Economics of Information and Its Implication

Khemraj Subedi

Associate Professor

Tikapur Multiple Campus

Abstract

This paper shows emergence of Economics of Information and provides insights into economic relations with choice of rational economic agents and provide explanations on how asymmetric information hampers efficient allocation of resources and causes market failure. This paper makes brief investigation on economics of information and various sub-fields. A high degree of perfection in Information is a desirable as market signaling for ensuring efficient allocation of resources. Asymmetric information poses the problems of market failure, adverse selection, and principal agent problem, moral hazards, exploiting “ignorance” and irrationalities and slack in labour productivity. It includes complete and scientific knowledge as special cases. The information revolution helped push back other boundaries within economics. Information economics provides the basis of the move towards behavioral economics. In fact, the scope of information is widening day by day and gaining popularity as quasi-public goods. Consequently, economics of information is recent advancement in the microeconomic theory. It has been contributing in greater magnitude and degree to refine the several braches of microeconomic theory. It has been widening the horizon for the search new knowledge in the field of behavioral microeconomics so as to make it more fruit bearing and light giving.

Key Words: Asymmetric Information, Search cost, Adverse selection, Market Failure,                                   Screening, Signaling

JEL Classification: D80, D81, D82, D83

Introduction

The economics of information is a branch of microeconomic theory that studies how information and information systems affect an economy. and economic decisions. Economic agents try to make rational and better choice for the disposal of limited and scarce resources so that it yields higher expected pay off. In the contemporary world, information is also considered as a good like any other good. Like other goods it has price also. Hence, information is also treated as tradable good having special characteristics that influence many decisions. Ironically, it is easy to create but hard to trust. It is easy to spread but hard to control. These special characteristics complicate many standard economic theories. The information economists have conceptualized several subfields of information economics such as the economics of search, asymmetric information: the market for lemons and adverse selection, market signaling, screening, the problem of moral hazards, the principal-agent theory and the efficiency wage-theory.

The perfect information has economic value because it allows individuals to make choices that yield higher expected payoffs or expected utility than they would obtain from choices made in the absence of information. Asymmetric information creates several problems such as adverse selection, moral hazards, principal-agent problem and so on. These problems eventually lead to market failure. Market failure is situation in which market forces (i.e. demand, supply and price mechanism) fail to ensure efficient allocation of resources. This paper tries search answer the question like; how economic agents try to maximize their pay by incurring certain to garner perfect information, what are the possible adverse situations of information asymmetries. To answer these questions findings of different scholars will be analyzed. This paper aims to have overview the different aspects of information asymmetries and their consequences. Likewise, it also tries to relate the information asymmetry to microeconomic decision making. The practice of golden parachutes is proliferated around the world to overcome the problem of principal-agent problem (Salvatore, 2013).

Emergence of Economics of Information

The starting point for economic analysis is the observation that information has economic value because it allows individuals to make choices that yield higher expected payoffs or expected utility than they would obtain from choices made in the absence of information. Initially, it was a content of game theory.

Ackerlof (1970) has proposed an example the markets for "lemons"(i.e., defective products, such as used cars, that will require a great deal of costly repairs and are not worth their price) and states that this problem leads adverse selection. Stiglitz (1987) opines that higher prices are themselves taken as an indication of higher quality. Spence (1974) pioneered the concept of market signaling and screening for resolving the problem information asymmetries. Nelson (1974) points out that advertising is necessary for both search goods and experience goods but magnitude may differ. Fama (1980) and Boumol (1967) that the owners of the firm want to maximize the total profits or present value of the firms where as the managers or agents want to maximize their own personal interest, such as their salaries, tenure, power, prestige. Furthermore, a firm's manager (agent) possesses more information than owner as a result managers try achieving undue benefit from owner that leads to principal-agent problem. This paper tries to relate possible areas of information asymmetry in the contemporary global community.

 The information economics includes several aspects such as the economics of search, asymmetric information: the market for lemons and adverse selection, market signaling, the problem of moral hazards, the principal-agent theory and the efficiency wage-theory. They will be discussed subsequently.

