1. Transaction Costs, Imperfect Information, and Market Behavior
Chapter 14
Transaction Costs, Imperfect Information, and Market Behavior
© 2006 Thomson/South-Western

2. Rationale for the Firm Ronald Coase
Firms are superior to markets when production is complicated
The more complicated the task, the greater the ability to economize on transaction costs through specialization and centralized control

3. Bounds of the Firm
Vertical integration: expansion of the firm into stages of production earlier or later than those in which it has specialized
Backward integration: steel company mines its own iron ore
Forward integration: forms raw steel into various components

4. Bounds of the Firm
How does the firm determine which activities to undertake and which to purchase from other firms?
Answer depends on a comparison of the benefits and costs of internal production versus market purchases – which method is more efficient
As firms take on more and more activities, managers lose track of things and quality of managerial decisions suffers

5. Bounded Rationality of the Manager
Manager’s bounded rationality: limits the amount of information a manager can comprehend about the firm’s operation
The more tasks, the more likely the firm is to experience diseconomies similar to those when expanding output beyond the efficient scale of production

6. Minimum Efficient Scale
The minimum efficient scale: the minimum level of output at which economies of scale have been fully exploited
Other things constant, a firm should buy an input if the market price is below what it would cost the firm to make

7. Exhibit 1: Minimum Efficient Scale and Vertical Integration
If a PC producer only requires 1,000,000 chips per year but the per unit cost of the chips is not minimized unless 5,000,000 are produced, the firm is better off purchasing the inputs than making them internally.
(a) Computer Manufacturer
Cost per unit
LRAC
1,000,000
Computers per year
(b) Chip Manufacturer
Cost per unit
LRAC
1,000,000
Computer chips per year
5,000,000

8. Number of Suppliers
When there are many interchangeable suppliers of a particular input, a firm is more likely to purchase that input in the market than produce it internally, other things constant
Competition also keeps the price down

9. Economies of Scope
Economies of scope: average costs decline as a firm makes different products rather than just one
Exist when it is cheaper to combine two or more product lines in one firm than to produce them in separate firms
Tend to occur because the cost of some fixed resources, such as specialized knowledge, can be spread across product lines

10. Market Behavior with Imperfect Information
Reliable information is often costly for both consumers and producers.

11. Marginal Cost of Search
Individuals gather the easy and obvious information first
as the search widens, the marginal cost of acquiring additional information increases because
Individuals may have to travel greater distances to check prices and services
opportunity cost of time increases as more time is spent acquiring information
Marginal cost curve for additional information slopes upward

12. Marginal Benefit of Search
The marginal benefit from acquiring additional information is
better quality at a given price or a lower price for a given quality
relatively large at first, but as more information is gathered and people grow more acquainted with the market, additional information yields less and less additional benefits
The marginal benefit curve for additional information slopes downward

13. Exhibit 2: Optimal Search with Imperfect Information
Market participants will continue to gather information as long as the marginal benefit of additional information exceeds its marginal cost
Optimal search occurs when the marginal benefit equals the marginal cost at point I*
As search levels exceed I*, the marginal benefit of additional information is still positive, but exceeds the cost
At some point the value of additional information reaches zero, Ip - this is referred to as perfect information
Marginal cost
of information
Information costs and benefits (dollars)
Marginal benefit
of information If
I * Ip
Quantity of information

14. Implications
Search costs result in price dispersion, or different prices, for the same product
Search costs lead to quality differences across sellers, even for identically priced products, because consumers find it too costly to shop for the highest quality product
The more expensive the commodity, the greater the price dispersion in dollar terms , thus the greater the incentive to shop around

15. Implications
As the consumer’s wage increases, so does the opportunity cost of time  the marginal cost of additional information increases  less searching and more price dispersion
Any change in technology that lowers the marginal cost of information will reduce the marginal cost of additional information  more information and less dispersion  internet

16. Winner’s Curse
The Winner’s Curse: plight of the winning bidder who overestimates an asset’s true value
Winners of such bids are said to experience the winner’s curse because they often lose money after winning the bid, because they were overly optimistic

17. Asymmetric Information in Product Markets
Two types of information that a market participant may want but lacks
One side of the market may know more about characteristics of the product for sale than the other side knows: asymmetric information involves hidden characteristics
One side of a transaction can pursue an action that affects the other side but that cannot be observed by the other side: asymmetric information involves hidden actions

18. Hidden Characteristics: Adverse Selection
Seller knows more about the quality of the product than do buyers
Buyers have less information
When those on the informed side of the market self-select in a way that harms the uninformed side this is called adverse selection

19. Hidden Actions: Principal-Agent Problem
Describes a situation in which one party, the principal, contracts with another party, the agent, in the expectation that the agent will act on behalf of the principal
The problem arises when the goals of the agent are incompatible with those of the principal and when the agent can pursue hidden actions

20. Asymmetric Information in Insurance Markets
In the insurance market, it is the buyers, not the sellers, who have more information about the characteristics and actions that predict their likely need for insurance in the future
If the insurance company has no way of distinguishing among applicants it must charge those who are good health risks the same as those who are poor health risks

21. Asymmetric Information in Insurance Markets
This price is attractive to poor health risks, but will seem too high to good health risks, some of whom will choose not to buy insurance
As the number of healthy people who don’t buy insurance increases, the insured group becomes less healthy on average  rates must rise  insurance is even less attractive to healthy people  adverse selection tends to make insurance buyers less healthy than the population as a whole

22. Asymmetric Information in Insurance Markets
Once people buy insurance, their behavior may change in a way that increases the probability that a claim will be made
This incentive problem is referred to as moral hazard  occurs when an individual’s behavior changes in a way that increases the likelihood of an unfavorable outcome
Moral hazard is a principal-agent problem

23. Coping with Asymmetric Information
An incentive structure or an information-revealing system can be developed to reduce the problem associated with the lopsided availability of information
Lemon laws that offer compensation to buyers of new or used cars that turn out to be lemons
Health insurance companies use a variety of tools
Physical exams and filling out questionnaires
Deductibles

24. Asymmetric Information in Labor Markets
Differences in the ability of labor present no particular problem as long as these differences can be readily observed by the employer
That is, if the productivity of each particular worker is easily quantified that measure can be used and serves as a basis for pay

25. Asymmetric Information in Labor Markets
Because production often takes place through the coordinated efforts of several workers, the employer may not be able to attribute specific outputs to each particular worker
An adverse-selection problem arises in the labor market when labor suppliers have better information about their own productivities than do employers, because a worker’s ability is not observed prior to employment  hidden characteristics

26. Asymmetric Information in Labor Markets
In a labor market with hidden characteristics, employers might be better off offering a higher wage  makes the job more attractive to more-qualified workers
Paying a higher wage gets at the problem of hidden actions by workers
Paying a higher wage to attract and retain more-productive workers is called paying efficiency wages

27. Signaling and Screening
Signaling: the attempt by the informed side of the market to communicate information that the other side would find valuable
Screening: the attempt by the uninformed side of the market to uncover the relevant but hidden characteristics of the informed party