ECONOMICS OF INFORMATION

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 Learning Objectives
1. Identify strategies to manage risk and uncertainty,
including diversification and optimal search
strategies.
2. Calculate the profit-maximizing output and price in
an environment of uncertainty.
3. Explain why asymmetric information about “hidden
actions” or “hidden characteristics” can lead to
moral hazard and adverse selection, and identify
strategies for mitigating these potential problems.
4. Explain how differing auction rules and information
structures impact the incentives in auctions, and
determine the optimal bidding strategies in a
variety of auctions with independent or correlated
values.
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 The Mean and the Variance

Measuring Uncertain Outcomes

• A variable that measures the outcome
of an uncertain event is called a
random variable.
– Probabilities can be attached to different
values of a random variable that denote
the chance that a value occurs.
• Information about uncertain outcomes
can be summarized by the mean (or,
expected value) and variance of a
random variable.

© 2017 by McGraw-Hill Education. All Rights Reserved. 12-3

 The Mean and the Variance
Measuring Uncertain
Outcomes: Mean
• The mean of a random variable is the sum of
the probabilities that different outcomes will
occur multiplied by the resulting payoffs.
• If denote the possible outcomes of the random
variable and the corresponding probabilities of
the outcomes, then the mean of is:

, where .
• The mean does not provide information about
the risk associated with the random variable.

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 Measuring Uncertain The Mean and the Variance
Outcomes:
Variance and Standard
• The variance of Deviation
a random variable is the sum
of the probabilities that different outcomes will
occur multiplied by the squared deviation from
the mean of the resulting payoffs.
• If denote the possible outcomes of the random
variable, their corresponding probabilities are ,
and the expected value of is , then the variance
of is:

• The variance is a common measure of risk.

• The standard deviation is the positive square
root of the variance: .
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 Uncertainty and Consumer Behavior

Risk Aversion
• Attitudes toward risk differ among
consumers.
– A risk-averse consumer prefers a sure
amount of to a risky prospect with an
expected value of .
– A risk-loving consumer prefers a risky
prospect with an expected value of to a
sure amount of .
– A risk-neutral consumer is indifferent
between a risky prospect with an expected
value of and a sure amount of .
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 Managerial Decisions with
Uncertainty and Consumer Behavior

Risk-Averse Consumers: Product

Quality
• Risk analysis can used to examine situations where
consumers are uncertain about product quality.
• Consider a consumer who regularly uses Brand X. If
a new product enters the market, Brand Y, under
what conditions will the consumer be willing to try
the new product?
– Issues to overcome and consider:
• Relative certainty about Brand X.
• At equal prices among other things, a risk averse consumer will
continue to purchase Brand X, since a risk averse consumer
prefers the sure thing (Brand X) to a risky prospect (Brand Y).
– Two tactics can be employed to induce a risk averse
consumer to try a new product:
• Lower the price of Brand Y.
• Try to convince consumer the new product’s quality is higher
than the old product.
© 2017 by McGraw-Hill Education. All Rights Reserved. 12-7
Managerial Decisions with Risk- Averse
Consumers
• Chain stores: may be in a firm’s best
interest to become part of a chain
store
– Standardization, reputation, increased
chance of survival
• Online reviews
• Insurance: the fact that consumers are
risk averse implies they are willing to
pay to avoid risk.

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 Uncertainty and Consumer Behavior

Consumer Search
• To identify the low-price seller from
among many firms selling an identical
product, consumers sometimes incur a
cost, , to obtain each price quote.
• After observing each price quote, a
consumer faces must weigh the
expected benefit from acquiring an
additional price quote with the
additional cost.

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 Uncertainty and Consumer Behavior

Consumer Search
• Suppose that three-quarters of stores in a
market charge and one-quarter charge .
– A consumer observing a price of should stop
searching since there is no price below .
– What should a risk-neutral consumer do after
observing a price of , if search occurs with
free recall and with replacement?
• One-quarter of the time the consumer will save .
• Three-quarters of the time the consumer will save
nothing.
• The expected benefit from an additional search is: .
• A consumer should search for a lower price as long
as the expected benefits for an additional search
are greater than the cost of an additional search.
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 Uncertainty and Consumer Behavior

Optimal Search Strategy

Expected
benefits
and costs 𝐸𝐵
𝐸𝐵 [ 𝑅 ] =𝑐

$𝑐 𝑐
Reservation price:
Price at which a consumer
is indifferent between
purchasing at that price an
searching for a lower price.

