Information, Knowledge- include signaling, screening, asymmetric information, adverse selection, moral hazard. Melissa Wagner
Economics knowledge, or The Economics of Information 1. Shopping for a gift, you find that there are 12 sellers in the market selling high quality product with a value of $549. There are an additional 8 sellers in the market offering low-quality versions of a similar product at a value of $250. What is the mean of this set of data? a) $250.00 b) $369.60 c) $549.00 d) $429.40
2. Shopping for a gift, you find that there are 5 sellers in the market. 4 of the sellers are offering a product at a price of $549.00. The remaining seller in the market is offering a price of $479. What is the expected benefit to you to continue searching for the best price? a) $14.00 b) $70 c) $0 d) None of the above
3. On a family vacation, you stop at an exit for gasoline. You happened upon an exit with only two gas stations, a Shell station, and a small family-owned station. You choose the Shell station. This makes you: a) Risk Neutral b) Risk loving c) Risk Averse d) None of the above
4. A consumer should continue searching for a lower price a) as long as the expected benefit is greater than the cost of an additional search b) as long as there are firms in the market offering better prices c) as long as the expected benefit is less than the cost of an additional search d) All of the above
5. Which is NOT an example of moral hazard: a) Purchasing home owner’s insurance and leaving the house without locking the doors b) An individual in poor health who purchases life insurance c) Purchasing auto insurance, and intentionally driving recklessly d) Purchasing insurance, then committing arson
ANSWERS: 1. D - $429.40 12/20(549) + 8/20(250) = 429.40
3. C - Risk Averse – you choose the Shell station because there is less risk associated with choosing the chain.
4. A – as long as the expected benefit is greater than the cost of an additional search (the cost to continue searching does not make the search beneficial if it exceeds the expected benefit of searching)
5. B – Moral hazard is immoral behavior that takes advantage of asymmetric information after a transaction. B – purchasing insurance KNOWING beforehand that you are in poor health is an example of adverse selection. A, C, and D are examples of moral hazard.
Information (or the lack thereof in some instances) plays a significant role in economic decision making. While it is assumed that both consumers and firms enjoy the benefit of having 'perfect information', that is not necessarily the case. Chapter 12 in Baye's Managerial Economics and Business Strategy textbook discusses the effects of uncertainty and imperfect information on business.According to Wikipedia, "Information economics or the economics of information is a branch of microeconomic theory that studies how information affects an economy and economic decisions." ("Wikipedia" November 06, 2011)
Uncertainty and Consumer Behavior (13-Oct-11 & 18-Oct-11) What affect does uncertainty have on consumer behavior? Uncertainty is “…the lack of certainty, a state of having limited knowledge where it is impossible to exactly describe existing state or future outcome”. Scott Baker, Nicholas Bloom, and Steven J. Davis have written a recent article in Bloomberg claiming that “a major factor behind the weak recovery and gloomy outlook is a climate of policy-induced economic uncertainty.” “…U.S. policy uncertainty [is] at historically high levels.” (Baker, Bloom, and Davis) Through this article they are claiming that the state of the economy has not recovered due to uncertainty. Consumers and firms alike are hesitant to make investments or purchase decisions not knowing what might be around the next corner.
It is not unusual to be in the market to purchase a good not knowing (for certain) the quality of the goods made available by various sellers. A recent homework assignment titled ‘Analyzing a Market for Lemons’ in Aplia explains the situation well. To figure out what a buyer might do (when the outcomes are uncertain), it is important to understand the expected value of the good in question. Aplia specifically looks at plums and lemons. The situation is such that there are 20 sellers in the market. 8 of the sellers can sell plums. As a result, the chance of getting a plum is 8/20, or 40%. The value associated with a plum is (hypothetically) $100. The remaining 12 sellers sell lemons. There is a 12/20 (or 60%) chance of getting a lemon. The value associated with a lemon is (hypothetically) $60.Uncertainty can be ‘measured’ using the mean (or expected value) of a set of data. The mean is a sum of the probabilities that different outcomes will occur multiplied by the resulting payoffs.In the plums vs. lemons example, the expected value is: .4($100) + .6($60) = $76.
