Download - ©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 11: The Economics of Information
©2012 The McGraw-Hill Companies, All Rights Reserved
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Chapter 11: The Economics of Information
©2012 The McGraw-Hill Companies, All Rights Reserved
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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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How does better information affect economic surplus?
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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How does better information affect economic surplus?
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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How does better information affect economic surplus?
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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Rational Search Guidelines
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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Rational Search Guidelines
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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Gamble Inherent in Search
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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Gamble Inherent in Search
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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Commitment Problems and Search
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 Problems and Search
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