Chapter 14

The economics of information

14.1 How the middleman adds value

- Internet retailers can sell for less because their costs are so much lower than those of
full-service retail stores.
Ø These stores must hire knowledgeable salespeople, put their merchandise on
display, rent space in shopping malls.
- Many believe the production worker is the ultimate source of economic value added.
Ø Sales agents are often disparaged as mere middlemen, parasites on the efforts of
others who do the real work.
Ø Viewing beyond the superficial level, we can see that the economic role of sales
agents is essentially the same as that of production works.
- E.g. when selling an item which will sell for a higher price on Ebay,
Ø The bidder with the highest reservation price wins, and the price she pays is the
reservation price of the second highest bidder.
Ø Hence higher total economic surplus if sold on Ebay.
- In a world of incomplete information, sales agents and other middlemen add genuine
economic value by increasing the extend to which buyers end up with goods and services
that are most valuable to them, and by making sure that goods and services find their
way to the consumers who value them most.

14.2 The optimal amount of information

- Having more information is better than having less.
- But information is generally costly to acquire.
- The value of additional information as reflected in the increase in buyer surplus, will
decline beyond some point.
Ø Low-hanging-fruit principle, gather information form the cheapest sources.
Ø The marginal benefit of information will decline and marginal cost will rise as
amount of information gathered increases.

Applying the cost-benefit test

- The cost-benefit principle states that a rational consumer will continue to gather
information as long as MB>MC.
- The optimal amount of information where MC=MB.
Ø Beyond that point additional units of information cost more to acquire than they
are worth.
Two guidelines for rational search
- Spending additional search time is more likely to be worthwhile for expensive items than
for cheap ones.
- Hence hiring an agent – someone who can assist with a search – is more likely to be good
investment in searching for something expensive.
Ø E.g. Seek doctor’s advice for chest pain but not for a splinter. Seek agent to sell a
house but not to sell a camera.
- When searching becomes more costly, we should expect to do less of it.
Ø The price we expect to pay will be higher and price dispersions greater when the
cost of a search is higher.

The free-rider problem

- Sellers must decide how much to invest in providing information to prospective buyers.
Ø Might not provide optimal amount of advice.
Ø Free-rider problem.
o Consumers can make use of services offered by retail stores without paying for
them, an example of the free-rider problem.
Ø Since retail stores have difficulty recovering the cost of providing information,
private incentives are likely to yield less than the socially optimal level of retail
service.
- Hence free-rider problems often hinder retailers’ efforts to provide information to
consumers.

The gamble inherent in search

- When you engage in further search, you must accept certain costs in return for unknown
benefits.
Ø Further search invariably carries an element of risk.
- In deciding whether to take a gamble, the first step is to compute its expected value.
Ø Expected value of a gamble – the average amount you would win or lose if you
played that gamble an infinite number of times. It is calculated as the sum of the
possible outcomes of the gamble multiplied by their respective probabilities.
 o E.g. on a coin toss, you win $1 if it’s heads and $1 if it’s tails, the expected
value is (1/2)($1) + (1/2)(-$1) = 0.
- Fair gamble – a gamble whose expected value is zero.
- Better-than-fair gamble – a gamble whose expected value of positive.
- Risk-neutral person – someone who would accept any gamble that is fair or better.
- Risk-averse person – someone who would refuse any fair gamble.

The commitment problem when search is costly

- The difficulty in maintaining stable matches between partners in ongoing relationships
would not arise in a world of perfect information.
- But when information is costly and search must be limited, there will always be the
potential for existing relationships to dissolve.
Ø This problem is solved not by conducting an exhaustive search, but by committing
themselves to remain in a relationship once a mutual agreement has been reached
to terminate the search.
o E.g. sign lease, employment contracts.

14.3 Asymmetric information

- One of the most common information problems occur when participants in a potential
exchange are not equally well informed about particular aspects of the transaction. E.g.
Ø The seller of the good has better information than the buyer about the
characteristics of the product offered for sale.
Ø A person on one side of an relationship may be able to take actions that have
negative consequences for the person on the other side of the transaction that the
latter cannot observe.
o Electrician billing a client for services not performed at all.
Ø Both of the above examples are called asymmetric information.
o Asymmetric information – situations in which people on different sides of an
economic exchange are not equally well informed about a particular aspect of
the transaction that will affect the outcome for them.