𝑅 Rejection Price Region Price

Acceptance Price Region

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 Uncertainty and Consumer Behavior

Consumer’s Search Rule

• The optimal search rule is such that
the consumer rejects prices above the
reservation price, , and accepts prices
below the reservation price. Stated
differently, the optimal search strategy
is to search for a better price when the
price charged by a firm is above the
reservation price and stop searching
when a price below the reservation
price is found.
© 2017 by McGraw-Hill Education. All Rights Reserved. 12-12
 Uncertainty and Consumer Behavior

Increasing Cost of Search

Expected
benefits
and costs 𝐸𝐵

∗ ∗
$𝑐 𝑐 Due to
Increase
in search
costs.
$𝑐 𝑐

𝑅 ∗ Price
𝑅

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 Uncertainty and the Firm

Manager’s Risk Attitudes

• While manager must understand the impact of
uncertainty on consumer behavior, uncertainty
also impacts the manager’s input and output
decisions.
• Manager’s risk profiles:
– Risk averse: a manager who prefers a risky project
with a lower expected value if the risk is lower than
a project with a higher expected value.
– Risk loving: manager who prefers a risky project
with higher expected value and higher risk to one
with lower expected value and lower risk.
– Risk neutral: manager interested in maximizing
expected profits; the variance of profits does not
impact a risk-neutral manager’s decisions.
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 Risk Aversion In Action:
Uncertainty and the Firm

Problem
• A risk-averse manager is considering two projects.
The first project involves expanding the market for
bologna; the second involves expanding the
market for caviar. There is a 10 percent chance of
recession and a 90 percent chance of an economic
boom. The following table summarizes the profits
under the different scenarios. Which project should
manager undertake,
Boom and why?
Recession Standard
Project Mean
(90%) (10%) Deviation
Bologna -$10,000 $12,000 -$7,800 $6,600
Caviar 20,000 -8,000 17,200 8,400
Joint 10,000 4,000 9,400 1,800
Safe (T-Bill) 3,000 3,000 3,000 0
a
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 Risk Aversion In Action: Uncertainty and the Firm

Answer
Boom Recession Standard
Project Mean
(90%) (10%) Deviation
Bologna -$10,000 $12,000 -$7,800 $6,600
Caviar 20,000 -8,000 17,200 8,400
Joint 10,000 4,000 9,400 1,800
Safe (T-Bill) 3,000 3,000 3,000 0

• Managers should not invest in T-Bills

– The joint project is assured of making at least $4,000, which is
greater than $3,000 under the T-Bill scenario.
• Since the expected returns of the bologna project are
negative, neither a risk-neutral nor a risk-averse manager
would choose to undertake this project.
• The manager should adopt either the caviar project or the
joint project. Which project will depend on his or her risk
preferences.
© 2017 by McGraw-Hill Education. All Rights Reserved. 12-16
 Uncertainty and the Firm

Manager’s Risk Attitudes

and Diversification
• Notice from the previous problem that
by investing in multiple projects, the
manager may be able to reduce risk.
• The process of potentially reducing
risk by investing in multiple projects is
called diversification.
• Whether it is optimal to diversify
depends on a manager’s risk
preferences and the incentives
provided to the manager to avoid risk.
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 Uncertainty and the Firm

Producer Search
• When producers are uncertain about
the prices of inputs, an optimizing firm
will use optimal search strategies.
– These strategies mimic consumer search
previously developed.

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 Uncertainty and the Firm

Profit Maximization and Uncertainty

• The basic principles of profit
maximization can be modified to deal
with uncertainty.
• If demand (hence, revenue) is
uncertain and the manager is risk
neutral, then the manager will want to
maximize expected profits by
producing the output where the
expected marginal revenue equals
marginal cost:
© 2017 by McGraw-Hill Education. All Rights Reserved. 12-19
 Uncertainty and the Firm

Profit Maximization and Uncertainty

In Action: Problem
• Appleway Industries produces apple juice and
sells it in a competitive market. The firm’s
manager must determine how much juice to
produce before he knows what the market
(competitive) price will be. Economists
estimate that there is a 30 percent chance the
market price will be $2 per gallon and a 70
percent chance it will be $1 per gallon when
the juice hits the market. If the firm’s cost
function is , how much juice should be
produced to maximize expected profits? What
are the expected profits of Appleway
Industries? © 2017 by McGraw-Hill Education. All Rights Reserved.
12-20
 Uncertainty and the Firm

Profit Maximization and Uncertainty

In Action: Answer
• Appleway Industries’ profits are

• Since price is uncertain, the firm’s

revenues and profit are uncertain. To
maximize expected profits, the manager
equates expected price with marginal cost.

