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Chapter 11 The Economics of Information Chapter 11 The Economics of Information

Chapter 11 The Economics of Information - PowerPoint Presentation

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Chapter 11 The Economics of Information - PPT Presentation

McGrawHillIrwin Copyright 2015 by McGrawHill Education Asia All rights reserved 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 ID: 631802

000 information search cost information 000 cost search gamble car death price risk sales politicians average reservation apartment penalty

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Slide1

Chapter 11

The Economics of Information

McGraw-Hill/Irwin

Copyright ©

2015

by

McGraw-Hill Education (Asia).

All rights reserved.Slide2

Learning Objectives

Explain how middlemen add value to market transactionsUse the concept of rational search to find the optimal amount of information market participants should obtainDefine asymmetric information and describe how it leads to the lemons problemDiscuss how advertising, conspicuous consumption, statistical discrimination, and other devices are responses to asymmetric informationSlide3

Information and the Invisible Hand

All parties have all relevant informationWithout free information, market results are not efficientBargaining for a bowl in KashmirParties must decide how much information to gatherInformation gathering strategies differSlide4

How The Middleman Adds Value

Buyers sometimes choose among several version of a productEach has complex feature setsResearch optionsCompany web siteAsk friends and familyConsumer Reports, online product reviewsVisit stores, ecommerce sitesSlide5

Consumer Choice: Buying DSLR Camera

Best Denki recommends US$1,200 Nikon D7100 DSLR cameraSales rep seems knowledgeableYour next move isThank them and do more researchTrust the sales rep and buy themGo home and buy at the best price online ($950)Evaluate the importance ofImmediate possessionBest pricePost-sales service and supportSlide6

The Value of the Middleman

Sales representatives supply information to buyersManufacturers can offer direct sales to bypass middlemenInformation makes markets more efficientPurchasing the bowl in KashmirSlide7

Selling Babe Ruth

Koh wants to sell a Win the War stamp.His reservation price is $300An ad in the local newspaper cost $5eBay cost is 5% of the Internet auction priceThe maximum price in the local market is $400Two eBay shoppers have secret reservation prices of $800 and $900, respectivelySlide8

Selling

Win the War stampBenefits of eBayCard sells for $800 on eBay less $40 commissionEllis nets $760, $460 above his reservation priceBuyer surplus is $100Local option is inferiorCard sells for $400 less $5 cost of adKoh nets $395, $95 more than his reservation priceBuyer surplus is $0Economic surplus is increased when a product goes to the person who values it the mostSlide9

$/unit

Units of information

MB

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

MC

I

*

OptimalSlide10

Free Rider Problem

A free-rider problem exists when non-payers cannot be excluded from consuming a goodInterferes with incentivesMarket quantity is below social optimumStores bear the cost of training sales reps on merchandiseShoppers use sales reps as information sourceThen some shoppers buy elsewhereStore is unable to capture some of the value it delivered to the shopper: a free-rider problemSlide11

Example: The Last Bookstore

Independent bookstores differentiate themselves with personalized serviceOffer more information and recommendations than Barnes & Nobles or BordersChain bookstores carry large inventory and shopping center location can erode local store baseEcommerce sites such as Amazon.com and Overstock.com offer reviews and recommendationsLarge inventory; quick deliveryOnline sales further reduce sales in independent storesSlide12

Rational Search Guidelines

Additional search time is more likely to be worthwhile for expensive items than cheap onesApartment search in Taipei, Tawian involves less time than Tokyo, JapanTaipei has lower rents and narrower price rangePrices paid will be higher when the cost of a search is higherTwo buyers, only one with a carBuyer with the car will look at more pianos before buyingSlide13

Gamble Inherent in Search

Additional search has costs that are certainBenefits are uncertain benefitsAdditional search has elements of a gambleA gamble has a number of possible outcomesEach outcome has a probability that it will occurSlide14

