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© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 14 ECON4 William A. McEachern
1
Transaction
Costs,
Imperfect
Information,
and Behavioral
Economics
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Rationale for the Firm
• Firms
– Minimize transaction costs
• Specialization and centralized control
– Minimize production costs
– More efficient
2
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Boundaries of the Firm
• Boundaries of the firm
– The appropriate degree of vertical
integration
• Vertical integration
– Expansion of a firm into stages of
production earlier or later than those in
which it specializes
3
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Boundaries of the Firm
• Outsourcing
– Firm buys products from outside
suppliers
• Core competency
– Area of specialty
– Product or phase of production a firm
supplies with greatest efficiency
4
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Boundaries of the Firm
• Bounded rationality
– Limit on information that a firm’s
manager can comprehend and act on
• Minimum efficient scale
– Minimum rate of output at which
economies of scale are fully exploited
• Easily observable quality
– Of the input
• Many suppliers of components 5
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 1
6
Minimum Efficient Scale and Vertical Integration
1,000,000 Computers per year0
5,000,0001,000,000 Chips per year0
Cost per
unit
Cost per
unit
(a) Computer manufacturer
(b) Chip manufacturer
The manufacturer in panel (a) is producing
at the minimum efficient scale of 1,000,000
computers per month. That output requires
1,000,000 computer chips. If the computer
manufacturer produced its own chips, the
cost would be much higher than if it buys
them from a chip maker operating on a
much larger scale. As panel (b) shows,
economies of scale in chip production are
far from exhausted when 1,000,000 chips a
month are produced.
LRAC
LRAC
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Economies of Scope
• Economies of scope
– Cheaper to produce different items in
one firm
– Average costs decline
– As the scope of the firm increases
• Firm makes a range of different products
rather than specialize in just one product
7
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Imperfect Information
• Marginal cost of search
– Marginal cost of information increases
• Marginal cost curve slopes upward
• Marginal benefit of search
– Better quality for a given price
– Lower price for a given quality
– Marginal benefit decreases
• Marginal benefit curve slopes upward
8
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 2
9
Optimal Search With Imperfect Information
If I* Ip0Quantity of
information
Info
rmation c
osts
and b
enefits
(dolla
rs)
Marginal cost
of information
Marginal benefit
of information
When information is not free,
additional information is
acquired as long as its marginal
benefit exceeds its marginal
cost. Equilibrium, or optimal
search, occurs where marginal
benefit equals marginal cost. I*
is the optimal quantity of
information.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Imperfect Information
• Optimal search
– Marginal benefit equals marginal cost
• IP = full information
• I* = optimal amount of information
• Search costs lead to
– Price dispersion
• Different prices for the same product
– Quality differences across sellers
10
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Winner’s Curse
• Auctions for product of uncertain value
• Many ‘winners’ end up losers
– Estimated value of products
– Winner: highest bid
• Most optimistic
• Competitive bidding with imperfect
information
11
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Asymmetric Information
• Asymmetric information
– One side of the market has better
information about the product than does
the other side
– Hidden characteristics
• Adverse selection
– Hidden action
• Principal-agent problem
12
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Asymmetric Information
• Hidden characteristics:
– One side of the market
• Knows more about product characteristics
that are important to the other side
• Adverse selection
– Those on the informed side of the market
• Self-select in a way that harms those on the
uninformed side of the market
13
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Asymmetric Information
• Adverse selection
– Lower-quality products dominate the
market
• If sellers have better information about a
product’s quality than buyers do
– Car sellers, the informed side
• Self-select: decide whether or not to offer
their cars for sale
• Increases the proportion of lemons for sale
14
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Asymmetric Information
• Hidden actions:
– One side of an economic relationship can
do something that the other side cannot
observe
• Principal-agent problem
– The agent’s objectives differ from those of
the principal’s
– And one side can pursue hidden actions
15
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Asymmetric Information
• Principal
– A person or firm who hires an agent to act
on behalf of that person or firm
• Agent
– A person or firm who is supposed to act
on behalf of the principal
16
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Asymmetric Information
• Insurance markets
– Buyers – have more information
– Adverse selection
• Insurance buyers tend to be less healthy
– Moral hazard
• Principal-agent problem
• Buyers – may take care less of their health
17
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Asymmetric Information
• Coping with asymmetric information
– Incentive structure or information-
revealing system
• “Lemon laws”
• Warranties
• Written estimates before a job is done
– Insurance companies
• Physical exam, health history, lifestyle
• Deductibles
• Copayments18
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Asymmetric Information
• Labor markets - Adverse selection
– Employer – Uninformed side
• Offers the going wage
– Candidates - Informed side
• Talented – don’t want it
• Less-talented – want it
• Efficiency wage theory – offer high wages
– Attracts a more talented labor pool
– Encourages good performance
19
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Signaling and Screening
• Signaling
– Proxy measures to communicate
information about unobservable
characteristics
– Attempt by the informed side to
communicate valuable information
– Useful as long as less-qualified applicants
face more difficulty sending the same
signal
20
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Signaling and Screening
• Screening
– Process used by employers to select the
most qualified workers based on
observable characteristics
– Attempt by the uninformed side to uncover
relevant but hidden characteristics
21
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