• The expected price is: .

• Therefore, manager should produce output
where gallons.
• Expected profits are $645.
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12-21
 Uncertainty and the Market

Asymmetric Information
• Uncertainty can profoundly impact markets
abilities to efficiently allocate resources.
• Some markets are characterized by individuals
who have better information than others.
– Implication: Those individuals with the least
information may choose not to participate in a market.
• When some people have better information than
others in a market, the information people have
is called asymmetric information.
• There are two specific manifestations related to
asymmetric information in markets:
– Adverse selection
– Moral hazard
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© 2017 by McGraw-Hill Education. All Rights Reserved. 23
Hidden Characteristics and Adverse Selection

Adverse selection arises when the seller knows more than the
buyer about the good being sold.
Example 1: The market for used cars
– The seller knows more than the buyer about
the quality of the car being sold.
– Owners of “lemons” more likely to put their
vehicles up for sale.
– So buyers are more likely to avoid used cars.
– Owners of good used cars less likely to get a
fair price, so may not bother trying to sell.
– Market for lemons
 Hidden Characteristics and Adverse Selection

Example 2: Insurance
– Buyers of health insurance know more
about their health than health insurance
companies.
– People with hidden health problems have
more incentive to buy insurance policies.
– So, prices of policies reflect the costs of a
sicker-than-average person.
– These prices discourage healthy people
from buying insurance.
In both examples, the information asymmetry prevents some
mutually beneficial trades.
 Uncertainty and the Market

Asymmetric Information:
Moral Hazard
• Moral hazard refers to a situation
where one party to a contract takes a
hidden action that benefits his or her
at the expense of another party.
– In this context, a hidden action is an
action taken by one party in a relationship
that cannot be observed by the other
party.
• One way to mitigate the moral hazard
problem is an incentive contract.
© 2017 by McGraw-Hill Education. All Rights Reserved. 12-26
 Uncertainty and the Market

Signaling
• Another way to mitigate the problem
of moral hazard is signaling, which is
an attempt by an informed party to
send an observable indicator of his or
her hidden characteristics to an
uninformed party.
• For signaling to be effective it must be:
– observable by the uninformed party.
– a reliable indicator of the unobservable
characteristic(s) and difficult for parties
with other characteristics to easily mimic.
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 Uncertainty and the Market

Screening
• A final way to mitigate the moral hazard
problem is by screening, which is an
attempt by an uninformed party to sort
individuals according to their
characteristics.
• Screening may be achieved through a
self-selection device.
– A self-selection device is a mechanism in
which informed parties are presented with a
set of options, and the options they choose
reveal their hidden characteristics to an
uninformed party.
© 2017 by McGraw-Hill Education. All Rights Reserved. 12-28
ACTIVE LEARNING 1
Asymmetric information

For each situation below,

 identify whether the problem is moral
hazard
or adverse selection
 explain how the problem has been
A. Aperion
reducedAudio sells home theater sound
systems over the Internet and offers to refund
the purchase price and shipping both ways
if the buyer is not satisfied.
B. Landlords require tenants to pay
security deposits.
ACTIVE LEARNING 1
Answers, part A

Aperion Audio sells home theater sound

systems over the Internet and offers to refund
the purchase price and shipping both ways if
the buyer is not satisfied.
Adverse selection:
Buyers may fear that systems purchased on the
Internet will not sound good, since the sellers
know that buyers cannot hear them first.
So, firms with good systems are less likely to be
successful selling them on the Internet.
 Aperion Audio reduces the problem by signaling
high quality with its generous return policy.
ACTIVE LEARNING 1
Answers, part B