With uncertainty comes a degree of ‘risk’. A consumer (or firm) is either risk adverse, risk loving, or risk neutral. Risk averse – a risk averse consumer will take the least risky option when given the choice Risk loving – a risk loving consumer will take the most risky option when given the choice Risk neutral – a risk neutral consumer is indifferent
Consumer behavior is affected by uncertainty due to the risk involved of not having perfect information to aid in the decision making process. Let’s look at an example …….. You are traveling (business or pleasure) and find yourself in need of gasoline. You are fortunate enough to come upon an exit with two gas stations – one is a chain you are familiar with, the other is a small family owned business. Which will a risk adverse consumer choose? Most generally the consumer will choose the chain as they are familiar with the quality and prices offered by the chain store. Chain stores are standardized and the type and quality of product offered are relatively certain. A fellow classmate confirms this by stating, “I find that I am a risk averse consumer -- as you pointed out if I'm out of my comfort zone I will pick a chain instead of a small local store.” (Maysen1975, Wiki, Oct 13, 2011) If you traveled the same route frequently, and had more information about the small family owned business, you might choose the family-owned business over the chain; however, with no information, consumers tend to stick to what they know.
As is the case with uncertainty, risk can also be measured. Risk is measured by acquiring the variance of a set of data. The square root of the variance is the standard deviation which actually determines the amount of risk involved. The higher the standard deviation, the higher the risk.Variance = q1(x1-E[x])2 + q2(x2-E[x])2 + ……. + qn(xn-E[x])2The square root of the variance is the standard deviation of a set of data.
Uncertainty and the Behavior of the Firm (25-Oct-11) What impact does uncertainty have on the behavior of a firm Managers within firms will make decisions taking risk-averse consumers into consideration. There are two primary tactics managers will take to induce risk averse consumers to try a new product. Those tactics are:
1) Reduce the price of the new product
Samples – have you either received samples of a new product in-store or via the mail?
Coupons –
Wendys recently sent coupons via the mail advertising ‘Dave’s HOT ‘N JUICY Cheeseburgers’. It is the ‘remaking of a classic’, and grants consumers a free single cheeseburger with the purchase of either another cheeseburger, or the purchase of small fries and a small drink. They are ‘luring’ consumers in with the reduction in price for a limited amount of time. (The uncertainty of the product is not as ‘risky’ if one does not have to pay for it.)
Johnson & Johnson – Plans to use coupons and product innovations in an attempt to regain lost territory associated with recalls of J&J over the counter products. (The recent recalls have resulted in a significant loss of market share to privately owned brands.) Recalls result in uncertainty. J&J is challenged with overcoming consumer uncertainty of J&J product by regaining customer trust and loyalty utilizing product innovations and coupons. (http://www.bloomberg.com/news/2011-10-18/j-j-says-private-labels-took-over-the-counter-market-share.htmlJ)
2) Comparison advertising
Taco Bell – “Think outside the bun”
Subway
Chick-Fil-A – “EAT MOR CHIKIN”
Additional offerings by firms to attract risk adverse consumers are:
Insurance (medical insurance, health insurance, automobile insurance, home owner's insurance, renter's insurance, etc) Consumers / individuals will pay money to avoid risk. Insurance happens to be a perfect example – “The size of the insurance industry indicates that people are eager to pay to avoid risk”. (Schenk)
Extended warranties - Firms / companies offer extended warranties (typically on higher dollar value products) to offset risk associated with buying the product. Examples: electronics (TVs, cameras), vacuum cleaners, appliances, laptops (just to name a few) http://gigaom.com/apple/new-applecare-extended-warranty-covers-accidents/
Likewise, car manufacturers have created onboard safety features such as OnStar and Safety Connect to lure safety conscious drivers. http://www.toyota.com/safetyconnect/
Consumer Price Search (04-Nov-11) When looking for that next big purchase (a TV, maybe an appliance, or an electronic gadget), do you find yourself searching the internet and newspaper ads for the best deals? As consumers, we are always searching for the lowest price given the uncertainty of the price of a given item charged by different stores. With the search though comes a price. There is an associated cost of looking for the lowest price. The internet makes price searches much more convenient than ever before, but there is still a cost associated with the time it takes to conduct the internet searches. On average though, “online shoppers save on average from 18 percent to 20 percent by not walking into the closest bricks-and-mortar store to make a consumer electronics purchase”. [http://query.nytimes.com/gst/fullpage.html?res_9800E0DB133BF930A35751C0A9639C8B63&sec=&spon=&pagewanted=2]
The expected benefit (EB) of searching for a lower price equates to the amount of money saved by looking. A consumer should continue searching for a lower price so long as the expected benefit is greater than the cost of an additional search. The expected benefit of searching depends on the lowest price found during previous searches. As lower prices are found, the savings associated with finding even lower prices goes down.
