Lecture Principles of economics (Asia Global Edition) - Chapter 11

This chapter introduces the model’s two key pieces—the aggregate-demand curve and the aggregatesupply curve. After getting a sense of the overall structure of the model in this chapter, we examine the pieces of the model in more detail in the next two chapters.

Chapter 11

The Economics of

Information

Learning Objectives

1. Explain how middlemen add value to market

transactions

2. Use the concept of rational search to find the

optimal amount of information market

participants should obtain

3. Define asymmetric information and describe

how it leads to the lemons problem

4. Discuss how advertising, conspicuous

consumption, statistical discrimination, and

other devices are responses to asymmetric

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

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

– Visit stores, ecommerce sites

Consumer Choice: Buying

DSLR Camera

• Best Denki recommends US$1,200 Nikon D7100 DSLR camera

– 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 ($950)

• Evaluate the importance of

– Immediate possession

– Best price

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

Selling Babe Ruth

• Koh wants to sell a Win the War stamp.

– 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

Selling Win the War stamp

• Benefits of eBay

– 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

– Koh 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

• 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,

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

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

Rational Search Guidelines

• Additional search time is more likely to be

worthwhile for expensive items than cheap ones

– Apartment search in Taipei, Tawian involves less

time than Tokyo, Japan

• Taipei 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

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

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

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

The Gamble in the Search

• You need a one-month sublet in Hong Kong

– One type of apartment rents for US$400 and it is

80% of the available market

– The other type rents for US$360 and makes up

20% of the market

– You must visit the apartment to get the rental rate

• Cost per visit is US$6

– You are risk-neutral

Hong Kong Apartment Search

• The first apartment you visit is the US$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 US$34 with 20% probability

• You find another US$400 apartment and your net benefit is – US$6 with 80% probability

– Expected value of the gamble is

(34) (0.20) + (– 6) (0.80) = US$2

• 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?

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

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

Private Sale of a Used Car

• Akari's Miata is in excellent condition

– Akari reservation price is $10,000

• Blue Book value is $8,000

• Haruto 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 Akari's car has a cost and the results are uncertain

– Haruto cannot verify that Akari's Miata is superior

• Haruto buys another Miata for $8,000; Akari's is unsold

Surplus Loss and Asymmetric

Information

• Haruto's loss is $1,000

– Pays $8,000 and has a gain of $1,000

– Haruto’s loss from buying an average car instead of Akari's

• $13,000 – $11,000 = $2,000

– Haruto's net loss is $1,000

• Akari’s loss from losing Haruto as a customer is

$1,000

• Total loss is $2,000

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

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

Nạve 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

Credibility Problem

• Parties gain if they find a way to communicate

information truthfully

• If Akari can convince Haruto her Miata is in

excellent condition, Haruto will buy

– Statements are not credible

– Akari offers Haruto 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

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

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

Conspicuous Consumption

• Choose a lawyer

– Lawyer A wears inexpensive suits and drives a

10-year old Toyota

– Lawyer B wears custom-tailored suits and drives a new Mercedes-Benz S 500

– No other information is available

• Conspicuous consumption signals success

– Choose Lawyer B

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

– 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

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

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

Moral Hazard

• Moral hazard is the tendency of people to

expend less effort protecting insured goods

– People take more risk with insured goods or

– The owner pays the first $1,000 of each claim

• Strong incentive to avoid accidents

– Claims less than $1,000 are not reported

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

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

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

Politicians and the Death

Penalty

• Politicians tough on crime and opposed to capital

punishment lose votes

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

Legalized Drugs

• Legalization solves most problems

– With lower drug prices, quantity demanded may

Rational Supporter Crazy Opponent Crazy Supporter

Opponents Supporters

The Economics of Information