ECON1010 Introductory Microeconomics
Introductory Microeconomics
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ECON1010
Introductory Microeconomics
LECTURE 12
Economics of Information
Q1. The clearest example of a good or service produced by
the private sector that has public good characteristics is:
b. education.
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e. bouncers at a nightclub.
d. MotoGP on Fox Sports (pay TV).
a. Weather report on the radio
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c. cars
Q2. A public good that would benefit Karen, Tammy and Max has
a one-time installation cost of $900. These three voters must
approve any tax plan by simple majority and all three will cast a
vote. Since the government does not know and cannot discover
the voters’ reservation prices, it proposes a head tax of $300 per
voter. The result of the referendum is:
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b. Max votes for the tax but Karen and Tammy
vote against it and it fails.
a. the tax passes and the public good is provided.
Voter Reservation
Price
Income
Karen $100 $1,000
Tammy $200 $5,000
Max $700 $6,000
c. Max votes for the tax, Karen votes against
it but Tammy’s vote is uncertain.
d. all three voters vote against the tax.
e. only Max casts a vote and the tax passes
Extra Question: Is the good
socially efficient? Yes $1000 > $900
Lecture 12 - overview
Lecture 12 ECON1010 4
Another context where economists know competitive
markets can produce an inefficient outcome in the
presence of costly and / or imperfect information.
Economists know that perfectly competitive markets
may not produce efficient outcomes. The list of
situations where this is seen to occur continues to grow.
The model of perfect competition assumes that
buyers and sellers have perfect information, or at the
very least are “well informed”.
What happens when this assumption doesn’t apply
in the real world?
In reality then:
The invisible hand theory assumes buyers are
fully informed, but this is rarely true.
Some market signals are false and misleading.
Given that consumers are not fully informed,
they must employ strategies for gathering
information.
Gathering the optimal amount of information
Having more information is better than less, but
more information is costly to acquire.
There can be rising marginal costs associated with
collecting information and diminishing returns.
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Cost-benefit principle indicates a rational consumer
will continue gathering information as long as
marginal benefit exceeds the marginal cost.
2The optimal amount of information.
M
B,
M
C
($
/u
ni
t)
Units of information
Marginal cost
of information
Marginal benefit
of information
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Ioptimal
The optimal amount of
information occurs
where MB = MC
Expert Advice
Lecture 12 ECON1010 8
“Experts” often say that good decision-making
means collecting as much information as possible
before making a decision. Is this sound advice?
Internet dating
Dating can be viewed as a search for information
regarding a potential spouse. What impact have on-
line dating sites (such as rsvp.com.au) had on the
spouse search process today compared to previous
generations?
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Search risks
Search often involves both uncertain benefits and costs.
In such situations, economists advocate calculating an
expected value which is based on probabilities.
= X * P(X) + Y * P(Y) + ………….
where
P(X) = probability of outcome X
P(Y) = probability of outcome Y
Expected value of a gamble
= the average outcome you would win (or
lose) if you played a particular gamble an
infinite number of times.
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Example 1. Expected Value (or outcome)
What is the expected value of tossing a coin if:
1. you win $1 if it lands heads
2. you lose $1 if it lands tails
Expected value = X * P(X) + Y * P(Y)
= 1* 0.5 + -1* 0.5
= $ 0
P(heads) = 0.5 P(tails) = 0.5
Outcome if get heads, X = win $1 (+)
Outcome if get tails, Y = lose $1 (-)
Lecture 12 ECON1010 11
Search risks
Fair gamble – a gamble whose expected value is zero.
Better than fair gamble – a gamble that has an
expected value that is 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.
Lecture 12 ECON1010 12
Example 2
You are a risk-neutral person looking for an apartment.
The distribution of apartments for rent is as follows:
50 % rent for $700 per month,
30 % rent for $600 per month,
20 % rent for $500 per month.
Your marginal cost increases by $20 for each additional
search (ie: marginal cost = $20, $40, $60 for the first,
second, third apartment etc. that you look at). What
would be your optimal number of searches?
3Example 2.