The Economics of Search: Search Cost and Its Computation

Economic agents spend time and money seeking information about the product's properties, the alternatives, quality assurance, safety provisions, and difference in the cost at one store to another and so on. The search cost refers to the time and money spent in seeking better information about a product that we are desirous to buy. The general rule is that a consumer should continue the search for lower prices as long as the marginal benefit (MB) from continuing the search exceeds the marginal cost, and until the marginal benefit equals the marginal cost (MC).The MB is equal to the degree by which a lower price is found as a result of each additional search times the number of units of the product purchased at the lower price. Likewise, the MC of continuing the search depends on the value that consumers place on their time. Since the value that consumers place on their time differs for different consumers, the product will be purchased at different price by different consumers based on their own MB=MC rule.

At any time, there will be a dispersion of price in the market even for a homogeneous product. A consumer has a choice either to accept the price quoted by the first seller of the product or to continue the search for lower prices. The consumer will continue for the lower price as long as the marginal benefit (MB) from continuing the search exceeds the marginal cost (MC) of additional search. In general, the MB from searching declines as the time spent searching for lower prices continues. Even if MC of additional search is constant, a point is reached where MB=MC. At that point, the consumer should end the search.

 For example, suppose that a consumer wants to purchase a small portable TV of a given brand and knows the prices of different sellers' ranges from $80 to $120. All sellers are identical in location, service, and so on, so that price is the only consideration. Suppose also that sellers are equally divided into five price classification: Sellers of type I charge a price of $80 for the TV, type II seller charge $90, type III charge $100, type IV charge $110, and type V charge $120. For a single search, the probability of each price is 1/5, and the expected price is the weighted average of all prices, i. e, $100. The expected price E (P) can be calculated as follows:

E(P) = $80(1/5)+$90(1/5)+$100(1/5)+$110(1/5)+$120(1/5)

        = $16+$18+$20+$22+$24 = $100

The consumer can purchase the TV at price of $100, or s/he can continue the search for lower prices. With each additional search the consumer will find a lower price, until the lowest price of $80 is found. The reduction in price with each search gives the MB of each search. How many searches the consumer conducts depends on the marginal cost that s/he faces. The consumer will end the search when the MB from search equals to the marginal cost.

We can use a simple formula to obtain the approximate lowest price expected with each additional search. This is as under:

Expected Price of additional Search= Lowest Price+

For example, the lowest TV price expected from one search is

     Expected Price = $80+  = $100

The approximate lowest expected price from two searches is $80+($40/3)=$93.33.

Thus, the approximate marginal benefit (MB) from the second search is $100-93.33=$6.67.

The lowest expected price with three searches is $80+($40/4)=$90.

Here, MB=$93.33-$90=$3.33. The lowest expected price with four searches is $80+($40/5)=$88, and MB =$2. Likewise, the approximate lowest expected price from two searches is $80+($40/6)=$86.67 and here MB $1.33.

The thing worth mention here is, with each additional searches MB declines. In the aforementioned example, MB =$6.67 for the second search, $3.33 for the third search, $2 for the fourth search, $1.33 for the fifth search and so on.

A rational consumer will continue searches as long as MB of additional search exceeds MC i.e. MB>MC as it pays him/her. Hence, so long as with additional search MB=MC, search will go on.   But, when with additional search MB<MC, search will stop as it does not pay him/her.  Thus, the higher the price of the commodity, and the greater the range of the product prices, the more searches the consumer will undertake. In conclusion, consumers face different MC of search, they will end the search at different points and end up paying different price for the product. This allows different producers to charge different prices. The producers selling the product at a higher price will sell only to those consumers who have less information.

Asymmetric Information

Asymmetric information refers to a situation when one party (i.e. the seller or buyer of product or service) to a transaction has more information than other party regarding the quality of the product or service. It affects in several way in the economic decision making. In 2001, the Nobel prize in economics was awarded to George Akerlof, Michael Spence, and Joseph E. Stiglitz "for their analyses of markets with asymmetric information." They are subsequently discussed here under.