The reservation price is the price at which the consumer is indifferent between purchasing at that price and searching for a lower price. If the cost of searching increases, the reservation price also increases allowing the consumer to find more prices to be acceptable and will search less intensively. However, if the cost of searching for lower prices decreases (note: the reservation price will also be lower), the consumer will search more intensely for lower prices.
Uncertainty and the Firm – Input Price Search (07-Nov-11 & 09-Nov-11) Just as consumers search for the lowest price of a given product, firms also search for low prices of inputs. As with the consumer search, there is a cost associated with searching for the lowest priced inputs. Firms should continue to look for lower priced inputs as long as the expected benefit of doing so does not exceed the cost of continuing to search. One of many examples is the wage requested of prospective new-hires. At what point does it no longer make sense to continue to search for an individual who will accept a lower wage? These are considerations a firm must make. “Information technology has created a data explosion” creating a level of visibility that no one has ever had before. The availability of information in today’s business environment creates opportunities to utilize data to literally change the way decisions are made. Erik Brynjolfsson (via a blog on EconomicsofInformation.com) states that “publicly-traded companies that were more data-driven were about 5% more productive than their competitors, a statistically significant difference”. (Brynjolfsson)
Both firms and consumers will typically do whatever they can to reduce risk.
In addition to finding the lowest cost inputs, firms will look to diversify in an attempt to reduce risk. Oftentimes, by investing in multiple projects, a firm has the potential to reduce risk - as the old saying goes “don’t put all your eggs in one basket”.
Reference Cody Muhlenkamp's blog (fellow BSU MBA classmate) regarding recommendations on how firms go about maximizing their profits.
Asymmetric Information (17-Nov-11) Investopedia defines Asymmetric Information as "a situation in which one party in a transaction has more or superior information compared to another". ("Investopedia" )It is most often the case that the seller knows more than potential buyers, but it is not uncommon for it to work the other way around at times. When one party knows more than another, the outcome could be harmful as the party with the information could easily take advantage of the other party's lack of knowledge. Asymmetric information is not as common as it once was. This is due largely to the availability of all types of information as a result of increased advancements in technology (one example being the sharing of information via the Worldwide Web).
Asymmetric Information typically leads to two main problems: 1. Adverse Selection - Investopedia defines Adverse Selection as "immoral behavior that takes advantage of asymmetric information before a transaction. For example, a person who is not in optimal health may be more inclined to purchase life insurance than someone who feels fine." ("Investopedia") Online Auctions - eBay - buyers do not see the goods in person, but instead must rely on (and trust) the information provided by the seller. The buyer must trust that the offering is not a scam, and that the goods are exactly what the seller claims they are selling. Insurance - Ideally, both the buyer and seller should benefit from the transaction (the insurance company by assigning the right price to the policy, and the insurance buyer by paying the appropriate amount for the policy they want/need). However, this is not necessarily the case in the real world. What most typically happens is that the Insurer would prefer to sell insurance to customers who are least likely to file claims, and the buyers are more likely to purchase a policy if they believe they might have reason to make a claim. If the Insurance provider does not find a way to group similar risks and charge accordingly, the product may be priced such that it only attracts those who will in fact 'use' it resulting in clients who have a bad reputation for taking advantage of insurance. The used car market is another example where adverse selection can be prevalent. There is an incentive to 'lie' to assure a better outcome for one party over another. 2. Moral Hazard - Investopedia defines Moral Hazard as "immoral behavior that takes advantage of asymmetric information after a transaction. For example, if someone has fire insurance they may be more likely to commit arson to reap the benefits of the insurance." ("Investopedia") Moral hazard occurs when an individual (or individuals) make less effort to avoid misfortune. (Schenk) Moral hazard occurs quite frequently in the insurance industry. In the case of insurance, the person purchasing the insurance may become careless knowing that they HAVE the insurance IF they need it. For example, a person who has insurance against theft may be less careful about locking the doors when leaving their house. In this case it is not the prior information that either party has, but the inability of the insurance provider to control and monitor increased risk-taking behavior. Moral hazard also tends to occur frequently in situations where warranties are offered on select products. Late in the spring I decided to purchase a very nice digital camera. I typically will not purchase the warranties that are offered, but I tend to have more trouble with cameras than items, so I did opt to purchase an additional warranty on the camera. The warranty assures that if anything happens to the camera (whether a result of product failure, an accident, or my stupidity), Sony will either repair or replace the camera at no additional expense to me. Where I might have otherwise been more careful, I find that while I am not intentionally doing anything to harm the camera, knowing the warranty is there and available IF I need it, I tend to be less careful than I might otherwise be. To follow is another example reported in the December 23, 1974 issue of The Wall Street Journal regarding an incentive individuals felt to cause accidents: ”[T]here is the macabre case of “Nub City”, a small Florida town that insurance investigators decline to identify by its real name because of continuing disputes over claims. Over 50 people in the town have suffered ‘accidents’ involving the loss of various organs and appendages, and claims of up to $300,000 have been paid out by insurers. Their investigators are positive the maimings are self-inflicted; many witnesses to the ‘accidents’ are prior claimants or relatives of the victims, and one investigator notes that ‘somehow they always shoot off parts they seem to need least’.”
