the economics of information slide 2

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The Economicsof Information

The Economicsof Information

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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.

MB MC How the MiddlemanAdds Value

ExampleHow should a consumer decide which pair

of skis to buy?Skis R Us has a.......

o knowledgeable sales staffo and a large inventory

They Recommend Salomon X-Scream 9 skis for $600


ExampleHow should a consumer decide which pair

of skis to buy?The skis can be purchased on the Internet for

$400

QuestionIs spending $600 on the right skis better

than $400 on the wrong ones?


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.


ExampleHow 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 = $95o eBay = $800 - $40 - $300

= $460 + $100 = $560


ExampleHow does better information affect

economic surplus?Economic surplus is increased when a product

goes to the person who values it the most.

MB MC The Optimal Amountof Information

$/u

nit

Units of information

Marginal costof information

Marginal benefitof information

I *

The optimal amount ofinformation (ignorance)occurs where MC = MB

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The Free Rider ProblemAn incentive problem in which too little

of a good or service is produced because nonpayers cannot be excluded from using it

The Optimal Amountof Information

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Economic NaturalistWhy is finding a knowledgeable salesclerk

often difficult?Why did Rivergate Books, the last

bookstore in Lambertville, NJ, recently go out of business?


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Two Guidelines for Rational SearchAdditional 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


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ExampleShould a person living in Paris, Tx, spend

more or less time searching for an apartment than someone living in Paris, France?


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ExampleTom 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?


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The Gamble Inherent in SearchWhen engaging in further search there are

additional costs and uncertain benefits and, therefore, there is a degree of risk or gamble from the search.


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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


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Determining whether or not to take the gamble:Fair Gamble

Coin flip: Heads win $1, Tails lose $1Expected value = (.5)($1) + (.5)(-$1) = 0


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Determining whether or not to take the gamble:Better-than-fair-gamble

Coin flip: Heads win $2, Tails lose $1Expected value = (.5)($2) + (.5)(-$1) = .5


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Determining whether or not to take the gamble:Risk-neutral person

Will accept any gamble that is fair or better

Risk-averse personWill refuse any fair gamble


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ExampleShould 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


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ExampleShould 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) + (.80)(-$6) = $2


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The Commitment Problems When Search is CostlyWhat happens when, by chance, a more

attractive option comes along after the search has ceased?


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The Commitment Problems When Search is CostlyWhen information is costly and the search

must be limited, a relationship may dissolve.


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The Commitment Problems When Search is CostlyCommitment agreements

Lease agreementsEmployment contractsMarriage contracts


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Asymmetric Information

Asymmetric InformationSituations in which buyers and sellers are

not equally well informed about the characteristics of goods and services for sale in the marketplace.

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ExampleWill Jane sell her car to Tom?

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ExampleWill Jane sell her car to Tom?

AssumeJane wants to sell a 2001 Miata

70,000 highway milesComplete maintenanceExcellent conditionAverage price is $8,000Jane’s reservation price is $10,000

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TomReservation 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 buys an average car

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ExampleThere is a loss in economic surplus

Assuming Tom had paid Jane $11,000

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ExampleTom

Pays $8,000 and has a gain of $1,000 ($9,000 - $8,000)

Tom’s Losso $13,000 - $11,000 = $2,000 - $1,000 = $1,000

Jane’s loss is $1,000Total loss is $2,000

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The Lemons ModelAsymmetric information tends to reduce

the average quality of goods offered for sale.

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The Lemons ModelPeople 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.

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The Lemons ModelBecause used car prices are low, people

with good cars keep them longer.The average quality of used cars falls even

further.

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ExampleShould you buy your aunt’s car?

4-year old AccordThe 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.

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ExampleHow much will a naïve buyer pay for a

used car?

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AssumeThere 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.

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ExampleCalculating the expected value:

(.90)($10,000) + (.10)($6,000) = $9,600o Reservation price for a risk-neutral buyer

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ExampleWho will sell a used car for what the naïve

buyer is willing to pay?Would not sell a good car that is worth $10,000Would sell a lemon that is worth $6,000Only lemons will be on the marketPrice will fall to $6,000

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What Do You Think?If you have a good used car for sale, how

can you get a higher price?

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The Credibility Problem In TradingPeople tend to interpret ambiguous

information in ways that promote their own interests.

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The Costly-to-Fake PrincipleTo communicate information credibly, a

signal must be costly or difficult to fake.

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Economic NaturalistWhy 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?

MB MC Conspicuous Consumptionas a Signal of Ability

Economic NaturalistWhy do many clients seem to prefer

lawyers who wear expensive suits?

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Statistical DiscriminationThe practice of making judgments about

the quality of people, goods, or services based on the characteristics of the groups to which they belong.

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Economic NaturalistWhy do males under 25 years of age pay

more than other drivers for auto insurance?

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Adverse SelectionThe pattern in which insurance tends to be

purchased disproportionately by those who are most costly for companies to insure

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Adverse SelectionRaises premiumsReduces the number of low-risk policy

holdersIncreases the risk level of the insured

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Moral HazardThe tendency of people to expend less

effort protecting those goods that are insured against theft or damage

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Moral HazardDeductibles are used to reduce moral

hazard and adverse selection.Lower ratesIncrease the incentive to drive safelyReduce the number of claims, which lowers

cost and premiums

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Disappearing Political Discourse

Economic NaturalistWhy do opponents of the death penalty

often remain silent?

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Disappearing Political Discourse

Economic NaturalistWhy do proponents of legalized drugs

remain silent?

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End ofChapterEnd of

Chapter

the economics of information slide 2

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