Economics of Information

Economics 230

J.F. O’Connor

Introduction• Information is essential for decision

making. Buyers need information about price and quality. Producers need to know the technology of production and the prices of inputs

• Information is not a free good. Its production and acquisition requires the use of scarce resources and thus, we can use benefit-cost analysis.

Sources of Information

• Media, print and electronic

• Friends, family, and neighbors

• Middlemen - information brokers

• Professionals – physicians, lawyers, pharmacists, economists, statisticians, etc.

Optimal Amount of Information

• Benefit-cost analysis is appropriate for deciding how much information to acquire for any decision, e.g. buying a house or a car or a pencil. Use MB = MC

• As benefits of search are high, you search more

• As costs of search increase, you search less.

• Supply of information can be adversely affected by free riders

• Information is often acquired in a search process. Looking for the best price, a new apartment, a job. There can be uncertainty or risk about the outcome of a search. If you search further, will the outcome improve? Have to look at expected benefits.

Risk• A risky prospect is a choice or action where the

outcome is not certain. Flip a coin, buy a stock.• Expected value of a prospect is the sum of the

values of each outcome weighted by the probability of it occurring.

• Suppose a prospect will pay $100 with probability of .2 and $50 with probability of .8. Then the expected (average) value is .2(100)+.8(50) = $60.

• How much would you pay for that prospect?

Attitude towards Risk

• If your reservation price is $60, you are risk neutral. If it is less than $60, you are risk averse and if it is more than $60 you are a risk lover.

• When the prospect involves a substantial amount of funds, most people are risk averse. How about playing the lottery?

An Example of Search

• School is out. Your plans to go to Europe for the Summer fell through and you need a job. You can work for three months, May 15 – August 15. Employers take on workers at the beginning and in the middle of the month.

• You have been offered a job that will pay $1,000 a month and you can start May 15.

• You believe that if you search further, the probability is .6 that you can get a job which pays $1,500 a month and .4 that you still get a $1,000 a month job.

The Choice?

• Further search means that you cannot start until June 1. In the mean time the opportunity cost of your time is zero. Should you take the job or search further?

• The expected value of searching is: .8(3750) + .2(2500) = $3,250

• The opportunity cost of search is $3,000. A risk neutral person will search. Would you?

Asymmetric Information

• Buyers and sellers are not equally informed about the characteristics of goods for sale.

• The asymmetry can result in market failure.

The Problem

• Joe’s 1999 Camry is in excellent condition, serviced regularly and driven carefully, mostly on the highway.

• The average 1999 Camry sells for $10,000 but since his is in excellent condition, Joe’s reservation price is $12,000.

• Pat’s reservation price for a Camry in excellent condition is $14,000 and one in average condition, $10,500

The Market Failure

• Pat has no sure way of verifying that Joe’s car is in excellent condition and buys a Camry for $10,000.

• Joe’s car remains unsold.

• Outcome is inefficient because a trade at $13K would have benefited both parties.

Lemons Model

• Explains how asymmetric information tends to reduce the average quality of used goods.

• The average quality of used cars is lower than the average quality of cars of that vintage. Why? People with cars that have not been well treated and cars that were not good to begin with are likely to be sold while cars working well are likely to be retained.

Making it Worse

• Knowing this buyers will have lower reservation prices.

• Lower reservation prices will cause people with better cars to not offer them for sale

• This further reduces the quality of cars in the used car market.

• In the extreme case, only lemons will be for sale!

Example

• A good used car is worth $10k while a lemon is worth $6k. Ninety percent are good. Reservation price for a risk neutral buyer is .9(10) + .1(6) = $9.6k.

• If you have a good car, will you sell for $9,600? No, your reservation is $10k.

• If you have a lemon, will you sell for $9.6k?

• Yes. In fact, the only cars for sale are lemons.

• Over time buyers figure this out and the price goes to $6k.

Credibility Problems

• In a potential trade, buyers and sellers have difficulty evaluating the credibility of statements by the other party. This is especially so in one-time trades.

• This problem can be overcome to some degree by signaling. To be effective, signaling must be costly or difficult to fake.

Effective Signaling

• Warranties

• Expensive advertising campaigns

• Graduating from demanding programs

• Conspicuous consumption