The Market for Lemons and Adverse Selection

Adverse selection refers to the situation where low-quality products drive high-quality product out of the market as a result of the existences of asymmetric information between buyers and sellers. Ackerlof (1970) has proposed an example the markets for "lemons"(i.e., defective products, such as used cars, that will require a great deal of costly repairs and are not worth their price) for the discussion of the concept of asymmetric information. For example, sellers of used cars know exactly the quality of the cars that they are selling while prospective buyers do not. As a result, the market price for used cars will depend on the quality of the average used car available for sale. As such, the owner of "lemons" would tend to receive a higher price than their cars worth, while the owners of "plums"(i.e. a good quality used cars) would tend to get a lower price than their cars are worth. The owner of plums would therefore withdraw their cars from the market. The withdrawal of above-average quality cars from the market makes further reduction in the quality and price of the remaining used cars offered for sale. The process continues until only the lowest-quality cars are sold in the market at the appropriate very low price. The end result of this process is that low-quality cars drive high-quality cars out of the market. This is known as adverse selection. Here worth mention, Stiglitz (1987) opines that higher prices are themselves taken as an indication of higher quality. The problem of adverse selection that arises from asymmetric information can be overcome or reduced through the acquisition of more information by the party lacking it. With more information on the quality of used cars, buyers would be willing to pay a higher price for plums and lower price for lemons. This helps in great deal to reduce the problem of adverse selection.

The Problem of Moral Hazard

Moral hazard in this context refers to the increase in the probability of illness, fire, or other accident when an individual is insured than when s/he is not insured. With insurance, the loss from an illness, fire or any other accident is shifted from the individual to the insurance company. Therefore, the individual who has insured will take fewer precautions to avoid the illness, fire or other accident. For example, Individual with medical insurance may spend less on preventive health care resulting the higher probability of getting ill. If she or he does become ill, will tend to spend more on treatment than she or he had no insurance. With auto insurance, an individual may drive more recklessly (thus increasing the probability of a car accident) and then may be likely to exaggerate the injury and inflate the property damage suffered if the driver does get into an accident. Similarly, with fire insurance, a firm may take fewer reasonable precautions thereby increasing the probability of a fire than in the absence of fire insurance; and then the firm is likely to inflate the property damage suffered if a fire does occur. In fact, the probability of a fire is high if the property is insured for an amount greater than the real value of the property. Thus, the problem of moral hazard arises whenever an externality is present (i.e., any time an economic agent can shift some of its costs to others).

The socially valid purpose of insurance is to share given risks of a large loss among many economic units. If the problem of moral hazard is not reduced or persists substantially, it could lead to unacceptably high insurance rates and costs and thus defeat the very purpose of insurance. But if ability to buy insurance increases total risks and claimed losses, then insurance is no longer efficient and may not be a possible.

The Principal-Agent Problem

In the modern corporate companies, there is separation between the ownership and management control of a firm. Fama (1980) postulates that a firm's managers act as the agents for the owners stockholders (legally referred to as the principals) of the firms. Because of this separation of ownership from control in the modern corporation, a principal-agent problem arises. Boumol (1967) postulates that the owners of the firm want to maximize the total profits or present value of the firms where as the managers or agents want to maximize their own personal interest, such as their salaries, tenure, power, prestige. This very situation is known as the principal-agent problem.

Asymmetric information plays a role in this principal-agent relationship. The managers or agents possess more information than owners. As a result, due to lack of information to the part of owners, the agents or managers have ample freedom to behave discretionally and take decisions to promote their own interest rather than the interest of the owners. This problem exist both in private as well as public enterprises. There are suggested some measures to reduce this problem such as profit-sharing contracts, providing part-ownership, incentive pay to managers. Morck, Shliefer and Vishny (1988) found that if managers own between 5 and 10 percent of the stock of a firm, the firm is likely to perform better in terms of profitability than if they own less than 5 percent.

Empirical Observations on Information Asymmetry and Adverse Selection

In order to have perfection of information, economic agents are increasingly using information technologies as far as possible. Nelson (1974) points out that advertising is necessary for both search goods and experience goods but magnitude may differ. In the contemporary world information asymmetry has given rise to the problems of market failure. In USA, the problem of the problem decline in labour force participation as symptoms of moral hazard problem (Pearson, 1980). In fact, asymmetric information causes adverse selection and it in turn low quality product drives the high quality product out from the market. Eventually, market failure occurs.

