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This chapter introduces the model’s two key pieces—the aggregate-demand curve and the aggregatesupply curve. After getting a sense of the overall structure of the model in this chapter, we examine the pieces of the model in more detail in the next two chapters.
The Economics of Information Chapter 11 McGrawHill/Irwin Copyright © 2015 by McGrawHill Education (Asia). All rights reserved Learning Objectives Explain how middlemen add value to market transactions Use the concept of rational search to find the optimal amount of information market participants should obtain Define asymmetric information and describe how it leads to the lemons problem Discuss how advertising, conspicuous consumption, statistical discrimination, and other devices are responses to asymmetric information 112 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 113 How The Middleman Adds Value • Buyers sometimes choose among several version of a product – • Each has complex feature sets Research options – – – – Company web site Ask friends and family Consumer Reports, online product reviews Visit stores, ecommerce sites 114 Consumer Choice: Buying DSLR Camera • Best Denki recommends US$1,200 Nikon D7100 DSLR camera – • Your next move is – – – • Sales rep seems knowledgeable Thank them and more research Trust the sales rep and buy them Go home and buy at the best price online ($950) Evaluate the importance of – – – Immediate possession Best price Post-sales service and support 115 The Value of the Middleman • Sales representatives supply information to buyers – • Manufacturers can offer direct sales to bypass middlemen Information makes markets more efficient – Purchasing the bowl in Kashmir 116 Selling Babe Ruth • Koh wants to sell a Win the War stamp – – – – – 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 Two eBay shoppers have secret reservation prices of $800 and $900, respectively 117 Selling Win the War stamp • Benefits of eBay – Card sells for $800 on eBay less $40 commission • • • Local option is inferior – – – • Ellis nets $760, $460 above his reservation price Buyer surplus is $100 Card sells for $400 less $5 cost of ad Koh nets $395, $95 more than his reservation price Buyer surplus is $0 Economic surplus is increased when a product goes to the person who values it the most 118 The Optimal Amount of Information More information is better than less – • Marginal benefit starts high, then falls rapidly – • • Gathering information has a cost Low-Hanging Fruit Principle Marginal cost starts low, then increases Optimal amount of information is I* where MC = MB Optimal MC $/unit • MB I* Units of information 119 Free Rider Problem • A free-rider problem exists when non-payers 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 1110 Credibility Problem • • Parties gain if they find a way to communicate information truthfully If Akari can convince Haruto her Miata is in excellent condition, Haruto will buy – – Statements are not credible Akari offers Haruto 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 1126 The Costly-to-Fake Principle • To communicate information credibly, a signal must be costly or difficult to fake – – Sellers have an incentive to exaggerate the quality of their product Buyers value objective information about quality 1127 Costly Signals • Television advertising is expensive – In print advertising, "As seen on TV" signals a company's commitment to its product • • Potential signal of quality Educational institutions' brands and students' grades signal quality – An A+ student from MIT is more likely to be offered a job than a C student from an average academic institution 1128 Conspicuous Consumption • Choose a lawyer – – – • Lawyer A wears inexpensive suits and drives a 10-year old Toyota Lawyer B wears custom-tailored suits and drives a new Mercedes-Benz S 500 No other information is available Conspicuous consumption signals success – Choose Lawyer B 1129 Statistical Discrimination • Statistical discrimination uses group characteristics to infer individual characteristics – – • Can be applied to people as well as to goods and services Results from observed differences between groups Example – – – This candidate for employment is in her late twenties Women have babies in their late twenties This candidate will have a baby in the next few years • High cost compared to other candidates 1130 Dangerous Drivers • Men under 25 years of age pay more than other drivers for auto insurance – Expected cost of insuring a driver depends the probability and size of claims • – Individual assessments are not possible Rates are based on demographic groups and the claim history of those groups • Individual rates are adjusted upward as more information becomes available 1131 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 1132 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 1133 Disappearing Political Discourse • Disappearing political discourse theory holds that politicians who support a policy will remain silent to avoid being misunderstood – Opposing the death penalty could be interpreted by voters as being soft on crime • • No necessary relationship between the two Assumes voters implicitly assign a position to a politician who has not made public statements 1134 Politicians and the Death Penalty • Arguments against the death penalty – – – • Expensive relative to life in prison without parole Irreversible for people later found innocent Does not deter capital crimes Politicians avoid taking a public position on capital punishment 1135 Politicians and the Death Penalty • Voters want politicians are tough on crime – • • Broader issue than the death penalty Two groups of politicians: tough on crime and soft on crime Voters use information about a politician's views on the death penalty to infer the politician's stand on crime 1136 Politicians and the Death Penalty Favor Death Penalty PLUS Remain Silent 95% tough on crime • 80% tough on crime Oppose Punishing Criminals Politicians tough on crime and opposed to capital punishment lose votes – – • Oppose only the Death Penalty They have an incentive to remain silent • Move to blue box Probability that a politician in the red box is tough on crime decreases • More defections Public statements not accurately reflect aggregate views of politicians on capital punishment 1137 Legalized Drugs • • Laws against buying and selling certain substances are intended to reduce the harm to society from drug use Laws have a cost – – – – – Price of illegal drugs increases Addicts commit crimes to pay for drugs Diverts people from productive employment Externalities of turf battles High cost to law enforcement, legal, and prison systems 1138 Legalized Drugs • Legalization solves most problems – With lower drug prices, quantity demanded may increase • • Not supported by evidence in UK and Netherlands An outspoken supporter is seen by voters as more likely to be crazy than an outspoken opponent – Opponents Rational Opponent Crazy Opponent Supporters Rational Supporter Crazy Supporter Rational supporters not speak out 1139 The Economics of Information 1140 ... expected value of zero A better-than-fair gamble has a positive expected value 11 14 Risk Preferences • A risk-neutral person would accept any gamble that is fair or better-than-fair – A risk-averse... elements of a gamble A gamble has a number of possible outcomes – Each outcome has a probability that it will occur 11 13 Gamble Inherent in Search • The expected value of a gamble is the sum of (the... importance of – – – Immediate possession Best price Post-sales service and support 11 5 The Value of the Middleman • Sales representatives supply information to buyers – • Manufacturers can offer