1. The Economics of Information
Chapter 11
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2. Learning Objectives
Explain how middlemen add value to market transactions
Use the concept of rational search to find the optimal amount of information market participants should obtain
Define asymmetric information and describe how it leads to the lemons problem
Discuss how advertising, conspicuous consumption, statistical discrimination, and other devices are responses to asymmetric information
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3. Information and the Invisible Hand
All parties have all relevant information
Without free information, market results are not efficient
Bargaining for a bowl in Kashmir
Parties must decide how much information to gather
Information gathering strategies differ
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4. How The Middleman Adds Value
Buyers sometimes choose among several version of a product
Each has complex feature sets
Research options
Company web site
Ask friends and family
Consumer Reports, online product reviews
Visit stores, ecommerce sites
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5. Consumer Choice: Buying Skis
Skis R Us recommend $600 Salomon X-Scream 9 skis
Sales rep seems knowledgeable
Your next move is
Thank them and do more research
Trust the sales rep and buy them
Go home and buy at the best price online ($400)
Evaluate the importance of
Immediate possession
Best price
Post-sales service and support
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6. The Value of the Middleman
Sales representatives supply information to buyers
Manufacturers can offer direct sales to bypass middlemen
Information makes markets more efficient
Purchasing the bowl in Kashmir
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7. Selling Babe Ruth 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
Two eBay shoppers have secret reservation prices of $800 and $900, respectively
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8. Selling Babe Ruth Benefits of eBay Local option is inferior
Card sells for $800 on eBay less $40 commission
Ellis nets $760, $460 above his reservation price
Buyer surplus is $100
Local option is inferior
Card sells for $400 less $5 cost of ad
Ellis nets $395, $95 more than his reservation price
Buyer surplus is $0
Economic surplus is increased when a product goes to the person who values it the most
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9. The Optimal Amount of Information
More information is better than less
Gathering information has a cost
Marginal benefit starts high, then falls rapidly
Low-Hanging Fruit Principle
Marginal cost starts low,
then increases
Optimal amount of
information is I* where
MC = MB
I *
Optimal
$/unit
Units of information MB MC
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10. 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
Stores bear the cost of training sales reps on merchandise
Shoppers use sales reps as information source
Then some shoppers buy elsewhere
Store is unable to capture some of the value it delivered to the shopper: a free-rider problem
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11. Example: The Last Bookstore
Independent bookstores differentiate themselves with personalized service
Offer more information and recommendations than Barnes & Nobles or Borders
Chain bookstores carry large inventory and shopping center location can erode local store base
Ecommerce sites such as Amazon.com and Overstock.com offer reviews and recommendations
Large inventory; quick delivery
Online sales further reduce sales in independent stores
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12. Rational Search Guidelines
Additional search time is more likely to be worthwhile for expensive items than cheap ones
Apartment search in Paris, Texas involves less time than Paris, France
Texas has lower rents and narrower price range
Prices paid will be higher when the cost of a search is higher
Two buyers, only one with a car
Buyer with the car will look at more pianos before buying
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13. Gamble Inherent in Search
Additional search has costs that are certain
Benefits are uncertain benefits
Additional search has elements of a gamble
A gamble has a number of possible outcomes
Each outcome has a probability that it will occur
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14. Gamble Inherent in Search
The expected value of a gamble is the sum of (the possible outcomes times their respective probability)
A fair gamble has an expected value of zero
A better-than-fair gamble has a positive expected value
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15. Risk Preferences
A risk-neutral person would accept any gamble that is fair or better-than-fair
A risk-averse person would refuse any fair gamble
A risk-loving person would enter even in an unfair gamble
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16. The Gamble in the Search
You need a one-month sublet in San Francisco
One type of apartment rents for $400 and it is 80% of the available market
The other type rents for $360 and makes up 20% of the market
You must visit the apartment to get the rental rate
Cost per visit is $6
You are risk-neutral
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17. San Francisco Apartment Search
The first 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 $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
Keep searching
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18. 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?
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19. Commitment Problems and Search
If information were freely available, there would be no commitment 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
Under some circumstances, one party may rationally choose to terminate the agreement and pay the penalties
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20. 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
Buyer
Seller
Fact D
Fact C
Fact B
Fact A
Fact 2
Fact 1
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21. Private Sale of a Used Car
Jane's Miata is in excellent condition
Jane's reservation price is $10,000
Blue Book value is $8,000
Tom wants to buy a Miata
His reservation price is $13,000 for one in excellent condition and $9,000 for one in average condition
Determining the condition of Jane's car has a cost and the results are uncertain
Tom cannot verify that Jane's Miata is superior
Tom buys another Miata for $8,000; Jane's is unsold
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22. Surplus Loss and Asymmetric Information
Tom's loss is $1,000
Pays $8,000 and has a gain of $1,000
Tom’s loss from buying an average car instead of Jane's
