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

2. 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. 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. 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. 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. 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. 7 Exhibit 1: Minimum Efficient Scale and Vertical Integration 0 LRAC 1,000,000 Computers per year Cost per unit (a) Computer Manufacturer LRAC 0 1,000,000 Computer chips per year 5,000,000 Cost per unit (b) Chip Manufacturer 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.

8. 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. 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. 10 Market Behavior with Imperfect Information  Reliable information is often costly for both consumers and producers.

11. 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. 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. 13 Exhibit 2: Optimal Search with Imperfect Information 0 Marginal cost of information Marginal benefit of information Quantity of information IfIf IpIp I * Information costs and benefits (dollars)  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, I p - this is referred to as perfect information

14. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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