Additional examples of moral hazard include: 1. Purposely driving recklessly because you know insurance will pick up the tab for damages. (rental cars) 2. Eating unhealthy food resulting in heart problems - knowing insurance will pay for treatment 3. Unemployment benefits / compensation - people are less inclined to get a job if they get paid for not having one. “If people are paid to be poor, some will become poor.” (Schenk)
In a case of moral hazard the outcome does not have to be intentional (arson, etc); however, taking fewer measures to prevent misfortune results in the same outcome ultimately. Adverse Selection and Moral Hazard can be related. A perfect example is, once again, insurance. An individual can conceal unhealthy habits or genetic traits that make insurance attractive to them. Then, once they have the insurance, they may indulge in unhealthy activities resulting in a greater chance of them having to take advantage of the benefits of having the insurance (reduced premiums or care that is paid for when their style of living catches up with them).
Screening & Signaling (22-Nov-11) Both screening and signaling are a transfer of information with an aim to resolve the asymmetry.
Signals allow buyers to distinguish between high quality and low quality products. The signals are sent by sellers TO buyers-. Buyers are then able, via the signals, to screen out erroneous information.
Ways in which sellers ‘signal’:
Guarantees
Warranties – only offer warranties on high quality product (A warranty is a signal to a buyer that the product is in fact of high quality. It is not in the interest of producers of low quality goods to offer warranties as the cost will offset profits made.)
Brand names
It takes time and resources to establish a brand name.
A producer or seller who has established a brand name will protect itself by offering only high quality product.
Signaling can also occur in the labor market. An employee can ‘signal’ potential employers by providing information regarding college degrees and/or certifications acquired via a resume (listing activities that signal attractive qualities to the prospective employer). Completed degrees or certifications signal intelligence and perseverance to a firm searching for candidates. Screening is an attempt to filter helpful from useless information. Screening is (and can be) used in a number of situations …. For example:
Blind Dates – two individuals will watch and listen carefully to ‘screen’ for helpful versus useless information about the other person
Employers (when making employment decisions)
Employers will give potential employees aptitude tests
Employers will check Letters of Recommendation
Employers may (or may not) make use of “Good Old Boy” networks
Employers will look for completion of prestigious MBA programs
3. Life insurance companies require medical examinations and refuse policies to individuals with terminal illnesses.
4. Automobile insurance companies charge a significant amount more to individuals with a conviction for drunk driving.
Screening can involve incentives that encourage the better informed to self-select or self-reveal. For example:
Low paying probationary period – If an individual knows they stand no chance of making it through a low paying probationary period, they will remove themselves from the running.
Lender who demands collateral for a loan – If an individual knows they can never repay the loan, but must provide collateral, they will not apply
Screening & Signaling provide means for the ‘uninformed’ to become informed thereby resolving the issues associated with asymmetry.
Melissa Wagner
Economics knowledge, or The Economics of Information
1. Shopping for a gift, you find that there are 12 sellers in the market selling high quality product with a value of $549. There are an additional 8 sellers in the market offering low-quality versions of a similar product at a value of $250.