$13,000 – $11,000 = $2,000
Tom's net loss is $1,000
Jane’s loss from losing Tom as a customer is $1,000
Total loss is $2,000
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23. The Lemons Model
People who have below average cars (lemons), 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
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
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24. The Lemons Model in Action
Your aunt offers you her 4-year old Accord
The asking price of $10,000 is 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
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25. Naïve Buyer Two 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 Cars
Lemons
Probability
90%
10%
Value
$10,000
$6,000
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26. Credibility Problem
Parties gain if they find a way to communicate information truthfully
If Jane can convince Tom her Miata is in excellent condition, Tom will buy
Statements are not credible
Jane offers Tom a six-month warranty on all car defects at the time of purchase
A warranty for a lemon would cost more than the economic surplus gained
Only sellers of good quality cars would offer the warranty
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27. The Costly-to-Fake Principle
To communicate information credibly, a signal must be costly or difficult to fake
Sellers have an incentive to exaggerate the quality of their product
Buyers value objective information about quality
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28. 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
Educational institutions' brands and students' grades signal quality
An A+ student from MIT is more likely to be offered a job than a C student from an average academic institution
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29. Conspicuous Consumption
Choose a lawyer
Lawyer A wears inexpensive suits and drives a 10-year old Dodge Neon
Lawyer B wears custom-tailored suits and drives a new BMW 745i
No other information is available
Conspicuous consumption signals success
Choose Lawyer B ….
… and pass on Ben Matlock!
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30. 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
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31. Dangerous Drivers
Men under 25 years of age 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
Why does Allstate offer forgiveness for an accident and a rebate for being accident-free in a six-month period
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32. 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
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33. 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
Moral hazard has been widely discussed in relation to the mortgage meltdown of late 2007 and Some argue that government help for financial institutions and individuals in foreclosure represent a moral hazard. The institutions and individuals took more risk than they anticipated or could bear. Since the problem is widespread, the government may provide some relief, in effect, providing the risk-takers with free insurance – at the expense of tax payers.
Looking beyond the immediate crisis, some argue that any bail-out will increase the overall risk taking in business and therefore increase the likelihood that government will bail out future industries whose risks don't pay off. Some would argue that since the businesses share only a portion of their benefits from a positive result (through taxes on net income), it is inappropriate for government to sustain the losses in any greater share than they would capture the gains.
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34. Disappearing Political Discourse
Disappearing political discourse theory holds that politicians who support a policy will remain silent to avoid being misunderstood
Opposing the death penalty could be interpreted by voters as being soft on crime
No necessary relationship between the two
Assumes voters implicitly assign a position to a politician who has not made public statements
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35. Politicians and the Death Penalty
Arguments against the death penalty
Expensive relative to life in prison without parole
Irreversible for people later found innocent
Does not deter capital crimes
Politicians avoid taking a public position on capital punishment
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36. Politicians and the Death Penalty
Voters want politicians are tough on crime
Broader issue than the death penalty
Two groups of politicians: tough on crime and soft on crime
Voters use information about a politician's views on the death penalty to infer the politician's stand on crime
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37. Politicians and the Death Penalty
Favor Death Penalty PLUS Remain Silent
95% tough on crime
Oppose only the Death Penalty
80% tough on crime
Oppose Punishing Criminals
Politicians tough on crime and opposed to capital punishment lose votes
They have an incentive to remain silent
Move to blue box
Probability that a politician in the red box is tough on crime decreases
More defections
Public statements do not accurately reflect aggregate views of politicians on capital punishment
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38. Legalized Drugs
Laws against buying and selling certain substances are intended to reduce the harm to society from drug use
Laws have a cost
Price of illegal drugs increases
Addicts commit crimes to pay for drugs
Diverts people from productive employment
Externalities of turf battles
High cost to law enforcement, legal, and prison systems
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39. Legalized Drugs Legalization solves most problems
Opponents
Supporters
Rational Opponent
Rational Supporter
Crazy Supporter
Crazy Opponent
Legalization solves most problems
With lower drug prices, quantity demanded may increase
Not supported by evidence in UK and Netherlands
An outspoken supporter is seen by voters as more likely to be crazy than an outspoken opponent
Rational supporters do not speak out
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40. The principal – agent model (Laffont) (1)
The asymmetric information between the P and the A has a huge impact on the contract they agree on
The efficient use of the factors of production requires that A’s private information become a common knowledge
P must transfer an “information rent” to A in order to make her reveal private information
The information rent adds to the technological costs of P. Consequently, the volume of trade differs from the one that would have been occurred under perfect information
The equilibrium is the “second best solution” of the game between P and A

