Ch 14 transaction costs, imperfect information, behavioral economics micro econ4

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Chapter 14 ECON4 William A. McEachern

1

Transaction

Costs,

Imperfect

Information,

and Behavioral

Economics





Rationale for the Firm

• Firms

– Minimize transaction costs

• Specialization and centralized control

– Minimize production costs

– More efficient

2





Boundaries of the Firm

• Boundaries of the firm

– The appropriate degree of vertical

integration

• Vertical integration

– Expansion of a firm into stages of

production earlier or later than those in

which it specializes

3






• Outsourcing

– Firm buys products from outside

suppliers

• Core competency

– Area of specialty

– Product or phase of production a firm

supplies with greatest efficiency

4






• Bounded rationality

– Limit on information that a firm’s

manager can comprehend and act on

• Minimum efficient scale

– Minimum rate of output at which

economies of scale are fully exploited

• Easily observable quality

– Of the input

• Many suppliers of components 5



Exhibit 1

6

Minimum Efficient Scale and Vertical Integration

1,000,000 Computers per year0

5,000,0001,000,000 Chips per year0

Cost per

unit

Cost per

unit

(a) Computer manufacturer

(b) Chip manufacturer

The manufacturer in panel (a) is producing

at the minimum efficient scale of 1,000,000

computers per month. That output requires

1,000,000 computer chips. If the computer

manufacturer produced its own chips, the

cost would be much higher than if it buys

them from a chip maker operating on a

much larger scale. As panel (b) shows,

economies of scale in chip production are

far from exhausted when 1,000,000 chips a

month are produced.

LRAC

LRAC





Economies of Scope

• Economies of scope

– Cheaper to produce different items in

one firm

– Average costs decline

– As the scope of the firm increases

• Firm makes a range of different products

rather than specialize in just one product

7





Imperfect Information

• Marginal cost of search

– Marginal cost of information increases

• Marginal cost curve slopes upward

• Marginal benefit of search

– Better quality for a given price

– Lower price for a given quality

– Marginal benefit decreases

• Marginal benefit curve slopes upward

8



Exhibit 2

9

Optimal Search With Imperfect Information

If I* Ip0Quantity of

information

Info

rmation c

osts

and b

enefits

(dolla

rs)

Marginal cost

of information

Marginal benefit

of information

When information is not free,

additional information is

acquired as long as its marginal

benefit exceeds its marginal

cost. Equilibrium, or optimal

search, occurs where marginal

benefit equals marginal cost. I*

is the optimal quantity of

information.





Imperfect Information

• Optimal search

– Marginal benefit equals marginal cost

• IP = full information

• I* = optimal amount of information

• Search costs lead to

– Price dispersion

• Different prices for the same product

– Quality differences across sellers

10





The Winner’s Curse

• Auctions for product of uncertain value

• Many ‘winners’ end up losers

– Estimated value of products

– Winner: highest bid

• Most optimistic

• Competitive bidding with imperfect

information

11





Asymmetric Information

• Asymmetric information

– One side of the market has better

information about the product than does

the other side

– Hidden characteristics

• Adverse selection

– Hidden action

• Principal-agent problem

12






• Hidden characteristics:

– One side of the market

• Knows more about product characteristics

that are important to the other side


– Those on the informed side of the market

• Self-select in a way that harms those on the

uninformed side of the market

13







– Lower-quality products dominate the

market

• If sellers have better information about a

product’s quality than buyers do

– Car sellers, the informed side

• Self-select: decide whether or not to offer

their cars for sale

• Increases the proportion of lemons for sale

14






• Hidden actions:

– One side of an economic relationship can

do something that the other side cannot

observe


– The agent’s objectives differ from those of

the principal’s

– And one side can pursue hidden actions

15






• Principal

– A person or firm who hires an agent to act

on behalf of that person or firm

• Agent

– A person or firm who is supposed to act

on behalf of the principal

16






• Insurance markets

– Buyers – have more information

– Adverse selection

• Insurance buyers tend to be less healthy

– Moral hazard


• Buyers – may take care less of their health

17






• Coping with asymmetric information

– Incentive structure or information-

revealing system

• “Lemon laws”

• Warranties

• Written estimates before a job is done

– Insurance companies

• Physical exam, health history, lifestyle

• Deductibles

• Copayments18






• Labor markets - Adverse selection

– Employer – Uninformed side

• Offers the going wage

– Candidates - Informed side

• Talented – don’t want it

• Less-talented – want it

• Efficiency wage theory – offer high wages

– Attracts a more talented labor pool

– Encourages good performance

19





Signaling and Screening

• Signaling

– Proxy measures to communicate

information about unobservable

characteristics

– Attempt by the informed side to

communicate valuable information

– Useful as long as less-qualified applicants

face more difficulty sending the same

signal

20





Signaling and Screening

• Screening

– Process used by employers to select the

most qualified workers based on

observable characteristics

– Attempt by the uninformed side to uncover

relevant but hidden characteristics

21

Economy & Finance

Ch 14 transaction costs, imperfect information, behavioral economics micro econ4