What is the mean of this set of data?
a) $250.00
b) $369.60
c) $549.00
d) $429.40
2. Shopping for a gift, you find that there are 5 sellers in the market. 4 of the sellers are offering a product at a price of $549.00. The remaining seller in the market is offering a price of $479. What is the expected benefit to you to continue searching for the best price?
a) $14.00
b) $70
c) $0
d) None of the above
3. On a family vacation, you stop at an exit for gasoline. You happened upon an exit with only two gas stations, a Shell station, and a small family-owned station. You choose the Shell station. This makes you:
a) Risk Neutral
b) Risk loving
c) Risk Averse
d) None of the above
4. A consumer should continue searching for a lower price
a) as long as the expected benefit is greater than the cost of an additional search
b) as long as there are firms in the market offering better prices
c) as long as the expected benefit is less than the cost of an additional search
d) All of the above
5. Which is NOT an example of moral hazard:
a) Purchasing home owner’s insurance and leaving the house without locking the doors
b) An individual in poor health who purchases life insurance
c) Purchasing auto insurance, and intentionally driving recklessly
d) Purchasing insurance, then committing arson
ANSWERS:
1. D - $429.40
12/20(549) + 8/20(250) = 429.40
2. A - $14.00
4/5(0) + 1/5(549-479) =
0 + .20(70) = 14
3. C - Risk Averse – you choose the Shell station because there is less risk associated with choosing the chain.
4. A – as long as the expected benefit is greater than the cost of an additional search (the cost to continue searching does not make the search beneficial if it exceeds the expected benefit of searching)
5. B – Moral hazard is immoral behavior that takes advantage of asymmetric information after a transaction. B – purchasing insurance KNOWING beforehand that you are in poor health is an example of adverse selection. A, C, and D are examples of moral hazard.
Information (or the lack thereof in some instances) plays a significant role in economic decision making. While it is assumed that both consumers and firms enjoy the benefit of having 'perfect information', that is not necessarily the case. Chapter 12 in Baye's Managerial Economics and Business Strategy textbook discusses the effects of uncertainty and imperfect information on business.According to Wikipedia, "Information economics or the economics of information is a branch of microeconomic theory that studies how information affects an economy and economic decisions." ("Wikipedia" November 06, 2011)
Uncertainty and Consumer Behavior (13-Oct-11 & 18-Oct-11)
What affect does uncertainty have on consumer behavior?
Uncertainty is “…the lack of certainty, a state of having limited knowledge where it is impossible to exactly describe existing state or future outcome”.
Scott Baker, Nicholas Bloom, and Steven J. Davis have written a recent article in Bloomberg claiming that “a major factor behind the weak recovery and gloomy outlook is a climate of policy-induced economic uncertainty.” “…U.S. policy uncertainty [is] at historically high levels.” (Baker, Bloom, and Davis)
Through this article they are claiming that the state of the economy has not recovered due to uncertainty. Consumers and firms alike are hesitant to make investments or purchase decisions not knowing what might be around the next corner.
It is not unusual to be in the market to purchase a good not knowing (for certain) the quality of the goods made available by various sellers. A recent homework assignment titled ‘Analyzing a Market for Lemons’ in Aplia explains the situation well. To figure out what a buyer might do (when the outcomes are uncertain), it is important to understand the expected value of the good in question. Aplia specifically looks at plums and lemons. The situation is such that there are 20 sellers in the market. 8 of the sellers can sell plums. As a result, the chance of getting a plum is 8/20, or 40%. The value associated with a plum is (hypothetically) $100. The remaining 12 sellers sell lemons. There is a 12/20 (or 60%) chance of getting a lemon. The value associated with a lemon is (hypothetically) $60.Uncertainty can be ‘measured’ using the mean (or expected value) of a set of data. The mean is a sum of the probabilities that different outcomes will occur multiplied by the resulting payoffs.In the plums vs. lemons example, the expected value is: .4($100) + .6($60) = $76.
With uncertainty comes a degree of ‘risk’. A consumer (or firm) is either risk adverse, risk loving, or risk neutral.
Risk averse – a risk averse consumer will take the least risky option when given the choice
Risk loving – a risk loving consumer will take the most risky option when given the choice
Risk neutral – a risk neutral consumer is indifferent
Consumer behavior is affected by uncertainty due to the risk involved of not having perfect information to aid in the decision making process.
Let’s look at an example …….. You are traveling (business or pleasure) and find yourself in need of gasoline. You are fortunate enough to come upon an exit with two gas stations – one is a chain you are familiar with, the other is a small family owned business. Which will a risk adverse consumer choose? Most generally the consumer will choose the chain as they are familiar with the quality and prices offered by the chain store. Chain stores are standardized and the type and quality of product offered are relatively certain. A fellow classmate confirms this by stating, “I find that I am a risk averse consumer -- as you pointed out if I'm out of my comfort zone I will pick a chain instead of a small local store.” (Maysen1975, Wiki, Oct 13, 2011)
If you traveled the same route frequently, and had more information about the small family owned business, you might choose the family-owned business over the chain; however, with no information, consumers tend to stick to what they know.