41. The principal – agent model (2)
P delegates the task to A that A should produce a good in an amount of q. The value of q for P is S(q) so, that
P cannot observe the production cost of q, but the possible distribution of costs are common knowledge between P and A
Marginal cost can have the following values:

42. The principal – agent model (3)
The aim of the contract is to achieve maximum allocative efficiency between P and A
P transfers pay t to A, and the feasible allocations of the contract are:
Efficient contract without uncertainty: marginal benefit = marginal cost:
It is reasonable to execute both production plans if social welfare function is non-negative

43. The principal – agent model (4)
Assume that A’s reservation wage, t0 = 0, and there is no fixed cost of production. Then, A’s participation constraint, depending on A’s type is
P’s contract offer is:
All risk is born by P, who is assumed to be risk neutral, while A is risk averse

44. The principal – agent model (5)
The inefficient agent must receive a higher pay beyond a certain level of output, for she must exert larger effort to produce that amount than the efficient agent q t

45. The principal – agent model: A graphic representation
The utility curves of A can intersect only once. B* is preferred by both agents to A*, for both U-curves that pass through B* correspond to a non-negative U-level
If A is efficient, the solution is A*, if not, it is B*. Since P has all the bargaining power, his only solution is V* = S(q*) – t* = W* t q B* A*

46. The principal – agent model (6)
If A has private information (about her costs), her choice always will be B*, although she could achieve A*, for B* requires less effort.
P’s offer of (A*, B*) does not provide incentives to A for self selection
Incentive compatibility constraints:
Incentive feasible menus: participation + incentive compatibility
The maximum wage that an efficient A can achieve by mimicking inefficiency is and her information rent is:
The object of the contract is the division of profit, Π between P and A. A’s wage must depend on Π, otherwise A would always select the “easy way”
Risk was born by P under perfect information, while risk will be allocated between P and A
Reservation wage is acceptable for an inefficient agent that also maximizes P’s profit

47. The principal – agent model (7)
The monotonicity constraint
From the incentive compatibility constraints it follows that
The above condition is the implementability constraint. Indeed, there exist transfers

48. The principal – agent model (8)
The profit maximization problem of P is:
Expected allocation efficiency Expected information rent
The constraints can be reduced to two: to the incentive compatibility constraint of the efficient agent and to the participation constraint of the inefficient agent
Thus, the simplified form of the P’s maximization problem is:

49. The principal – agent model (10)
The second best solution: marginal benefit of P = marginal cost of A
Solution for an efficient q, t and information rent

50. Compensation and motivation
Managerial compensation schemes
Share options
Repurchase options
Compensation on a one time basis
Compensation on a repeated contract basis
The static prisoners’ dilemma game
The repeated prisoners’ dilemma game
What to motivate for?
Means of motivation

51. The Economics of Information
Middlemen
Free-Rider Problem
Rational Search
Optimal amount of information
Search as a gamble
Risk preferences
Commitment problems
Asymmetric Information
Credibility problem
Costly to fake principle
Statistical discrimination
Adverse selection
Moral hazard
Political discourse
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