Suppose, it costs $10 to produce a low-quality school bag and $ 20 to produce a high-quality bag, where consumers cannot distinguish between the products before purchase. Let's imagine that there are no repeat purchases and consumers value the bags at their cost of production. There are five firms in a market that produce 100 bags and if a firm produces only high-quality bags and remaining four produce low quality bags, then the expected value per bag to consumers is

Thus, if one firm raises the quality of its product, all firms benefit because the bags are sold for $12 instead of $10. Here, the firm with high quality bag incurs all the expenses of raising quality, $10 extra per bag, and reaps only a fraction $2, where firms with low quality reap higher benefit without incurring any expenses for raising quality. Thus, the high quality firm has no incentive for further production of high quality bags and opts not to produce the high-quality bags. Therefore, due to asymmetric information on the part of consumers, the firms do not produce high-quality goods even though consumers are willing to pay for the extra quality.

Resolution to the Problem of Asymmetric Information

Market Signaling

The problem of adverse selection resulting from asymmetric information can be resolved or substantially reduced by market signaling. Spence (1974) pioneered the concept of market signaling. If sellers of higher-quality products, lower-risk, individuals, better-quality borrowers, or more productive workers can somehow inform or send signal of their superior quality, lower risk, or greater productivity to potential buyers of the products, insurance companies, credit companies and employers, then the problem of adverse selection can solved at greater extent. The potential consumers would then be able to identify high-quality products; insurance and credit companies would be able to distinguish between low and high risk individuals and firms; and potential employer firms would able to identify higher-productive workers. As a result, sellers of higher-quality products would be able to sell their products at commensurately higher prices; lower-risk individuals could be charged lower insurance premiums; better quality borrowers would have more access to credit; and higher-productivity workers could be paid higher wages. Thus, market signaling can overcome the problem of adverse selection significantly.

Screening

Screening is also another measure to combat the problem of adverse selection. The concept of screening was first developed by Michael Spence. Joseph E. Stiglitz pioneered the theory of screening. The screening should be distinguished from signaling, which implies that the informed agent moves first. For example, banks often screen people interested in borrowing money in order to weed out those who won't be able to pay it back. Banks might ask potential borrowers for their financial history, job security, and reasons for borrowing, assets, education, and experience and so on. In this way the under informed party can induce the other party to reveal their information. They can provide a menu of choices in such a way that the optimal choice of the other party depends on their private information. By making a particular choice, the other party reveals that he has information that makes that choice optimal. For example, an amusement park wants to sell more expensive tickets to customers who value their time more and money less than other customers. Asking customers their willingness to pay will not work - everyone will claim to have low willingness to pay. But the park can offer a menu of priority and regular tickets, where priority allows skipping the line at rides and is more expensive. This will induce the customers with a higher value of time to buy the priority ticket and thereby reveal their type.

Specification of the precautions

 The problems of Moral hazard can be resolved by specifying the precautions that an individuals or firm must take as a condition for buying insurance.

Coinsurance

 Coinsurance is another method used by insurance companies to overcome or reduce the problem of moral hazard. This refers to insuring only part of the possible loss or value of property being insured.

Concluding Remarks

Information economics has a transformative effect on economics and economic policy. Economic agents spend time and money to have accurate information for choosing better products. The Rational economic agents are increasingly investing resources to garner perfect information which is essential for making better decision and better choice that yields higher expected pay off or utility. The consumer would continue the search for lower prices as long as the marginal benefit (MB) from continuing the search exceeds the marginal cost, and until the marginal benefit equals the marginal cost (MC). Asymmetric information poses number of problem like market failure, adverse selection, moral hazards and principal-agent problem. In fact, the scope of information is widening day by day and gaining popularity as quasi-public goods. In nutshell, economics of information is recent advancement in the microeconomic theory. It has been contributing in greater magnitude and degree to refine the several braches of microeconomic theory. It has been widening the horizon for the search new knowledge in the field of behavioral microeconomics so as to make it more fruit bearing and light giving.

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