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 zeroA better-than-fair gamble has a positive expected valueSlide15

Risk Preferences

A risk-neutral person would accept any gamble that is fair or better-than-fairA risk-averse person would refuse any fair gambleSlide16

The Gamble in the Search

You need a one-month sublet in Hong KongOne type of apartment rents for US$400 and it is 80% of the available marketThe other type rents for US$360 and makes up 20% of the marketYou must visit the apartment to get the rental rateCost per visit is US$6You are risk-neutralSlide17

Hong Kong Apartment Search

The first apartment you visit is the US$400 versionLook at the next apartment if the gamble is at least fairTwo outcomes to the gambleYou find a lower-priced apartment and your net benefit is US$34 with 20% probabilityYou find another US$400 apartment and your net benefit is – US$6 with 80% probabilityExpected value of the gamble is (34) (0.20) + (– 6) (0.80) = US$2 Keep searchingSlide18

Commitment Problems

and SearchSome searches are for circumstances requiring commitment over some period of timeLeasing an apartmentTaking a jobGetting marriedSearch is costly and therefore limitedPeople end their searches when the marginal cost of searching exceeds the marginal benefitBUT… what if you fall into a better option?Slide19

Commitment Problems

and SearchIf information were freely available, there would be no commitment problemContracts are used to bind parties together ANDContracts carry penalties for breaking the arrangementPeople terminate their search because information gathering is costlyUnder some circumstances, one party may rationally choose to terminate the agreement and pay the penaltiesSlide20

Asymmetric Information

Asymmetric information occurs when either the buyer or seller Is better informed about the goods in the marketMutually beneficial trades may not occurA seller might know thata murder was committed in a house offered for saleBuyer does not knowSlide21

Private Sale of a Used Car

Akari's Miata is in excellent conditionAkari reservation price is $10,000Blue Book value is $8,000Haruto wants to buy a MiataHis reservation price is $13,000 for one in excellent condition and $9,000 for one in average conditionDetermining the condition of Akari's car has a cost and the results are uncertainHaruto cannot verify that Akari's Miata is superiorHaruto buys another Miata for $8,000; Akari's is unsoldSlide22

Surplus Loss and Asymmetric Information

Haruto's loss is $1,000Pays $8,000 and has a gain of $1,000Haruto’s loss from buying an average car instead of Akari's$13,000 – $11,000 = $2,000Haruto's net loss is $1,000Akari’s loss from losing Haruto as a customer is $1,000Total loss is $2,000Slide23

The Lemons Model

People who have below average cars (lemons), are more likely to want to sell themBuyers know that below average cars are likely to be on the market and lower their reservation pricesGood quality cars are withdrawn from the marketAverage quality decreases further and reservation prices decrease againThe lemons model says that asymmetric information tends to reduce the average quality of goods for saleSlide24

The Lemons Model in Action

Your aunt offers you her 4-year old AccordThe asking price of $10,000 is the blue book valueYou believe the car is in good conditionBlue book value is the equilibrium price for below average carsYou should buy the car for $10,000It is in better condition than the average Accord of the same vintage and mileageSlide25

Naïve Buyer

Two kinds of cars: good cars and lemonsOwners know what kind they haveBuyers can't determine a car's qualityBuyers are risk neutralWhat would the buyer offer for a used car?Expected value of a car is(0.90) ($10,000) + (0.10) ($6,000) = $9,600The buyer gets a lemon

Good Cars

Lemons

Probability

90%

10%

Value

$10,000

$6,000Slide26

Credibility Problem

Parties gain if they find a way to communicate information truthfullyIf Akari can convince Haruto her Miata is in excellent condition, Haruto will buyStatements are not credibleAkari offers Haruto a six-month warranty on all car defects at the time of purchaseA warranty for a lemon would cost more than the economic surplus gainedOnly sellers of good quality cars would offer the warrantySlide27

