The economics of information

1. 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?

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. Some examples of MC and MB curves of information

9. 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

10. 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

11. 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

12. 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

13. The following example is purely hypothetical • You can make your own conclusions the usefulness of a store stocking certain merchandise

14. 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

15. $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?

16. Let’s look at the description again (emphasis mine) • Bloomingdale’s website • Sutton Studio Exclusive Loopy Terry Casual Hoodie Jacket – Petites’ • $89 on Bloomingdale’s website • Notice that nobody sells this jacket except Bloomingdale’s

17. 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

18. 100% probability of good product, $89 50% probability of good product, $50 Suppose you trust Bloomingdale’s more

19. 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

20. 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

21. 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

22. 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”

23. 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

24. Example 1 Yugo car • 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. Summary: Asymmetric information • The Lemons model • Under what conditions will plums never enter the market?