The lemons model

- The economic incentives created by asymmetric information suggest that most used cars
put up for sale will be of lower-than average quality.
Ø People who mistreat their cars are more likely than others to want to sell them.
Ø Buyers know that cars for sale are more likely to be lemons than those that aren’t
for sale.
Ø This causes them to lower their reservation prices for a used car.
Ø Once used car prices have fallen, the owners of cars that are in good condition have
an even stronger incentive to hold onto them.
Ø The average quality of cars offered for sale on the used car market to decline still
 further.
Ø This downward spiral is explained by the lemons model.
o Lemons model – George Akerlof’s explanation of how asymmetric information
about the characteristics of goods tends to reduce the average quality of used
goods offered for sale.
- Red book value of a car is the average price for which cars of that age and model sell in
the used car market.
- A naïve, risk neutral buyer’s reservation price for a used car is (% of getting a good
car/100)(worth of good cars) + (% of getting a lemon/100)( worth of lemons).
Ø A seller of good car will not sell, but seller of lemon will sell.
Ø In the end all used cars will sell for price of lemons and all will be lemons.
- The logic of lemons model explains an owner’s frustration at having to sell at a price that
does not reflect the product’s condition.
Ø Hence sellers let prospective buyers known the reason they are selling their cars.

Principal-agent problem
- The gains from specialization mean that individuals rely heavily on experts when making
many decisions. Medical or financial advice.
Ø The defining feature of an expert is that they are better informed about such things
than the people who hire them.
- Arrangements between clients and their doctors, mechanics, lawyers and real estate
agents are called principal-agent relationships.
Ø Principal – someone who contracts or hires another party to perform some service
or provide some good on their behalf.
Ø Agent – someone who is contracted or hired by another party to perform some
service or provide some good on t heir behalf.
Ø Principal-agent problem – a situation where an agent, whose actions are costly to
monitor and whose objectives are not aligned with those of the principal, takes
actions that do not result in the best outcome for the principal.
- Solutions to principal-agent problems involve finding ways of aligning the interests of an
agent with those of the principal.
Ø A restaurant owner unable to monitor the performance of waiters directly may rely
on customer tipping to induce waiters to provide good service.
Ø Principals may require written quotes, seek price estimates from many potential
agents, and design incentive-compatible reward schemes.
Ø It may be in the agent’s best interest to find credible ways of communicating
reliable information about their trustworthiness and reliability as an agent.

The credibility problem in trading

- Buyers’ and sellers’ interests tend to conflict.
- Potential employees may be tempted to overstate their qualifications and experience for
a job.
- Whilst most people don’t consciously misrepresent the truth in communicating with
their potential trading partners, but people tend to interpret ambiguous information in
 ways that promote their own interests.
Ø “Lake Wobegon effect”, all children are above average.

The costly-to-fake principle

- The idea that to communicate information credibly to a potential rival, a signal must be
costly or difficult to fake.
Ø E.g. mere statements about a car’s quality may not be persuasive, but the seller
might offer a warranty which entail costs that are significantly higher for defective
cars than for good cars; hence their credibility as a signal of product quality.
- Many firms make a big deal of letting prospective buyers know that they advertise their
product on national TV by including this information in printed media advertising.
Ø Since the cost of a national tv campaign can run into the millions of dollars, a sum a
company would be foolish to spend on an inferior product, an expensive national
advertising campaign is a credible signal that the producer thinks its product is a
good one.
- Information asymmetries and other communication problems between potential
exchange partners can often be solved through the use of signals that are costly or
difficult to fake.

Conspicuous consumption as a signal of ability

- In competitive markets, the people with the most ability tend to receive the highest
salaries, and as suggested by the cost-benefit principle, they are more likely to spend on
high-quality goods and services.
- The correlation between salary and the ability buyers value most is particularly strong in
the legal profession.
Ø Lawyers who drive a BMW is more likely to be hired by one who drives a Holden.
Ø The problem of conspicuous consumption as an ability signal does not arise with
equal forces in every environment.

