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The Economics of Information Slide 2

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Transcript

  • 1. The Economics of Information
  • 2. Introduction
    • The invisible hand theory assumes that buyers are fully informed.
    • Given that consumers are not fully informed, they must employ strategies for gathering information.
  • 3. How the Middleman Adds Value
    • Example
      • How should a consumer decide which pair of skis to buy?
        • Skis R Us has a.......
          • knowledgeable sales staff
          • and a large inventory
        • They Recommend Salomon X-Scream 9 skis for $600
  • 4. How the Middleman Adds Value
    • Example
      • How should a consumer decide which pair of skis to buy?
        • The skis can be purchased on the Internet for $400
    • Question
      • Is spending $600 on the right skis better than $400 on the wrong ones?
  • 5. How the Middleman Adds Value
    • How does better information affect economic surplus?
      • Ellis wants to sell a Babe Ruth baseball card.
        • 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.
  • 6. How the Middleman Adds Value
    • Example
      • How does better information affect economic surplus?
        • The maximum prices in the eBay market is $900 and $800.
        • Economic surplus:
          • Local market = $400 - $5 - $300 = $95
          • eBay = $800 - $40 - $300
          • = $460 + $100 = $560
  • 7. How the Middleman Adds Value
    • Example
      • How does better information affect economic surplus?
        • Economic surplus is increased when a product goes to the person who values it the most.
  • 8. The Optimal Amount of Information $/unit Units of information Marginal cost of information Marginal benefit of information I * The optimal amount of information (ignorance) occurs where MC = MB
  • 9.
    • The Free Rider Problem
      • An incentive problem in which too little of a good or service is produced because nonpayers cannot be excluded from using it
    The Optimal Amount of Information
  • 10.
    • Economic Naturalist
      • Why is finding a knowledgeable salesclerk often difficult?
      • Why did Rivergate Books, the last bookstore in Lambertville, NJ, recently go out of business?
    The Optimal Amount of Information
  • 11.
    • Two Guidelines for Rational Search
      • Additional search time is more likely to be worthwhile for expensive items than cheap ones
      • Prices paid will be higher when the cost of a search is higher
    The Optimal Amount of Information
  • 12.
    • Example
      • Should a person living in Paris, Tx, spend more or less time searching for an apartment than someone living in Paris, France?
    The Optimal Amount of Information
  • 13.
    • Example
      • Tom and Tim are shopping for a used upright piano.
      • Tom has a car & Tim does not.
      • Which one should expect to examine fewer pianos before making a purchase?
    The Optimal Amount of Information
  • 14.
    • The Gamble Inherent in Search
      • When engaging in further search there are additional costs and uncertain benefits and, therefore, there is a degree of risk or gamble from the search.
    The Optimal Amount of Information
  • 15.
    • Determining whether or not to take the gamble:
      • Compute the expected value of the gamble
        • The sum of the possible outcomes multiplied by their respective probabilities
    The Optimal Amount of Information
  • 16.
    • Determining whether or not to take the gamble:
      • Fair Gamble
        • Coin flip: Heads win $1, Tails lose $1
        • Expected value = (.5)($1) + (.5)(-$1) = 0
    The Optimal Amount of Information
  • 17.
    • Determining whether or not to take the gamble:
      • Better-than-fair-gamble
        • Coin flip: Heads win $2, Tails lose $1
        • Expected value = (.5)($2) + (.5)(-$1) = .5
    The Optimal Amount of Information
  • 18.
    • Determining whether or not to take the gamble:
      • Risk-neutral person
        • Will accept any gamble that is fair or better
      • Risk-averse person
        • Will refuse any fair gamble
    The Optimal Amount of Information
  • 19.
    • Example
      • Should you search further for an apartment?
        • Searching for an apartment in a neighborhood where identical apartments rent for $400 & $360
        • Of the vacant apartments, 80% rent for $400 and 20% rent for $360
        • You must visit the apartment to get the rental rate
    The Optimal Amount of Information
  • 20.
    • Example
      • Should you search further for an apartment?
        • The first visit is a $400 apartment.
        • The opportunity cost of an additional visit is $6.
      • The expected value of another visit:
        • (.2)($34) + (.80)(-$6) = $2
    The Optimal Amount of Information
  • 21.
    • The Commitment Problems When Search is Costly
      • What happens when, by chance, a more attractive option comes along after the search has ceased?
    The Optimal Amount of Information
  • 22.
    • The Commitment Problems When Search is Costly
      • When information is costly and the search must be limited, a relationship may dissolve.
    The Optimal Amount of Information
  • 23.
    • The Commitment Problems When Search is Costly
      • Commitment agreements
        • Lease agreements
        • Employment contracts
        • Marriage contracts
    The Optimal Amount of Information
  • 24. Asymmetric Information
    • Asymmetric Information
      • Situations in which buyers and sellers are not equally well informed about the characteristics of goods and services for sale in the marketplace.
