ECON1101 - The Economics of Information

Whilst the invisible hand theory assumes that sellers and buyers are fully informed, this is not always the case. A lack of information can lead to:

  • Beneficial exchanges not occurring
  • Non-beneficial exchanges occurring
  • Goods going to consumers who don't value them the most

The Optimal Quantity of Information

Uninformed consumers must pay an opportunity cost to gather information (e.g. hiring an agent, researching the product).

Consumers should acquire information about the product to the point where the Marginal Cost equals the Marginal Benefit.

The Optimal Provision of Information

Sellers must decide how much information to provide, but given information is a public good and suffers from the free rider problem, typically too little information is provided.

Search vs Commitment

Searching for a deal is a gamble, as there is the risk of passing up on a good offer, or of accepting a mediocre offer only to miss an upcoming good one.

Hence it may be beneficial to commit to a decision, to balance out the two risks.

Asymmetric Information

A situation in which people on different sides of the exchange have a non-equal amount of information is called asymmetric. This leads to problems such as adverse selection and moral hazards.

Example of Adverse Selection

Adverse selection is the tendency to self-select in such a way that reduces the quality of the good sold.

Cars in excellent condition have a higher asking price. But as the buyer cannot guarantee the condition of the car, they will buy a car below their reservation price which will often end up being worse. And hence their reservation price will drop and the cycle continues.

Example of Moral Hazards

Moral hazards are the tendency for people to change behaviour once they have entered into a contract.

People with car insurance tend to take less care when looking at damage prevention than those without.

The Principle-Agent Problem

The Principle-Agent Problem is that of differing interests between a client (principle) and the specialist (agent) that they hire for a purpose.

One of the potential problems is that of reputation, which can be solved by whether or not a signal of quality would be costly to fake.