©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 11: The Economics of Information

©2012 The McGraw-Hill Companies, All Rights Reserved 2 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

©2012 The McGraw-Hill Companies, All Rights Reserved 3 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

©2012 The McGraw-Hill Companies, All Rights Reserved 4 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…

©2012 The McGraw-Hill Companies, All Rights Reserved 5 The Middleman Adds Value Buyers sometimes choose among several versions of a product  Each has complex features that buyers do not fully understand Research options  Company web site  Ask friends and family  Consumer Reports, online product reviews  Visit stores, ecommerce sites

©2012 The McGraw-Hill Companies, All Rights Reserved 6 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?

©2012 The McGraw-Hill Companies, All Rights Reserved 7 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?

©2012 The McGraw-Hill Companies, All Rights Reserved 8 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 bills His 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

©2012 The McGraw-Hill Companies, All Rights Reserved 9 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

©2012 The McGraw-Hill Companies, All Rights Reserved 10 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

©2012 The McGraw-Hill Companies, All Rights Reserved 11 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

©2012 The McGraw-Hill Companies, All Rights Reserved 12 $/unit 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

©2012 The McGraw-Hill Companies, All Rights Reserved 13 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

©2012 The McGraw-Hill Companies, All Rights Reserved 14 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

©2012 The McGraw-Hill Companies, All Rights Reserved 15 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

©2012 The McGraw-Hill Companies, All Rights Reserved 16 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

©2012 The McGraw-Hill Companies, All Rights Reserved 17 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

©2012 The McGraw-Hill Companies, All Rights Reserved 18 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

©2012 The McGraw-Hill Companies, All Rights Reserved 19 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

©2012 The McGraw-Hill Companies, All Rights Reserved 20 Gamble Inherent in Search Additional search has elements of a gamble A gamble has a number of possible outcomes  Each outcome has a probability that it will occur 1 st 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

©2012 The McGraw-Hill Companies, All Rights Reserved 21 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

©2012 The McGraw-Hill Companies, All Rights Reserved 22 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

©2012 The McGraw-Hill Companies, All Rights Reserved 23 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 1 st type and 20% are of the 2 nd 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 1 st type apartment  Should you visit another apartment or rent the one you’ve found?

©2012 The McGraw-Hill Companies, All Rights Reserved 24 Istanbul Apartment Search The 1 st 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

©2012 The McGraw-Hill Companies, All Rights Reserved 25 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?

©2012 The McGraw-Hill Companies, All Rights Reserved 26 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

©2012 The McGraw-Hill Companies, All Rights Reserved 27 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

©2012 The McGraw-Hill Companies, All Rights Reserved 28 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 BuyerSeller Fact DFact C Fact B Fact A Fact 2Fact 1

©2012 The McGraw-Hill Companies, All Rights Reserved 29 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?

©2012 The McGraw-Hill Companies, All Rights Reserved 30 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

©2012 The McGraw-Hill Companies, All Rights Reserved 31 The Lemons Model Economic incentives suggest that most used cars that are put up for sale will be of lower- than-average quality (lemons)  1 st : people who mistreat their cars are more likely than others to want to sell them  2 nd : 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

©2012 The McGraw-Hill Companies, All Rights Reserved 32 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

©2012 The McGraw-Hill Companies, All Rights Reserved 33 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

©2012 The McGraw-Hill Companies, All Rights Reserved 34 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) = $9,600 The buyer gets a lemon Good CarsLemons Probability90%10% Value$10,000$6,000

©2012 The McGraw-Hill Companies, All Rights Reserved 35 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

©2012 The McGraw-Hill Companies, All Rights Reserved 36 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 cars People have a natural tendency to exaggerate  92% of factory employees surveyed in a study rated themselves as more productive than the average factory worker

©2012 The McGraw-Hill Companies, All Rights Reserved 37 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

©2012 The McGraw-Hill Companies, All Rights Reserved 38 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

©2012 The McGraw-Hill Companies, All Rights Reserved 39 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

©2012 The McGraw-Hill Companies, All Rights Reserved 40 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

©2012 The McGraw-Hill Companies, All Rights Reserved 41 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!

©2012 The McGraw-Hill Companies, All Rights Reserved 42 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

©2012 The McGraw-Hill Companies, All Rights Reserved 43 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

©2012 The McGraw-Hill Companies, All Rights Reserved 44 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

©2012 The McGraw-Hill Companies, All Rights Reserved 45 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

©2012 The McGraw-Hill Companies, All Rights Reserved 46 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 claims Adverse selection increases insurance premiums  Reduces attractiveness of insurance to low-risk customers  "Best" insurance risk customers opt out  Rates increase  Repeat

©2012 The McGraw-Hill Companies, All Rights Reserved 47 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 cautious Suppose 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

©2012 The McGraw-Hill Companies, All Rights Reserved 48 Moral Hazard Insurance premiums go down for 2 reasons  1 st : The policies are cheaper for insurance companies to provide  2 nd : 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