Introduction to Economics and Business
Lecture 5: Markets & Information
17-9-2018
Different currents in economics
• Neoclassical theory of the firm
• Game theory
• Transaction costs economics
• Agency theory
• Behavioral theory
• Competitive & Corporate strategy
• Evolutionary theory
Theme of the book
• Governance structures:
- How are transactions organised?
- Why?
• Examples: On the market, in a firm, a collaboration between firms, by the
government?
• In a firm: How large is that firm? Franchise? Self-employed?
Outsourcing? Alliance?
• All governance structures have different advantages and disadvantages.
• We should be able to explain their existence and importance in different
environments.
We are not self sufficient
Consequence  Division of labor
Consequence  Specialisation
• .
Condition: Coordination (market or organisation)
Markets according to neoclassical economics
• Perfect competition
- Large amount of buyers and sellers
- Homogeneous goods
- Free entry and exit
- Free, perfect and symmetric information
- Consequence: Everybody is a “price taker”
• Other assumptions neoclassical economics:
- Consumer: unboundedly rational and utility maximizing
- Firms: unboundedly rational and profit maximizing
– Firms are holistic entities embedded between markets
– Firms are production formulas: Y=Lx + Ky + Mz
- Markets function in isolation
Firms
• Stupid question: what is a company? What is the size of a company?
• Is a company just a production function?
- Input markets  Firm  Output markets
• Labor division & specialization:
- By markets (between companies)
- Within companies
• In markets: relative costs determine the outcome
• In companies: managers determine the outcome
• Why do companies exist?
Neoclassical “Theory of the firm”
• A firm:
- Is homogeneous
- Is holistic
- Is managed by one rational actor who makes all decisions
- Only has profit maximization as a goal
- Buys inputs on markets, sells outputs on markets
- Acts like a production function
Consequence:
- If a firm observes multiple investment opportunities, it will choose the one
with the highest expected return
- If a firm could become more profitable by changing their strategy, they will
immediately do so
Markets according to neoclassical economics
• Individuals maximize their utility; this is based ont heir preferences
• Firms are ‘black boxes’ that act like production functions
• “Prices are a sufficient statistic”
• Pareto optimal – no actor can be better off without another actor being
worse off
• Realistic?
• Buchanan (1979): “Choice, by its nature, cannot be predetermined and
remain choice”
The paradox of profits
• Every firm has profit maximization as their goal
• However, if the market is truly perfect
• No firm will be able to make high profits in the long run
The paradox of profits
€ 5 miljard
€ 5,4 miljard
$ 53,7 miljard
Stock market: the perfect market?
• Markets are usually not perfect  financial markets?
• Why does stock have value?
• Why would this value change?
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•
•
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Efficient market hypothesis – price contains all relevant information
Every change in expected returns is immediately eliminated
Consequence: Every stock has the same expected return
Only new unanticipated information can change the price
• However:
- January effect
- Small Firm effect
- Bubbles
Markets function in isolation? In the beginning there
were markets
• The starting point of neoclassical economics is behavior on
markets
• Important (neglected) question: What makes markets?
• Some basic “institutions” are necessary for the existence and
functioning of markets:
- Property rights
- Juridical system
- Regulations
• What if these institutions differ? What if they are the same?
Institutions
• Instituties: "humanly devised constraints that structure political, economic and social
interactions“ (North, 1991)
• In other words: The rules of the game
• The way transactions are organised (governance structures) is based on the institutions
• Rules of the game  Play of the game
• If these instititions are less developed, the market will function less well.
• If these institutions differ between countries, markets will differ between these countries
as well
• “Institutional comparative advantages”
• If the environment changes, institutions have to change as well
• If institutions change, optimal “governance structures” will change as well
Markets in isolation?
Institutions?
Institutions?
Institutions?
So: markets do not function in isolation
Ronald Coase:
• Welfare is based on productivity
• Productivity is based on specialization
• Specialization is only possible with transactions
• The amount of transactions depends on transaction costs
• Transaction costs are determined by the institutional environment
•  Institutional environment determines welfare
Coase: “Neoclassical economics studies the blood circulation, and ignores
the body.”
Markets
•
Markets do not function in isolation  A “free” market does not exist
•
Paradox:
•
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Markets can only exist with a government (institutions)
-
More markets leads to more government control
Governments intervene in markets:
- Regulations
- Public goods
- Common goods & Externalities
• And organisations create markets within organizations:
- Internal labor market
- Internal capital market
- Why?
