The economics of information

Information is valuable, since the right buyer is more likely to find the right seller Middleman is often knowledgeable

about a market, which is valuable This leads to the question: How much

information is optimal?

Information is typically not complete nor perfect

Since firms and customers are usually not fully informed, we lose efficiency Firms are unable to notify every

potential customer that her/his business is ready to sell

Customers may not know all options of companies that sells a good or service

Do we want full information in every market?

No Prohibitively costly, if it is even

possible In our analysis, we will find the

optimal amount of information

The middleman A good middleman (or

middlewoman) is knowledgeable about the market in question Some customers are willing to pay for

this service Some information providers today

are not human Google and many other search

engines have paid advertising

What is optimal?

As usual, we will use marginal analysis We will search for information is long

as MB > MC The middleman often provides this

information, but at a cost

More on the middleman Basic information can be

provided at low cost, since many people are usually knowledgeable in the topic

Very specialized information can be costly Someone may have to do

substantial research to get this specialized information

MC of information usually increases at an increasing rate

Marginal benefit of information

Basic information about a product is usually very valuable

Very specialized information usually has little value

MB of information typically gets steeper as the number of units increases

Some examples of MC and MB curves of information

Optimal amount of information?

Find the point where MB = MC

Example: Use MC1 and MB1 curves Optimal amount

of information is 7 units, at a cost of $15 per unit

Summary: The economics of information

Information is useful, and thus has value MB/MC analysis still applies The “middleman” often provides

information, at a price

The internet and information The internet has lowered costs, but it also

sometimes gives less reliable information at little cost Example: Customer feedback

Information markets would be more efficient if information was charged in stores, with prices for goods comparable to on-line purchases American norms prevent this from happening

The internet and information

Stores that give useful information are at the mercy of buyers Buyers can use the information and

buy on-line if the good is easily found Free-rider problem

Stores may have to cut costs to stay competitive, leading to a sub-optimal amount of information given

The following example is purely hypothetical

You can make your own conclusions the usefulness of a store stocking certain merchandise

Example of a market where information is valuable Bloomingdale’s

website Sutton Studio

Exclusive Loopy Terry Casual Hoodie Jacket – Petites’

$89 on Bloomingdale’s website

$89 That’s too much

You try to find the same item on other websites

You find other websites offering the exact same item Click Back to Bloomingdale’s Why can’t I buy this from another

website?

Let’s look at the description again (emphasis mine)

Bloomingdale’s website Sutton Studio ExclusiveExclusive Loopy Terry

Casual Hoodie Jacket – Petites’ $89 on Bloomingdale’s website

Notice that nobody sells this jacket except Bloomingdale’s

Where is the information?

Some people believe that clothes from Bloomingdale’s is too expensive

Why not buy this jacket from bella.com for $50

Suppose you trust Bloomingdale’s more

100% probability of good product, $89

50% probability of good product, $50

Analysis Assumption

Any product that is not good is worthless If you trust Bloomingdale’s pay $89;

know with certainty you get a good product If you believe that the $50 jacket is good

with 50% probability, you would expect to buy 2 (on average) before buying a good jacket Expected spending: $100

Answer

Buy the Bloomingdale’s jacket for two reasons No risk (risk is costly to some people) Lower expected cost to buy a good

product

Summary: The internet and information With the widespread use of the

internet, information is free and plentiful Free-rider problem if store with good

information also charges a higher price Sellers in some markets can gain

“exclusive” rights to sell an item Buyers can judge in advance the

quality, based on who the vendor is

Asymmetric information Some markets have sellers knowing

more about their product for sales than buyers This is known as asymmetric information

Most common example: Used cars Buyer knows less about the car than the

seller Some cars are good: “plums” Some cars are bad: “lemons”

Lemons model

When buyers do not have information as to which cars are lemons and which cars are plums, sometimes only the lemons go on the market

We will go through two examples to show a case where only lemons are available on the market

Example 1 A used car dealer has the following

information about used Yugo limos: Plums are worth

$3,000 to the dealer $1,200 to the owner

Lemons are worth $250 to the dealer $100 to the owner

100 Yugo limos owned privately Half of the limos are plums, half are lemons

Yugo car

What should the used car dealer offer for Yugo limos? Suppose the used car dealer offers

$1,201 for used Yugo limos 1,201 > 1,200 Plum owners sell to dealer 1,201 > 100 Lemon owners sell to dealer

Profit if all 100 are bought Total value = 50 3,000 + 50 250 =

$162,500 Total cost of buying Yugos = 100 1,201 =

$120,100 Total profit = $162,500 - $120,100 = $42,400

What should the used car dealer offer for Yugo limos?

Should the used car dealer offer an amount other than $1,201? Offer a higher price increased cost

for no gain in value Offer a price below $1,200 only the

lemon owners would sell their cars Profit if $101 was offered 50 (250 –

101) = $7,450

What is the best price to offer?

Offer $1,201 profit is $42,400 Offer $101 profit is $7,450 Highest profit occurs if $1,201 is

offered

Example 2: Everything is the same except the last bullet point

A used car dealer has the following information about used Yugo limos: Plums are worth

$3,000 to the dealer $1,200 to the owner

Lemons are worth $250 to the dealer $100 to the owner

100 Yugo limos owned privately One-quarter of the limos are plums, three-

quarters are lemons

What should the used car dealer offer for Yugo limos? Suppose the used car dealer offers

$1,201 for used Yugo limos 1,201 > 1,200 Plum owners sell to dealer 1,201 > 100 Lemon owners sell to dealer

Profit if all 100 are bought Total value = 25 3,000 + 75 250 =

$93,750 Total cost of buying Yugos = 100 1,201 =

$120,100 Total profit = $93,750 - $120,100 = –$26,350

Notice here that the dealer will never offer $1,201

Why? Profits are negative Profits can be zero by not attempting

to buy Yugo limos

What should the used car dealer offer for Yugo limos?

Offer a price below $1,200 only the lemon owners would sell their cars Profit if $101 was offered 75 (250

– 101) = $11,175 Offer $101 to maximize profit

What else could the car dealer do?

The dealer could hire a mechanic to try to determine if the Yugo limos are lemons or plums Will do it if MB of information exceeds

MC

Summary: Asymmetric information

The Lemons model Under what conditions will plums

never enter the market?