As is the case with uncertainty, risk can also be measured. Risk is measured by acquiring the variance of a set of data. The square root of the variance is the standard deviation which actually determines the amount of risk involved. The higher the standard deviation, the higher the risk.Variance = q1(x1-E[x])2 + q2(x2-E[x])2 + ……. + qn(xn-E[x])2The square root of the variance is the standard deviation of a set of data.
Uncertainty and the Behavior of the Firm (25-Oct-11)
What impact does uncertainty have on the behavior of a firm Managers within firms will make decisions taking risk-averse consumers into consideration. There are two primary tactics managers will take to induce risk averse consumers to try a new product. Those tactics are:
1) Reduce the price of the new product
- Samples – have you either received samples of a new product in-store or via the mail?
- Coupons –
- Wendys recently sent coupons via the mail advertising ‘Dave’s HOT ‘N JUICY Cheeseburgers’. It is the ‘remaking of a classic’, and grants consumers a free single cheeseburger with the purchase of either another cheeseburger, or the purchase of small fries and a small drink. They are ‘luring’ consumers in with the reduction in price for a limited amount of time. (The uncertainty of the product is not as ‘risky’ if one does not have to pay for it.)
- Johnson & Johnson – Plans to use coupons and product innovations in an attempt to regain lost territory associated with recalls of J&J over the counter products. (The recent recalls have resulted in a significant loss of market share to privately owned brands.) Recalls result in uncertainty. J&J is challenged with overcoming consumer uncertainty of J&J product by regaining customer trust and loyalty utilizing product innovations and coupons. (http://www.bloomberg.com/news/2011-10-18/j-j-says-private-labels-took-over-the-counter-market-share.htmlJ)
2) Comparison advertisingAdditional offerings by firms to attract risk adverse consumers are:
Insurance (medical insurance, health insurance, automobile insurance, home owner's insurance, renter's insurance, etc) Consumers / individuals will pay money to avoid risk. Insurance happens to be a perfect example – “The size of the insurance industry indicates that people are eager to pay to avoid risk”. (Schenk)
Money back guarantees - Firms will offer money back guarantees to entice consumers to purchase products they may otherwise not purchase.
http://wasimismail.com/business-2/using-money-back-guarantee-to-sell-your-products/
Examples: Turbo Tax – 60-day money back guarantee if the consumer is not satisfied with the product
Opus Software - 90 day money back guarantee
ProActiv - 60 day money back guarantee
Many mail order offers come with money back guarantees (if claimed within certain timeframes).
http://www.pantene.com/en-US/news-and-offers/pages/satisfaction-guaranteed.aspx
http://www.swiffer.com/coupons-and-promotions/money-back-guarantee
Extended warranties - Firms / companies offer extended warranties (typically on higher dollar value products) to offset risk associated with buying the product.
Examples: electronics (TVs, cameras), vacuum cleaners, appliances, laptops (just to name a few)
http://gigaom.com/apple/new-applecare-extended-warranty-covers-accidents/
Likewise, car manufacturers have created onboard safety features such as OnStar and Safety Connect to lure safety conscious drivers.
http://www.toyota.com/safetyconnect/
Consumer Price Search (04-Nov-11)
When looking for that next big purchase (a TV, maybe an appliance, or an electronic gadget), do you find yourself searching the internet and newspaper ads for the best deals?
As consumers, we are always searching for the lowest price given the uncertainty of the price of a given item charged by different stores. With the search though comes a price. There is an associated cost of looking for the lowest price.
The internet makes price searches much more convenient than ever before, but there is still a cost associated with the time it takes to conduct the internet searches. On average though, “online shoppers save on average from 18 percent to 20 percent by not walking into the closest bricks-and-mortar store to make a consumer electronics purchase”.
[http://query.nytimes.com/gst/fullpage.html?res_9800E0DB133BF930A35751C0A9639C8B63&sec=&spon=&pagewanted=2]
The expected benefit (EB) of searching for a lower price equates to the amount of money saved by looking. A consumer should continue searching for a lower price so long as the expected benefit is greater than the cost of an additional search.