Coordination & Information
• For the production of almost all goods and services different actors “work
together”.
• But how is this “collaboration” organised?
• Great importance for information:
- On a perfect market: Price contains all information necessary.
- Within organisation: Price does not contain all information necessary.
Information & perfect markets
• Firms cannot influence prices  prices are a “sufficient statistic”
• Homogeneous goods  all information is in the price
• (In) complete contracts  information about future development
and complete information about the transaction
• Information symmetry  all actors have access to the same
information
• What if information is not free, complete and/or symmetric?
Market failure: Imperfect or asymmetric information
• Where the buyer or seller has more/better information than the
other party
• Asymmetric and/or incomplete information will generally exist for:
- heterogeneous commodities with
- characteristics that are costly to determine
• Information asymmetry examples:
– A firm possessing limited information about a potential worker’s abilities
– A used car buyer not having complete repair and maintenance history on an
auto
– An insurance company not knowing risky behavior of a potential insurer
– A buyer of a difficult financial product doesn’t have the knowledge to fully
understand the product.
– A teacher who doesn’t know how hard his students study
Fundamental paradox of information
- If information is not free, perfect and/or symmetric
- Information gathering, analyzing and distributing necessary.
- Market solution: Firms gather, analyze and sell information?
- But what is the value of (unique) information?
- Value can only be assessed by revealing the information 
but then it losses its value
- In other words: The market solution to information
asymmetry has an information asymmetry problem itself.
Information as an economic good
• Information is different form “normal” goods
• Information is not a “rival good”
• Information has high fixed costs, but almost non existing
marginal costs
• Outcome: “winners takes (almost) all”
• Data (information) the new oil?
• “Sony has ‘secret'
Spotify-collective”
Information
• Neoclassical “theory of the firm”:
- Perfect, symmetric and free information  (in)complete
contracts
• Often not the case
- Asymmetric & imperfect information  Market failure
- Market failure: Optimal efficiency is not reached
Information asymmetry and opportunistic behaviour
Information problems arise when:
-The price doesn’t reflect all the dimensions of the good.
-Uncertainty is present about the future and/or the present.
-Information asymmetry exists.
• This can lead to opportunistic behaviour:
‘Seeking self-interest with guile’ (Williamson)
• We assume the possibility of opportunistic behavior to occur
whenever possible
Information asymmetry and opportunistic behaviour
Actors will try to exploit information assymetries  All
actors will potentially act opportunistic
This can be done:
• Before a contract is written, which will lead to “hidden
information” or ‘adverse selection’.
• After a contract is written, which will lead to “hidden
action” or “Moral hazard”
Adverse selection
• ‘ex ante’ information problem  hidden information
• Examples:
• Hope Scholarships
• The market for lemons
• Health insurances
• Hiring layoffs
• In common: Quality (risk) hard to observe
• In common: Self selection
• In general: “Selection bias”
• Can also be used!  WWII bomber planes
Market for lemons
• A lemon is a second-hand car of “low” quality.
• When you buy a second hand car, you are not able to
observe the quality of this car.
• Suppose there are two types of cars:
- Low quality: value 500,- High quality: value 2500,• If you cannot see the quality, you will be willing to pay at
max the average value: 1500,- (lower demand)
• Sellers of good quality cars are not willing to offer their car
for that price.
• For that reason there will be only bad quality cars in the
market  Or no market at all
Solutions against adverse selection
• Increase observability:
- Screening
- Independent inspections
• Signalling:
- Brands (Since ……..)
- Education
- (online) reviews (potential problems?)
• Risk pooling (collective insurances)
• Risk redistribution (guarantees)
• Risk segmentation (health care, zipcode, age)
Moral hazard
• ‘ex post’ information problem combined with a moral risk
• Also called “hidden action”
• Actors will make use of information advantage and profit from it 
Opportunistic behaviour.
• Actor behaves differently as opposed to situation before/without
transaction/contract.
Examples:
• Insurances
• Manegerial incentives (bonus)
• Shirking (employees, students)
• People, Banks, Greece
• Dentists
• Politicians
Moral hazard?
Moral hazard?
Solutions against moral hazard
• Information about behavior:
- Collective information sharing
– Black lists
- Monitoring
• Incentives for good behavior:
- Bonuses
- Own risk premia
- Discount for not using insurance (no-claim)