Keep searching up to the point where MB >= MC
The expected value of the MB from searching is
Finding a $700 apartment gives MB = 0
Finding a $600 apartment gives MB = $100
= 0.5 x 0 + 0.3 x 100 + 0.2 x 200
= 0 + 30 + 40 = $70/apartment
Looking at 3 apartments, MC = $60/apartment
Looking at 4 apartments, MC = $80/apartment
Conclusion: look at 3 apartment so that MB > MC
Finding a $500 apartment gives MB = $200
marginal cost =
$20, $40, $60 for
the first, second,
third apartments
etc.
Lecture 12 ECON1010 14
Asymmetric Information
Definition:
Situations in which buyers, and sellers, are
not equally well informed about the
characteristics of goods and services for sale
in the market place.
Lecture 12 ECON1010 15
Asymmetric Information
Examples:
1. A person selling a car has more
information about the car than the buyer.
2. A radio station bids for a new license, but
they do not have complete information
about the value of the license.
Asymmetric Information
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The Lemons Model (by George Akerlof)
Asymmetric information tends to reduce the
average quality of used goods offered for sale.
People who have below average cars
(lemons) are more likely to want to sell them.
Buyers know below average cars are likely to be
on the market and lower their reservation price.
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Example 3.
1. What would be the most a risk-neutral buyer
be willing to pay for a used car?
2. Over time, what price will all used cars be
traded at and what will their quality be?
Assume good quality used cars are worth
$10,000 to their owners while “lemons” are
only worth $5,000 to their owners. Buyers know
that some proportion of used cars for sale are
lemons, say 25%, but are unable to tell whether
a specific car is a lemon or not. In this situation:
Example 3.
A risk neutral buyer will take a gamble as long as it is fair
or better than fair. Unable to tell the difference between
a good car and a lemon, the expected value for the car
would be the price the risk neutral person would pay.
1. The expected value of the car is:
E(car) = 0.75 x 10,000 + 0.25 x 5,000
= 7,500 + 1,250
= $8,750
Note: those with good cars wanting $10,000 ….. no sale!
those with lemons wanting $5,000….. make $3,750
2. In the end, only lemons will be for sale at $5,000.
419
used car prices are low, so people with
good cars keep them longer
The Lemons Model (cont.)
Information problems reduce
economic efficiency in a market
the average quality of used cars falls even further
eventually only lemons are for sale
Asymmetric Information – what’s the point?
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rarely true
reduces the argument that
“the free market works best”
some market signals are false and misleading
Asymmetric information is a
form of market failure
The Invisible Hand theory assumes
buyers are fully informed
Asymmetric Information – what’s the point?
Information has economic value
Imperfect information can affect consumer decisions
Need strategies for gathering reliable information
Less than efficient outcomes
Recommendations and government policies formed to
improve the information provided
More efficient choices can be made in allocating
scarce resources
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1. Principal - Agent Problem
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= 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.
A classic example of the principal-agent problem
occurs with publicly-listed companies.
Inefficiencies and Information Issues.
Principal - Agent Problem
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Example:
Shareholders are owners of a firm (principals)
while managers run the firm (agents).
Principals want to maximise profits.
Agents would like to maximise their salaries,
enjoy spacious well furnished offices etc. (at
the expense of the principal).
Other examples?
2. Adverse Selection Problem
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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.
eg: in the used car market, most used cars offered
for sale will be lemons (the average quality of
used cars for sale is reduced).
eg: insurance markets (can result in only
those likely to make a claim continuing to
remain insured).
5Adverse Selection
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Example: Health Insurance Market
Insurance tends to be purchased disproportionately
by those most costly for companies to insure
raises premiums
increases the risk level of the fund
reduces the number of low-risk policy holders
3. Moral Hazard Problem
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The tendency of people to change their behaviour
once they become party to a contract.
The classic example = the insurance market.
Lecture 12 ECON1010
How might your behaviour change if your car
was insured versus if it was not insured?
Moral Hazard
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Insurance companies take steps to reduce the
moral hazard problem by offering incentives.
1. lower annual rates for no claims
3. offer co-payments so the insurer pays only
a percentage of the claim
2. lower excess for no claims
Moral Hazard
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Road safety:
Studies have shown that the introduction of
certain road safety initiatives, such as the
compulsory wearing of seatbelts, coincided with
a reduction in the number of car occupants
dying on the roads.
However, there was a rise in the number of
some other user groups, such as motorcyclists.
Thinking like an economist how might you
explain such findings?