1. Chapter 14Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 1 ECON Designed by Amy McGuire, B-books, Ltd. 14 CHAPTER Transaction Costs, Imperfect Information, and Market Behavior Micro McEachern 2008-2009

2. Chapter 14Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 2 LO 1 Firm’s Rationale; Scope of Operation  Firms  Minimize transaction costs  Minimize production costs  More efficient

3. Chapter 14Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 3 LO 1 Firm’s Rationale; Scope of Operation  Firm’s boundaries  Vertical integration  Expansion into earlier/later stages of production  Bounded rationality  Minimum efficient scale  Easily observable quality  Many suppliers

4. Chapter 14Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 4 Exhibit 1 LO 1 Minimum Efficient Scale and Vertical Integration The computer manufacturer is producing at the minimum efficient scale of 1,000,000 computers per year. That output requires 1,000,000 computer chips. If the computer manufacturer produced its own chips, the cost would be much higher than if it buys them from a chip maker, operating on a much larger scale. Economies of scale in chip production are fat from exhausted when 1,000,000 chips a year are produced.

5. Chapter 14Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 5 LO 1 Firm’s Rationale; Scope of Operation  Market purchases of inputs  Specialization, comparative advantage  Firm buys a component (not produce) if  Buying is cheaper than making it  Well defined, and its quality easily observable  Many suppliers

6. Chapter 14Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 6 LO 1 Case Study The Trend Toward Outsourcing  Outsourcing  Firm buys products or services from outside suppliers  Firm  Division of labor  Law of comparative advantage  Core competency

7. Chapter 14Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 7 LO 1 Case Study The Trend Toward Outsourcing  Benefits  Firms that supply what other firms no longer do for themselves  Lower costs, lower prices  Allows producers to focus on what it does best and turn everything else over to other firms  Problems  Loss of control  Could weaken customer ties

8. Chapter 14Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 8 LO 1 Economies of Scope  Economies of scope  Cheaper to produce different items in one firm  Average cost per unit falls  As the firm supplies more types of products  Scope increases

9. Chapter 14Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 9 Market Behavior Imperfect Information LO 2  Marginal cost of search  Common knowledge is freely available  MC of information increases  MC curve slopes upward  Marginal benefit of search  Better quality for a given price  Lower price for a given quality  Marginal benefit decreases  Marginal benefit curve slopes upward

10. Chapter 14Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 10 Exhibit 2 LO 2 Optimal Search with Imperfect Information IfIf I*IpIp 0 Quantity of information Information costs and benefits (dollars) Marginal cost of information Marginal benefit of information When information is not free, additional information is acquired as long as its marginal benefit exceeds its marginal cost. Equilibrium, or optimal search, occurs where marginal benefit equals marginal cost. I* is the optimal quantity of information.

11. Chapter 14Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 11 Market Behavior Imperfect Information LO 2  Optimal search  Marginal benefit equals marginal cost  I P = full information  I* = optimal amount of information  Search costs  Price dispersion  Different prices for the same product  Quality differences across sellers

12. Chapter 14Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 12 The Winner’s Curse LO 2  Auctions for product of uncertain value  Many ‘winners’ end up losers  Estimated value of products  Winner: highest bid  Most optimistic  Competitive bidding with imperfect information

13. Chapter 14Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 13 Asymmetric Information in Product Market LO 3  Asymmetric information  One side of the market knows more  Hidden characteristics: Adverse selection  The informed side of the market self-select  Harms the uninformed side of the market

14. Chapter 14Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 14 Asymmetric Information in Product Market LO 3  Hidden actions: Principal-agent problem  The goals of the agent are incompatible with those of the principal  The agent can pursue hidden actions

15. Chapter 14Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 15 Asymmetric Information in Product Market LO 3  Insurance markets  Buyers – have more information  Adverse selection  Insurance buyers tend to be less healthy  Moral hazard  Principal-agent problem  Buyers – may take care less of their health

16. Chapter 14Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 16 Asymmetric Information in Product Market LO 3  Coping with asymmetric information  Incentive structure  Information- revealing system

17. Chapter 14Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 17 Asymmetric Information in Labor Market LO 4  Adverse selection  Employer – offers the going wage  Uninformed side  Candidates  Informed side  Talented – don’t want it  Less-talented – want it  Employers – better off offering a higher wage  Efficiency wages

18. Chapter 14Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 18 Asymmetric Information in Labor Market LO 4  Signaling  Attempt by the informed side to communicate valuable information  Proxy measures

19. Chapter 14Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 19 Asymmetric Information in Labor Market LO 4  Screening  Attempt by the uninformed side to uncover relevant but hidden characteristics

20. Chapter 14Copyright ©2009 by South-Western, a division of Cengage Learning. All rights reserved 20 LO 4 Case Study Reputation of a Big Mac  30,000 restaurants  100 countries  Product consistency  Competent and reliable franchise owners  Incentives  Constraints  Protect its reputation