MBMC The Economics of Information The Economics of Information

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 2 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.

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 3 How the Middleman Adds Value Example How should a consumer decide which pair of skis to buy?  Skis R Us has a oknowledgeable sales staff oand a large inventory  They Recommend Salomon X-Scream 9 skis for $600

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 4 How the Middleman Adds Value Example How should a consumer decide which pair of skis to buy?  The skis can be purchased on the Internet for $400 Question Is spending $600 on the right skis better than $400 on the wrong ones?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 5 How the Middleman Adds Value 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.

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 6 How the Middleman Adds Value Example How does better information affect economic surplus?  The maximum prices in the eBay market is $900 and $800.  Economic surplus: oLocal market = $400 - $5 - $300 = $95 oeBay = $800 - $40 - $300 = $460 + $100 = $560

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 7 How the Middleman Adds Value Example How does better information affect economic surplus?  Economic surplus is increased when a product goes to the person who values it the most.

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 8 The Optimal Amount of Information $/unit Units of information Marginal cost of information Marginal benefit of information I * The optimal amount of information (ignorance) occurs where MC = MB

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 9 The Free Rider Problem An incentive problem in which too little of a good or service is produced because nonpayers cannot be excluded from using it The Optimal Amount of Information

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 10 Economic Naturalist Why is finding a knowledgeable salesclerk often difficult? Why did Rivergate Books, the last bookstore in Lambertville, NJ, recently go out of business? The Optimal Amount of Information

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 11 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 The Optimal Amount of Information

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 12 Example Should a person living in Paris, Tx, spend more or less time searching for an apartment than someone living in Paris, France? The Optimal Amount of Information

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 13 Example Tom 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? The Optimal Amount of Information

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 14 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. The Optimal Amount of Information

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 15 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 The Optimal Amount of Information

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 16 Determining whether or not to take the gamble: Fair Gamble  Coin flip: Heads win $1, Tails lose $1  Expected value = (.5)($1) + (.5)(-$1) = 0 The Optimal Amount of Information

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 17 Determining whether or not to take the gamble: Better-than-fair-gamble  Coin flip: Heads win $2, Tails lose $1  Expected value = (.5)($2) + (.5)(-$1) =.5 The Optimal Amount of Information

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 18 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 The Optimal Amount of Information

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 19 Example Should 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 The Optimal Amount of Information

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 20 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 Optimal Amount of Information

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 21 The Commitment Problems When Search is Costly What happens when, by chance, a more attractive option comes along after the search has ceased? The Optimal Amount of Information

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 22 The Commitment Problems When Search is Costly When information is costly and the search must be limited, a relationship may dissolve. The Optimal Amount of Information

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 23 The Commitment Problems When Search is Costly Commitment agreements  Lease agreements  Employment contracts  Marriage contracts The Optimal Amount of Information

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 24 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.

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 25 Asymmetric Information Example Will Jane sell her car to Tom?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 26 Asymmetric Information Example Will Jane sell her car to Tom? Assume Jane wants to sell a 2001 Miata  70,000 highway miles  Complete maintenance  Excellent condition  Average price is $8,000  Jane’s reservation price is $10,000

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 27 Asymmetric Information Tom Reservation 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

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 28 Asymmetric Information Example There is a loss in economic surplus  Assuming Tom had paid Jane $11,000

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 29 Asymmetric Information Example Tom  Pays $8,000 and has a gain of $1,000 ($9,000 - $8,000)  Tom’s Loss o$13,000 - $11,000 = $2,000 - $1,000 = $1,000 Jane’s loss is $1,000 Total loss is $2,000

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 30 Asymmetric Information The Lemons Model Asymmetric information tends to reduce the average quality of goods offered for sale.

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 31 Asymmetric Information 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.

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 32 Asymmetric Information 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.

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 33 Asymmetric Information Example Should you buy your aunt’s car?  4-year old Accord  The 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.

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 34 Asymmetric Information Example How much will a naïve buyer pay for a used car?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 35 Asymmetric Information 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 $6,000. The used car market is 90% good cars and 10% lemons.

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 36 Asymmetric Information Example Calculating the expected value:  (.90)($10,000) + (.10)($6,000) = $9,600 oReservation price for a risk-neutral buyer

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 37 Asymmetric Information 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 $6,000

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 38 Asymmetric Information What Do You Think? If you have a good used car for sale, how can you get a higher price?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 39 Asymmetric Information The Credibility Problem In Trading People tend to interpret ambiguous information in ways that promote their own interests.

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 40 Asymmetric Information The Costly-to-Fake Principle To communicate information credibly, a signal must be costly or difficult to fake.

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 41 Asymmetric Information Economic Naturalist Why 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?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 42 Conspicuous Consumption as a Signal of Ability Economic Naturalist Why do many clients seem to prefer lawyers who wear expensive suits?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 43 Asymmetric Information 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.

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 44 Asymmetric Information Economic Naturalist Why do males under 25 years of age pay more than other drivers for auto insurance?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 45 Asymmetric Information Adverse Selection The pattern in which insurance tends to be purchased disproportionately by those who are most costly for companies to insure

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 46 Asymmetric Information Adverse Selection Raises premiums Reduces the number of low-risk policy holders Increases the risk level of the insured

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 47 Asymmetric Information Moral Hazard The tendency of people to expend less effort protecting those goods that are insured against theft or damage

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 48 Asymmetric Information Moral Hazard 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

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 49 Disappearing Political Discourse Economic Naturalist Why do opponents of the death penalty often remain silent?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: The Economics of Information Slide 50 Disappearing Political Discourse Economic Naturalist Why do proponents of legalized drugs remain silent?

MBMC End of Chapter End of Chapter