  • 25. Asymmetric Information
    • Example
      • Will Jane sell her car to Tom?
  • 26. Asymmetric Information
    • Example
      • Will Jane sell her car to Tom?
    • Assume
      • Jane wants to sell a 2001 Miata
        • 70,000 highway miles
        • Complete maintenance
        • Excellent condition
        • Average price is $8,000
        • Jane’s reservation price is $10,000
  • 27. Asymmetric Information
    • Tom
      • Reservation price
        • $13,000 if in excellent condition
        • $9,000 if not in excellent condition
      • Will not pay $10,000 because he cannot tell if Jane’s car is an excellent buy
        • Tom buys an average car
  • 28. Asymmetric Information
    • Example
      • There is a loss in economic surplus
        • Assuming Tom had paid Jane $11,000
  • 29. Asymmetric Information
    • Example
      • Tom
        • Pays $8,000 and has a gain of $1,000 ($9,000 - $8,000)
        • Tom’s Loss
          • $13,000 - $11,000 = $2,000 - $1,000 = $1,000
      • Jane’s loss is $1,000
      • Total loss is $2,000
  • 30. Asymmetric Information
    • The Lemons Model
      • Asymmetric information tends to reduce the average quality of goods offered for sale.
  • 31. Asymmetric Information
    • The Lemons Model
      • People who have below average (lemons) cars, 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.
  • 32. Asymmetric Information
    • The Lemons Model
      • Because used car prices are low, people with good cars keep them longer.
      • The average quality of used cars falls even further.
  • 33. Asymmetric Information
    • Example
      • Should you buy your aunt’s car?
        • 4-year old Accord
        • The asking price of $10,000 is the blue book value.
        • You believe the car is in good condition.
        • It is a good deal because the blue book value is the equilibrium price for below average cars.
  • 34. Asymmetric Information
    • Example
      • How much will a naïve buyer pay for a used car?
  • 35. Asymmetric Information
    • Assume
      • There are only good cars and lemons.
      • 10% of all new cars are lemons.
      • Good used cars are worth $10,000 and lemons are worth $6,000.
      • The used car market is 90% good cars and 10% lemons.
  • 36. Asymmetric Information
    • Example
      • Calculating the expected value:
        • (.90)($10,000) + (.10)($6,000) = $9,600
          • Reservation price for a risk-neutral buyer
  • 37. Asymmetric Information
    • Example
      • Who will sell a used car for what the naïve buyer is willing to pay?
        • Would not sell a good car that is worth $10,000
        • Would sell a lemon that is worth $6,000
        • Only lemons will be on the market
        • Price will fall to $6,000
  • 38. Asymmetric Information
    • What Do You Think?
      • If you have a good used car for sale, how can you get a higher price?
  • 39. Asymmetric Information
    • The Credibility Problem In Trading
      • People tend to interpret ambiguous information in ways that promote their own interests.
  • 40. Asymmetric Information
    • The Costly-to-Fake Principle
      • To communicate information credibly, a signal must be costly or difficult to fake.
  • 41. Asymmetric Information
    • Economic Naturalist
      • Why do firms insert the phrase “As advertised on TV” when they advertise their products in magazines and newspapers?
      • Why do many companies care so much about elite educational credentials?
  • 42. Conspicuous Consumption as a Signal of Ability
    • Economic Naturalist
      • Why do many clients seem to prefer lawyers who wear expensive suits?
  • 43. Asymmetric Information
    • Statistical Discrimination
      • The practice of making judgments about the quality of people, goods, or services based on the characteristics of the groups to which they belong.
  • 44. Asymmetric Information
    • Economic Naturalist
      • Why do males under 25 years of age pay more than other drivers for auto insurance?
  • 45. Asymmetric Information
    • Adverse Selection
      • The pattern in which insurance tends to be purchased disproportionately by those who are most costly for companies to insure
  • 46. Asymmetric Information
    • Adverse Selection
      • Raises premiums
      • Reduces the number of low-risk policy holders
      • Increases the risk level of the insured
  • 47. Asymmetric Information
    • Moral Hazard
      • The tendency of people to expend less effort protecting those goods that are insured against theft or damage
  • 48. Asymmetric Information
    • Moral Hazard
      • Deductibles are used to reduce moral hazard and adverse selection.
        • Lower rates
        • Increase the incentive to drive safely
        • Reduce the number of claims, which lowers cost and premiums
  • 49. Disappearing Political Discourse
    • Economic Naturalist
      • Why do opponents of the death penalty often remain silent?
  • 50. Disappearing Political Discourse
    • Economic Naturalist
      • Why do proponents of legalized drugs remain silent?
  • 51. End of Chapter