The expected benefit of searching depends on the lowest price found during previous searches. As lower prices are found, the savings associated with finding even lower prices goes down.
The reservation price is the price at which the consumer is indifferent between purchasing at that price and searching for a lower price.
If the cost of searching increases, the reservation price also increases allowing the consumer to find more prices to be acceptable and will search less intensively. However, if the cost of searching for lower prices decreases (note: the reservation price will also be lower), the consumer will search more intensely for lower prices.
Uncertainty and the Firm – Input Price Search (07-Nov-11 & 09-Nov-11)
Just as consumers search for the lowest price of a given product, firms also search for low prices of inputs. As with the consumer search, there is a cost associated with searching for the lowest priced inputs. Firms should continue to look for lower priced inputs as long as the expected benefit of doing so does not exceed the cost of continuing to search.
One of many examples is the wage requested of prospective new-hires. At what point does it no longer make sense to continue to search for an individual who will accept a lower wage? These are considerations a firm must make.
“Information technology has created a data explosion” creating a level of visibility that no one has ever had before. The availability of information in today’s business environment creates opportunities to utilize data to literally change the way decisions are made. Erik Brynjolfsson (via a blog on EconomicsofInformation.com) states that “publicly-traded companies that were more data-driven were about 5% more productive than their competitors, a statistically significant difference”. (Brynjolfsson)
Both firms and consumers will typically do whatever they can to reduce risk.
In addition to finding the lowest cost inputs, firms will look to diversify in an attempt to reduce risk. Oftentimes, by investing in multiple projects, a firm has the potential to reduce risk - as the old saying goes “don’t put all your eggs in one basket”.
Reference Cody Muhlenkamp's blog (fellow BSU MBA classmate) regarding recommendations on how firms go about maximizing their profits.
Asymmetric Information (17-Nov-11)
Investopedia defines Asymmetric Information as "a situation in which one party in a transaction has more or superior information compared to another". ("Investopedia" )It is most often the case that the seller knows more than potential buyers, but it is not uncommon for it to work the other way around at times. When one party knows more than another, the outcome could be harmful as the party with the information could easily take advantage of the other party's lack of knowledge.
Asymmetric information is not as common as it once was. This is due largely to the availability of all types of information as a result of increased advancements in technology (one example being the sharing of information via the Worldwide Web).
Asymmetric Information typically leads to two main problems:
1. Adverse Selection - Investopedia defines Adverse Selection as "immoral behavior that takes advantage of asymmetric information before a transaction. For example, a person who is not in optimal health may be more inclined to purchase life insurance than someone who feels fine." ("Investopedia")
Online Auctions - eBay - buyers do not see the goods in person, but instead must rely on (and trust) the information provided by the seller. The buyer must trust that the offering is not a scam, and that the goods are exactly what the seller claims they are selling.
Insurance - Ideally, both the buyer and seller should benefit from the transaction (the insurance company by assigning the right price to the policy, and the insurance buyer by paying the appropriate amount for the policy they want/need).
However, this is not necessarily the case in the real world. What most typically happens is that the Insurer would prefer to sell insurance to customers who are least likely to file claims, and the buyers are more likely to purchase a policy if they believe they might have reason to make a claim.
If the Insurance provider does not find a way to group similar risks and charge accordingly, the product may be priced such that it only attracts those who will in fact 'use' it resulting in clients who have a bad reputation for taking advantage of insurance.
The used car market is another example where adverse selection can be prevalent. There is an incentive to 'lie' to assure a better outcome for one party over another.
2. Moral Hazard - Investopedia defines Moral Hazard as "immoral behavior that takes advantage of asymmetric information after a transaction. For example, if someone has fire insurance they may be more likely to commit arson to reap the benefits of the insurance." ("Investopedia") Moral hazard occurs when an individual (or individuals) make less effort to avoid misfortune. (Schenk)
Moral hazard occurs quite frequently in the insurance industry. In the case of insurance, the person purchasing the insurance may become careless knowing that they HAVE the insurance IF they need it. For example, a person who has insurance against theft may be less careful about locking the doors when leaving their house. In this case it is not the prior information that either party has, but the inability of the insurance provider to control and monitor increased risk-taking behavior.