The Costly-to-Fake Principle

To communicate information credibly, a signal must be costly or difficult to fakeSellers have an incentive to exaggerate the quality of their productBuyers value objective information about qualitySlide28

Costly Signals

Television advertising is expensiveIn print advertising, "As seen on TV" signals a company's commitment to its productPotential signal of qualityEducational institutions' brands and students' grades signal qualityAn A+ student from MIT is more likely to be offered a job than a C student from an average academic institutionSlide29

Conspicuous Consumption

Choose a lawyerLawyer A wears inexpensive suits and drives a 10-year old ToyotaLawyer B wears custom-tailored suits and drives a new Mercedes-Benz S 500No other information is availableConspicuous consumption signals successChoose Lawyer BSlide30

Statistical Discrimination

Statistical discrimination uses group characteristics to infer individual characteristicsCan be applied to people as well as to goods and servicesResults from observed differences between groupsExampleThis candidate for employment is in her late twentiesWomen have babies in their late twenties This candidate will have a baby in the next few yearsHigh cost compared to other candidatesSlide31

Dangerous Drivers

Men under 25 years of age pay more than other drivers for auto insuranceExpected cost of insuring a driver depends the probability and size of claimsIndividual assessments are not possibleRates are based on demographic groups and the claim history of those groupsIndividual rates are adjusted upward as more information becomes availableSlide32

Adverse Selection

Adverse selection occurs because insurance tends to be purchased more by those who are most costly for companies to insureInsurance is most valuable to those with many claimsAdverse selection increases insurance premiumsReduces attractiveness of insurance to low-risk customers"Best" insurance risk customers opt outRates increaseRepeatSlide33

Moral Hazard

Moral hazard is the tendency of people to expend less effort protecting insured goodsPeople take more risk with insured goods or activitiesDeductibles give policy holders an incentive to be more cautiousSuppose a car owner has a $1,000 deductible policyThe owner pays the first $1,000 of each claimStrong incentive to avoid accidentsClaims less than $1,000 are not reportedInsurance premiums go downSlide34

Disappearing Political Discourse

Disappearing political discourse theory holds that politicians who support a policy will remain silent to avoid being misunderstoodOpposing the death penalty could be interpreted by voters as being soft on crimeNo necessary relationship between the twoAssumes voters implicitly assign a position to a politician who has not made public statementsSlide35

Politicians and the Death Penalty

Arguments against the death penaltyExpensive relative to life in prison without paroleIrreversible for people later found innocentDoes not deter capital crimesPoliticians avoid taking a public position on capital punishmentSlide36

Politicians and the Death Penalty

Voters want politicians are tough on crimeBroader issue than the death penaltyTwo groups of politicians: tough on crime and soft on crimeVoters use information about a politician's views on the death penalty to infer the politician's stand on crimeSlide37

Politicians and the Death Penalty

Politicians tough on crime and opposed to capital punishment lose votesThey have an incentive to remain silentMove to blue boxProbability that a politician in the red box is tough on crime decreasesMore defectionsPublic statements do not accurately reflect aggregate views of politicians on capital punishment

Favor Death Penalty PLUS Remain Silent95% tough on crime

Oppose only the

Death Penalty

Oppose Punishing Criminals

80% tough on crimeSlide38

Legalized Drugs

Laws against buying and selling certain substances are intended to reduce the harm to society from drug useLaws have a costPrice of illegal drugs increasesAddicts commit crimes to pay for drugsDiverts people from productive employmentExternalities of turf battlesHigh cost to law enforcement, legal, and prison systems Slide39

Legalized Drugs

Legalization solves most problemsWith lower drug prices, quantity demanded may increaseNot supported by evidence in UK and NetherlandsAn outspoken supporter is seen by voters as more likely to be crazy than an outspoken opponentRational supporters do not speak outRational Opponent

Rational Supporter

Crazy Opponent

Crazy Supporter

Opponents

SupportersSlide40

The Economics of Information