she is likely to spend on high-quality goods and services

As such, these tendencies often lead us to infer a person’s ability from the amount and quality of the goods he consumes


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Conspicuous Consumption as a Signal of Ability

You need to choose a lawyer: You face two choices Lawyer A wears inexpensive suits and drives

a 10-year old Dodge Neon

Lawyer B wears custom-tailored suits and drives a new BMW 750i

No other information is available Which lawyer would you hire?

Conspicuous consumption signals success Choose Lawyer B because it is the only piece

of information you have!


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Statistical Discrimination

Statistical discrimination uses group characteristics to infer individual characteristics Can be applied to people as well as to goods

and services Results from observed differences between

groups Example

This candidate for employment is in her late twenties

Women have babies in their late twenties This candidate will have a baby in the next few

years High cost compared to other candidates


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Statistical Discrimination

Employers know that many people with only a high school diploma are more productive than a college graduate Employers usually cannot tell in advance who

those people are, they have to offer higher wages to college graduates

Universities realize that many applicants with low admission exam scores will earn higher grades than applicants with high scores. But if two applicants look equally promising

except for their admission exam scores, universities have to favor the applicant with higher scores


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Dangerous Drivers

Men under 25 years of age typically pay more than other drivers for auto insurance Expected cost of insuring a driver

depends the probability and size of claims

Individual assessments are not possible Rates are based on demographic groups

and the claim history of those groups Individual rates are adjusted upward as

more information becomes available


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Adverse Selection

Since insurance companies routinely practice statistical discrimination, each individual within a group pays the same rate, even though individuals within the group often differ sharply in terms of their likelihood of filing claims

Within each group, buying insurance is thus most attractive to those individuals with the highest likelihood of filing claims

As a result, high-risk individuals are more likely to buy insurance than low-risk individuals


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Adverse Selection

Adverse selection occurs because insurance tends to be purchased more by those who are most costly for companies to insure Insurance is most valuable to those with

many claimsAdverse selection increases

insurance premiums Reduces attractiveness of insurance to

low-risk customers "Best" insurance risk customers opt out

Rates increase Repeat


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Moral Hazard

Moral hazard is the tendency of people to expend less effort protecting insured goods People take more risk with insured goods or

activities Deductibles give policy holders an incentive

to be more cautiousSuppose a car owner has a $1,000

deductible policy The owner pays the first $1,000 of each

claim Strong incentive to avoid accidents

Claims less than $1,000 are not reported Insurance premiums go down


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Moral Hazard

Insurance premiums go down for 2 reasons

1st: The policies are cheaper for insurance companies to provide

2nd: Because the holder of a policy with a deductible provision will not file a claim at all if the damage to his car in an accident is less than the deductible threshold Insurance companies require fewer resources to

process and investigate claims increasing savings that get passed along in the form of lower premiums

chapter 11: the economics of information

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