Econ 2610: Principles of
Microeconomics
Yogesh Uppal
Email: yuppal@ysu.edu
Chapter 12
The Economics of Information
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
The Optimal Amount of
Information



More information is better than less
 Gathering information has a cost
Marginal benefit starts high, then falls rapidly
Marginal cost starts low, then
increases
 Low-Hanging Fruit Principle
Optimal amount of information
is I* where MC = MB
Optimal
MC
$/unit

I*
Units of information
MB
Free Rider Problem

A free-rider problem exists when nonpayers 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
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
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
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
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
Buyer
Seller
Private Sale of a Used Car

Jane's Miata is in excellent condition

Jane's reservation price is $10,000


Blue Book value is $8,000
Tom 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 Jane's car has a cost
and the results are uncertain
Tom cannot verify that Jane's Miata is superior
The Lemons Model

People who have below average cars
(lemons), are more likely to want to sell them


Good quality cars are withdrawn from the
market


Buyers know that below average cars are likely to
be on the market and lower their reservation
prices
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
Your Aunt's Car

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
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
Probability
Value
Good Cars
Lemons
90%
10%
$10,000
$6,000
Credibility Problem


Parties gain if they find a way to
communicate information truthfully
If Jane can convince Tom her Miata is in
excellent condition, Tom will buy


Statements are not credible
Jane offers Tom 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
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
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