Moral hazard also tends to occur frequently in situations where warranties are offered on select products. Late in the spring I decided to purchase a very nice digital camera. I typically will not purchase the warranties that are offered, but I tend to have more trouble with cameras than items, so I did opt to purchase an additional warranty on the camera. The warranty assures that if anything happens to the camera (whether a result of product failure, an accident, or my stupidity), Sony will either repair or replace the camera at no additional expense to me. Where I might have otherwise been more careful, I find that while I am not intentionally doing anything to harm the camera, knowing the warranty is there and available IF I need it, I tend to be less careful than I might otherwise be.
To follow is another example reported in the December 23, 1974 issue of The Wall Street Journal regarding an incentive individuals felt to cause accidents:
”[T]here is the macabre case of “Nub City”, a small Florida town that insurance investigators decline to identify by its real name because of continuing disputes over claims. Over 50 people in the town have suffered ‘accidents’ involving the loss of various organs and appendages, and claims of up to $300,000 have been paid out by insurers. Their investigators are positive the maimings are self-inflicted; many witnesses to the ‘accidents’ are prior claimants or relatives of the victims, and one investigator notes that ‘somehow they always shoot off parts they seem to need least’.”
Additional examples of moral hazard include:
1. Purposely driving recklessly because you know insurance will pick up the tab for damages. (rental cars)
2. Eating unhealthy food resulting in heart problems - knowing insurance will pay for treatment
3. Unemployment benefits / compensation - people are less inclined to get a job if they get paid for not having one. “If people are paid to be poor, some will become poor.” (Schenk)
In a case of moral hazard the outcome does not have to be intentional (arson, etc); however, taking fewer measures to prevent misfortune results in the same outcome ultimately.
Adverse Selection and Moral Hazard can be related. A perfect example is, once again, insurance. An individual can conceal unhealthy habits or genetic traits that make insurance attractive to them. Then, once they have the insurance, they may indulge in unhealthy activities resulting in a greater chance of them having to take advantage of the benefits of having the insurance (reduced premiums or care that is paid for when their style of living catches up with them).
Screening & Signaling (22-Nov-11)
Both screening and signaling are a transfer of information with an aim to resolve the asymmetry.
Signals allow buyers to distinguish between high quality and low quality products. The signals are sent by sellers TO buyers-. Buyers are then able, via the signals, to screen out erroneous information.
Ways in which sellers ‘signal’:
Signaling can also occur in the labor market. An employee can ‘signal’ potential employers by providing information regarding college degrees and/or certifications acquired via a resume (listing activities that signal attractive qualities to the prospective employer). Completed degrees or certifications signal intelligence and perseverance to a firm searching for candidates.
Screening is an attempt to filter helpful from useless information.
Screening is (and can be) used in a number of situations …. For example:
3. Life insurance companies require medical examinations and refuse policies to individuals with terminal illnesses.
4. Automobile insurance companies charge a significant amount more to individuals with a conviction for drunk driving.
Screening can involve incentives that encourage the better informed to self-select or self-reveal.
For example:
Screening & Signaling provide means for the ‘uninformed’ to become informed thereby resolving the issues associated with asymmetry.
BIBLIOGRAPHY
Wikipedia, "Wikipedia." Last modified November 06, 2011. Accessed October 06, 2011. http://en.wikipedia.org/wiki/Information_economics.
Baker, Scott R., Nicholas Bloom, and Steven J. Davis. “Policy Uncertainty is Chocking Recover.” Bloomberg. N.p., 05 Oct 2011. Web. 23 Nov 2011. <http://www.bloomberg.com/news/2011-10-06/policy-uncertainty-is-choking-recovery-baker-bloom-and-davis.html>.
Nussbaum, Alex. Bloomberg, "J&J CFO Says Private Labels Took Over-Counter Market Share." Last modified October 18, 2011. Accessed October 18, 2011. http://www.bloomberg.com/news/2011-10-18/j-j-says-private-labels-took-over-the-counter-market-share.html.
Schenk, Robert. “Insurance.” Ingrimayne. Fortiguard, Feb 2011. Web. 23 Nov 2011. <http://ingrimayne.com/econ/RiskExclusion/Risk.html>.
Brynjolfsson, Erik. “Data-Driven Decision-Making.” Economics of Information. MIT Sloan, 14 Oct 2011. Web. 23 Nov. 2011. <http://www.economicsofinformation.com/2011/10/data-driven-decision-making.html>.
"Investopedia." Accessed November 17, 2011. http://www.investopedia.com/terms/a/asymmetricinformation.asp