Information and its value Lecture 4 4UZE402 Economics of Business Organizations

Outline Risk Coordination and information Hidden information Hidden action The value of information

Coordination and information Assumptions of perfect competition: Firms are price takers, they have no power to affect the price of the product Freedom of entry of new firms; complete factor mobility in the long run: higher profits attracts capital, workers and etc. All firms produce an identical product (homogeneous good). No quality differences, branding or advertising Producers and consumers have perfect knowledge of the market.

Coordination and information Market can only handle quite limited information requirements. Solutions to information problem: Brand names – signals of particular quality classes Contingent claims contract - specific terms of the contract are made contingent (conditional) upon the uncertainty involved Information asymmetry – situation when information is available but it is unevenly distributed. Fundamental paradox of information: the value of information can only be revealed to another party by disclosing that information, while such disclosure destroys its value. Opportunistic behaviour

Consequences of asymmetric information Task

Hidden information Hidden information (adverse selection) is an information problem that already exists before the transaction (ex ante info problem); one party is better informed about a relevant variable in the transaction than the other party Low risk Average risk (AR) High risk

Hidden information Reasons of adverse selection phenomenon: One party has private information that is relevant to a potential transaction This private information is basically unobservable to the other party Possible solutions: Signalling Increase observability Pool the risks Redistribute the risks Segment the risks

Hidden action Hidden action (moral hazard) is an information asymmetry that may develop during or after the execution of a transaction (ex post info problem) Possible solutions Increase observability Risk-sharing arrangements Organizational arrangements

Risk Risk is associated with the probability of undesirable event. Attitude towards risk: Risk-neutral person– someone who is completely indifferent to the risk involved in an investment and is only concerned about expected return. Risk-averse person – someone who wants to avoid risk unless adequately compensated for it. Risk-lover – a person who has a preference for risk

The value of information Information has value because of its scarcity. STATES OF NATURE Success Failure ACTS Introduce 8 - 2 Do not introduce Probabilities of states 0.3 0.7 8 Success 0.3 A 1 Introduce - 2 Failure 0.7 C Do not introduce B E(A) = 0.3 x 8 + 0.7 x (-2) = 1

The value of information You have a suggestion to run a marketing test. After this test your chances of success increase to 80%. However, this service will cost you $3 million. Will you run the test? C 1 No test marketing 8 Success 0.8 Test marketing Introduce 6 B Failure 0.2 6 Do not introduce -2

Glossary Price-taker - an economic entity has to accept the prevailing market price and cannot hope to influence the price level Homogeneous good – a good that comes only in one standardized form Opportunistic behaviour – a situation in which one party takes advantage of his superior knowledge, in order to further his/her interests Probability – the odds or chance that the outcome will occur - you should choose between two values the largest one - you should calculate the payoff using possible outcomes and probabilities

Reading Douma S., Schreuder H. (2002) Economic Approaches to Organizations. Prentice Hall. Ch. 4 (pp.51- 62) Samuelson W., Marks S. (2003) Managerial Economics, 4th edition. Ch.15 (pp. 632-643)