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
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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
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Warranties
Expensive advertising campaigns
Graduating from demanding programs
Conspicuous consumption