MBMC Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 14-1 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 Jennings Slides 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.

14-3 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 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.

14-4 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 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?

14-5 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan How the middleman adds value (cont.) 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.

14-6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan How the middleman adds value (cont.) Example –How does better information affect economic surplus?  The maximum prices in the eBay market is $9000 and $8000.  Economic surplus: Local market = $ $10 - $3000 = $990 eBay = $ $400 - $3000 = $ $1000 = $5600

14-7 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan How the middleman adds value (cont.) Example –How does better information affect economic surplus?  Economic surplus is increased when a product goes to the person who values it the most.

14-8 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 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.

14-9 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 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.

14-10 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan The optimal amount of information (cont.) $/unit Units of information Marginal cost of information Marginal benefit of information I * The optimal amount of information (ignorance) occurs where MC = MB

14-11 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan The optimal amount of information (cont.) 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.

14-12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 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?

14-13 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan The optimal amount of information (cont.) 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?

14-14 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan The optimal amount of information (cont.) 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.

14-15 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan The optimal amount of information (cont.) Thinking as an economist –Why is finding a knowledgeable salesperson often difficult?

14-16 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan The optimal amount of information (cont.) 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.

14-17 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan The optimal amount of information (cont.) 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.

14-18 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan The optimal amount of information (cont.) 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

14-19 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan The optimal amount of information (cont.) 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

14-20 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan The optimal amount of information (cont.) 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.

14-21 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan The optimal amount of information (cont.) 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.

14-22 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan The optimal amount of information (cont.) 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

14-23 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan The optimal amount of information (cont.) The commitment problem when search is costly –What happens when, by chance, a more attractive option comes along after the search has ceased?

14-24 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan The optimal amount of information (cont.) The commitment problems when search is costly –When information is costly and the search must be limited, a relationship may dissolve.

14-25 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan The optimal amount of information (cont.) The commitment problems when search is costly –Commitment agreements  Lease agreements  Employment contracts  Marriage contracts

14-26 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 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.

14-27 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Asymmetric information (cont.) Example –Will Jane sell her car to Tom?

14-28 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Asymmetric information (cont.) Example –Will Jane sell her car to Tom? Assume –Jane wants to sell a 1998 Subaru Forester  highway km  Complete maintenance  Excellent condition  Average price is $  Jane’s reservation price is $22 000

14-29 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Asymmetric information (cont.) Tom –Reservation price  $ if in excellent condition.  $ if not in excellent condition. –Will not pay $ because he cannot tell if Jane’s car is an excellent buy. –Tom buys an average car.

14-30 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Asymmetric Information (cont.) Example –There is a loss in economic surplus  Assuming Tom had paid Jane $23 000

14-31 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Asymmetric Information (cont.) Example  Tom pays $ and has a gain of $2000 ($ $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.

14-32 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Asymmetric information (cont.) The lemons model –Asymmetric information tends to reduce the average quality of used goods offered for sale.

14-33 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Asymmetric information (cont.) 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.

14-34 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Asymmetric information (cont.) 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.

14-35 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Asymmetric information (cont.) Example –Should you buy your aunt’s car?  4-year old VW Beetle  The asking price of $ 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.

14-36 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Asymmetric information (cont.) Example –What is a naïve buyer’s reservation price for a used car?

14-37 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Asymmetric information (cont.) Assume –There are only good cars and lemons. –10% of all new cars are lemons. –Good used cars are worth $ and lemons are worth $6000. –The used car market is 90% good cars and 10% lemons.

14-38 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Asymmetric information (cont.) Example –Calculating the expected value  (.90)($10 000) + (.10)($6000) = $9600 Reservation price for a risk-neutral buyer

14-39 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Asymmetric information (cont.) 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 $  Would sell a lemon that is worth $  Only lemons will be on the market.  Price will fall to $6000.

14-40 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Asymmetric information (cont.) What do you think? –If you have a good used car for sale, how can you get a higher price?

14-41 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Asymmetric information (cont.) 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.

14-42 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Asymmetric information (cont.) The credibility problem in trading –People tend to interpret ambiguous information in ways that promote their own interests.

14-43 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Asymmetric information (cont.) The costly-to-fake principle –To communicate information credibly, a signal must be costly or difficult to fake.

14-44 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Asymmetric information (cont.) Thinking as an economist –Why do many companies care so much about elite educational credentials?

14-45 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Asymmetric information (cont.) 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.

14-46 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Asymmetric information (cont.) Thinking as an economist –Why do many clients seem to prefer lawyers who wear expensive suits?

14-47 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Asymmetric information (cont.) 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.

14-48 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Asymmetric information (cont.) Thinking as an economist –Why do males under 25 years of age pay more than other drivers for comprehensive car insurance?

14-49 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Asymmetric information (cont.) 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.

14-50 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Asymmetric information (cont.) 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

14-51 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Disappearing political discourse Thinking as an economist –Why might proponents of ‘safe injection rooms’ often remain silent?

14-52 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 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.

14-53 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan 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?

14-54 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Information and health care delivery (cont.) Designing a solution Moral hazard problem Waste cost by full insurance coverage –Price inelastic demand: negligible waste –Price elastic demand: significant waste

14-55 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Information and health care delivery (cont.) Private health care insurance –Private health insurance is promoted as a way of augmenting the resource available through the publicly funded system.

14-56 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Microeconomics by Frank, Bernanke and Jennings Slides prepared by Nahid Khan Information and health care delivery (cont.) Thinking as an economist –Why have so many young people abandoned private health insurance?