Statistical discrimination
- In a competitive market with perfect information, the price the buyer of a service would
pay equals the seller’s cost of providing the service.
Ø In many markets, e.g. fire insurance, the seller does not know the exact cost of
serving each individual buyer.
- The missing information has an economic value.
Ø If the seller can come up with even a rough estimate of the missing information,
she can improve her position.
Ø Firms often impute characteristics to individuals on the basis of the groups to which
they belong.
- An insurance company must collect enough money from premiums to cover the cost of
the claims it pays out, plus admin expenses.
Ø Young males are likely to be charged a higher premium.
 Ø This is an example of statistic discrimination.
o 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.
- E.g. paying higher salaries to people with university degrees.
- When people are judged on the basis of the groups to which they belong.
- Competitions promote statistical discrimination.
- Statistical discrimination is the result of observable differences in group characteristics,
not the cause of those differences.
- With insurance, on average, the group’s rates will be appropriate to the claims its
members generate.
- Competitive forces provide firms an incentive to identify such individuals and treat them
more favourably whenever practical.

Adverse selection
- Buying insurance is most attractive to those with the highest likelihood of filing claims.
Ø Insurance companies are forced to raise t heir premiums, which makes buying
insurance even less attractive to low-risk individuals, which raises still further the
average risk level of those who remained insured. Example of adverse selection.
- Adverse selection – a pattern which emerges in markets where those on the informed
side of the market self-select in a way that tends to reduce the average quality of the
good or service sold.
Ø When people on the informed side of a market (those seeking insurance) self-select
in the actions they choose (to take insurance at a given price) in such a way that
those on the other side of the market are harmed (insurance companies).
Ø Akerlof’s market for lemons is an example of adverse selection.

Moral hazard
- Moral hazard – the tendency of people to change their behaviour once they become
party to a contract.
- People take fewer precautions when they know they are insured.
Ø By offering policies with varying “excess” provisions geared to the driver’s age and
experience, insurance companies help many of their potential clients soften the
consequences of problems like moral hazard and adverse selection. These policies
are positive in that,
o Since policies are cheaper for insurance companies to provide, they sell for
lower prices, which represent a much better bargain for drivers who are least
likely to file insurance claims.
o Excess clauses confront careless drivers with more of the extra costs for which
they are responsible, giving them additional incentives to take precautions.
14.4 Disappearing political discourse
- Disappearing political discourse – the theory that people who support a position may
remain silent, because speaking out would create a risk of being misclassified on the
basis of their membership of a statistical group.

14.5 Information and healthy care delivery

- Governments in all countries must decide how much health care programs are to be
delivered to their citizens.
- Australia has opted for a hybrid, two-tier healthy care system, comprising both public
and private hospitals and medical practitioners, a universal tax-financed Australia-wide
health insurance scheme system called Medicare and dozens of private insurance
schemes offering a wide range of options for additional coverage.
Ø In 2005-06, of the $87 billion spent on health, 70% was taxpayer funded with the
remaining 30% financed by private sector expenditures.
- The problem is that, whether publicly or privately funded, first-dollar insurance coverage
where 100% of claimants’ medical expenses are covered by insurance can spawn
hundreds of millions of dollars of waste each year.
Ø First-dollar insurance coverage – insurance that pays all expenses associated with
claims generated by the insured activity.

Applying the cost-benefit test

- The cost-benefit test is the only sensible criterion for deciding which services ought to be
performed.
Ø The fact that a medical procedure has some benefit does not imply that the
procedure should be performed.
- Example when a patient decides number of days to stay in a hospital.
Ø If they have to pay themselves, they’ll stay for 1 day. If the cost is covered by
insurance, the marginal cost is 0 to them (where in fact it’s several hundred dollars)
and they’ll stay for 3 days.
o Example of moral hazard.
- People also make choices about their consumption of health care as if they were wanting
to “get their money’s worth”.
- Wastes that result from first-dollar insurance coverage.
Designing a solution
- The insurance company can give the patient a cash payment towards hospital expenses
and let him decide how long to stay in hospital.
- The amount of waste caused by full insurance coverage depends on the price elasticity of
demand for medical services.
Ø The more elastic the demand, the greater the waste.

Private health care insurance

- People do not buy private insurance because it is “too expensive” and that “Medicare
coverage is sufficient”.
Ø Private health funds have been bounded by the principle of community rating.
o Community rating – the requirement that private health insurance companies
must not use statistical discrimination to set higher premiums for fund
members who pose higher risks.
Ø Policyholders pay higher premiums; and private cover becomes less affordable for
those on low incomes.
- Mounting insurance premiums have caused many people in good health to do without
health coverage, resulting in higher premiums for those who remain insured.
- Attempts to encourage private health insurance are often frustrated by adverse selection.