mbmc copyright 2007 mcgraw-hill australia pty ltd ppts t/a principles of microeconomics by frank,...

Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and JenningsSlides prepared by Nahid Khan

14-1

MB MC

Chapter 14

The economics of information

14-2 Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and JenningsSlides prepared by Nahid Khan

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.


How the middleman adds value

• Example– How should Jason decide which camera to buy?

Camera World has a …• knowledgeable sales staff• and a large inventory.

The salesperson recommends a brand and model for $500.


How the middleman adds value (cont.)

• Example– How should a consumer decide which brand and model of

camera to buy? The camera can be purchased on the Internet for $450.

• Question– Is spending $500 on the right camera better than spending

$450 on the wrong one?



• How does better information affect economic surplus?– Sally wants to sell a rare art deco sideboard.

Her reservation price is $3000. An ad in the local newspaper costs $10. eBay cost is 5% of the Internet auction price. The maximum price in the local market is $4000.



• Example– How does better information affect economic

surplus? The maximum prices in the eBay market is $9000 and $8000. Economic surplus:

• Local market = $4000 - $10 - $3000 = $990• eBay = $8000 - $400 - $3000

= $4600 + $1000 = $5600



• Example– How does better information affect economic

surplus? Economic surplus is increased when a product goes to the

person who values it the most.


The optimal amount of information– Having more information is better than having less.– But information is costly to acquire.– According to low-hanging fruit principle, people tend to

gather information from the cheapest sources first.


The optimal amount of information (cont.)• Applying the cost–benefit test

– The cost-benefit principle A rational consumer will continue to gather information as long

as its marginal benefit exceeds it marginal cost.


The optimal amount of information (cont.)

$/u

nit

Units of information

Marginal costof information

Marginal benefitof information

I *

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



• 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.


Two guidelines for rational search

• Example– Should a person living in Wanganui, NZ, spend more or less

time searching for an apartment than someone living in Auckland, NZ?



• Example– Tom and Tim are shopping for a used upright piano.– Tom has a car & Tim does not.– Who should expect to search longer for a good price on a

used piano?



• The free-rider problem– An incentive problem in which too little of a good or service

is produced because non-payers cannot be excluded from using it.



• Thinking as an economist– Why is finding a knowledgeable salesperson often difficult?



• 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.



• Determining whether or not to take the gamble– Compute the expected value of the gamble

The sum of the possible outcomes of the gamble multiplied by their respective probabilities.



• Determining whether or not to take the gamble– Fair gamble

A gamble whose expected value is zero Coin flip: heads win $1, tails lose $1 Expected value = (.5)($1) + (.5)(-$1) = 0



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

A gamble whose expected value is positive Coin flip: heads win $2, tails lose $1 Expected value = (.5)($2) + (.5)(-$1) = .5



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

Will accept any gamble that is fair or better.

– Risk-averse person Will refuse any fair gamble.



• Example– Should you search further for an apartment?

Searching for an apartment in a neighbourhood 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.



• 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) + (.80)(-$6) = $2



• The commitment problem when search is costly– What happens when, by chance, a more attractive option

comes along after the search has ceased?



• The commitment problems when search is costly– When information is costly and the search must be limited,

a relationship may dissolve.



• The commitment problems when search is costly– Commitment agreements

Lease agreements Employment contracts Marriage contracts


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.


Asymmetric information (cont.)

• Example– Will Jane sell her car to Tom?



• Example– Will Jane sell her car to Tom?

• Assume– Jane wants to sell a 1998 Subaru Forester

112 000 highway km Complete maintenance Excellent condition Average price is $20 000 Jane’s reservation price is $22 000



• Tom– Reservation price

$25 000 if in excellent condition. $21 000 if not in excellent condition.

– Will not pay $22 000 because he cannot tell if Jane’s car is an excellent buy.

– Tom buys an average car.


Asymmetric Information (cont.)

• Example– There is a loss in economic surplus

Assuming Tom had paid Jane $23 000


Asymmetric Information (cont.)

• Example Tom pays $23 000 and has a gain of $2000 ($25 000 - $23 000) Jane would have a gain of $1000

– If Tom ends up buying a Forester that is in average condition, his surplus is only $1000 and Jane gets no economic surplus.



• The lemons model– Asymmetric information tends to reduce the average quality

of used goods offered for sale.



• 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.



• 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.



• Example– Should you buy your aunt’s car?

4-year old VW Beetle The asking price of $18 000 is the red book value. You believe the car is in good condition. It is a good deal because the red book value is the equilibrium

price for below average cars.



• Example– What is a naïve buyer’s reservation price for a used car?



• 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

$6000.– The used car market is 90% good cars and 10% lemons.



• Example– Calculating the expected value

(.90)($10 000) + (.10)($6000) = $9600• Reservation price for a risk-neutral buyer



• 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 $6000.



• What do you think?– If you have a good used car for sale, how can you get a

higher price?



• Principal–agent problem– A situation where an agent whose actions are costly to

monitor and whose objectives are not aligned with those of the principal, takes actions that do not result in the best outcome for the principal.

– The principal-agent problem arises where agent and principal do not share the same objectives and where the agent can pursue actions that affect the principal but that the principal cannot directly observe.



• The credibility problem in trading– People tend to interpret ambiguous information in ways that

promote their own interests.



• The costly-to-fake principle– To communicate information credibly, a signal must be costly

or difficult to fake.



• Thinking as an economist– Why do many companies care so much about elite

educational credentials?



• Conspicuous consumption as a signal ability– To assess a person’s ability from the amount and quality of

the goods he or she consumes.– An ability signal does not arise with equal force in every

environment.



• Thinking as an economist– Why do many clients seem to prefer lawyers who wear

expensive suits?



• 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.



• Thinking as an economist– Why do males under 25 years of age pay more than other

drivers for comprehensive car insurance?



• 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 the risk level of the insured.



• Moral hazard– The tendency of people to change their behaviour once they

become party to a contract.– 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


Disappearing political discourse

• Thinking as an economist– Why might proponents of ‘safe injection rooms’ often remain

silent?


Information and health care delivery

• In Australia, Medicare provides a universal, tax-financed third-party payment scheme that reflects the principle that access to health care should be driven by need and not by the ability to pay.

• A large number of private health insurance schemes provide the option of buying additional cover.

• First-dollar insurance coverage pays all expenses associated with claims generated by the insured activity.


Information and health care delivery (cont.)

• Applying the cost–benefit test– The cost of medical procedures are relatively easy to

measure but the usual measure of the benefit of a service may not be acceptable.

– Society has a responsibility to ensure essential medical services regardless of affordability.

– Example David needs his tonsils removed for which he must personally

pay for the number of days he stays in the hospital. How long should David stay in the hospital? What if the cost of hospital room is completely covered by

insurance?



• Designing a solution• Moral hazard problem• Waste cost by full insurance coverage

– Price inelastic demand: negligible waste– Price elastic demand: significant waste



• Private health care insurance– Private health insurance is promoted as a way of

augmenting the resource available through the publicly funded system.



• Thinking as an economist– Why have so many young people abandoned private health

insurance?

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