1. Chapter 11 The Economics of Information McGraw-Hill/Irwin Copyright © 2015 by McGraw-Hill Education (Asia). All rights reserved.

2. 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

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

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

5. 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 –Post-sales service and support

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

7. 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

8. 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

9. $/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 * Optimal

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

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

12. 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

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

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

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

16. 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

17. 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 –Keep searching

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?

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

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 BuyerSeller Fact DFact C Fact B Fact A Fact 2Fact 1

21. 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

22. 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

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

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

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 CarsLemons Probability90%10% Value$10,000$6,000

26. 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 warranty

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

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

29. 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

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

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

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

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

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

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

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

37. Politicians and the Death Penalty 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 Favor Death Penalty PLUS Remain Silent 95% tough on crime Oppose only the Death Penalty Oppose Punishing Criminals 80% tough on crime

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

39. Legalized Drugs 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 Rational Opponent Rational Supporter Crazy Opponent Crazy Supporter OpponentsSupporters

40. The Economics of Information 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