Chapter 11 - The economics of information

How the middleman adds value

• One of the most common problems consumers confront is the need to choose among different versions of a product whose many complex features they don't fully understand.

• In a world of incomplete information, sales agents and other middlemen add genuine economic value by increasing the extent to which goods and services find their way to the consumers who value them most.

  • For example, when a sales agent causes a good to be purchased by a person who values it by $20,000 more than the person who would have bought it in the absence of a sales agent, that agent augments total economic surplus by $20,000, an achievement on a par with the production of a $20,000 car.

The optimal amount of information

• Free-rider problem: incentive problem in which too little of a good or service is produced because non-payers cannot be excluded from using it.

• Expected value of a gamble: sum of the possible out comes of the gamble multiplied by their respective probabilities.

• Fair gamble: gamble whose expected value is zero.

• Better-than-fair gamble: gamble whose expected value 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.

Asymmetric information

• Asymmetric information: situations in which buyers and sellers are not equally well informed about the characteristics of goods and services for sale in the marketplace.

• Lemons model: George Akerlof’s explanation of how asymmetric information tends to reduce the average quality of goods offered for sale.

The credibility problem in trading

• Why can't someone with a high-quality used car simply tell the buyer about the car's condition? The difficulty is that buyers' and sellers' interests tend to conflict.

  • For example, sellers of used cars have an economic incentive to overstate the quality of their products. Buyers, for their part, have an incentive to understate the amount they are willing to pay for used cars and other products (in the hope of bargaining for a lower price). Potential employees may be tempted to overstate their qualifications for a job.

• Costly-to-fake principle: to communicate information credibly to a potential rival, a signal must be costly or difficult to fake.

• Statistical discrimination: practice of making judgments about the quality of people, goods, or services based on the characteristics of the groups to which they belong.

• Adverse selection: pattern in which insurance tends to be purchased disproportionately by those who are most costly for companies to insure.

• Moral hazard: tendency of people to expend less effort protecting those goods that are insured against theft or damage.

• Disappearing political discourse: theory that people who support a position may remain silent because speaking out would create a risk of being misunderstood.