Landlords require tenants to pay security

deposits.
 Moral hazard:
The landlord (principal) does not know how well
the tenant (agent) treats the apartment.
Tenants may not be careful if they can get
away without paying for damage they cause.
 The security deposit increases the likelihood
the tenant will take care of the property in
order to receive his deposit back when he
moves out.
• Risk is the future uncertainty of deviation from the
expected
• It is the responsibility of risk managers to
understand the specific risks facing by financial
institutions.
• Sole reason for the collapse and bailout of some of
the largest banks (Bear Sterns and Lehman
Brothers)
• George Akerlof laid the groundwork for modern
discussions on information asymmetry by relating
quality and uncertainty. (The Market for "Lemons“:
Quality Uncertainty and the Market Mechanism)
• Joseph Stiglitz has built upon what Akerlof started.
• In his paper Information and the Change in the
Paradigm in Economics, Stiglitz discusses the
change in the economics of information paradigm
and that we need to devote energy to thinking of
information as imperfect.
• Andrew Michael Spence contributed to the theories
of labor markets with his work Job Market Signaling.
• He ties the conceptual ideas of market phenomena
such as promotions within a company, loans and
consumer credit to the job market and discusses
the impact of market signaling
• Akerlof, Spence, and Stiglitz were
awarded the Nobel Prize in Economic
Science in 2001 for their works
relating to information.
• Using certain mathematical and
Econometric Models (Tools), Economic
agents should have all the Perfect
Information and know all risks and
possibilities of a specific action.
 The Principal-Agent
Problem
• Agent: a person who is performing a task
on someone else’s behalf (e.g., a worker)
• Principal: the person for whom this action
is being performed (e.g., an employer)
• When the principal cannot perfectly monitor

the agent’s behavior, there is a risk

(“hazard”) that the agent may do something
undesirable (“immoral”).
– Example: Worker may play video games or surf
the web while on the clock.
 How Principals May
Respond
• Better monitoring
Parents plant hidden cameras in the home to
increase the chance of detecting undesirable
behavior.
• Higher wages
Employers pay workers efficiency wages
(wages above the equilibrium level) to increase
the penalty for being caught shirking.
• Delayed payment
Firms delay payment (e.g., year-end bonuses)
to increase the penalty for being caught
shirking.
 Corporate Management
• The separation of ownership and control of corporations
creates a principal-agent problem:
– Principals: the shareholders,
pay managers to maximize the firm’s
profits
– Agents: the managers,
may pursue their own objectives
• Shareholders hire a board of directors to oversee
management, create incentives for management to pursue
the firm’s goals instead of their own.
• Corporate managers sometimes sent to jail for taking
advantage of shareholders.
 Auctions

Types of Auctions
• An auction is a mechanism where potential buyers
compete for the right to own a good, service, or,
more generally, anything of value.
• Sellers participating in an auction offer an item for
sale, and wish to obtain the highest price.
• Buyers participating in an auction seek to obtain
the item at the lowest possible price.
– Bidders’ risk preferences can affect bidding strategies
and the expected revenue a seller receives.
• Four basic auction types:
– English (ascending-bid)
– First-price, sealed-bid
– Second-price, sealed-bid
– Dutch (descending-bid)
© 2017 by McGraw-Hill Education. All Rights Reserved. 12-38
 Auctions

Differences Among Auctions Types

• The timing of bidder decisions
(simultaneously or sequentially)
• The amount the winner is required to
pay.

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 Auctions

English Auction
• An English auction is an ascending
sequential-bid auction in which bidders
observe the bids of others and decide
whether or not to increase the bid. The
auction ends when a single bidder
remains; this bidder obtains the item and
pays the auctioneer the amount of the
bid.
– Bidders continually obtain information about
one another’s bids.
– Bidder who values the item the most will win.

© 2017 by McGraw-Hill Education. All Rights Reserved. 12-40

 Auctions

First-Price, Sealed-Bid Auction

• A first-price, sealed-bid auction is a
simultaneous-move auction in which bidders
simultaneously submit bids to an auctioneer.
The auctioneer awards the item to the highest
bidder, who pays the amount bid.
– Bidders obtain no information about one another’s
bids.
– Bidder who values the item the most will win.

© 2017 by McGraw-Hill Education. All Rights Reserved. 12-41

 Auctions

Second-Price, Sealed-Bid Auction

• A second-price, sealed-bid auction is a
simultaneous-move auction in which bidders
simultaneously submit bids to an auctioneer.
The auctioneer awards the item to the highest
bidder, who pays the amount bid by the second-
highest bidder.
– Bidders obtain no information about one another’s
bids.
– Bidder who values the item the most will win, but
pays the second-highest bid.

© 2017 by McGraw-Hill Education. All Rights Reserved. 12-42

 Auctions

Dutch Auction
• A Dutch auction is a descending sequential-bid
auction in which the auctioneer beings with a
high asking price and gradually reduces the
asking price until one bidder announces a
willingness to pay that price for the item.
– Bidders obtain no information about one another’s
bids throughout the auction process.
– Bidder who values the item the most will win and
pay the amount of his or her bid.

© 2017 by McGraw-Hill Education. All Rights Reserved. 12-43

 Strategic Equivalence of Dutch
Auctions

and First-Price Auctions

• The Dutch and first-price, sealed-bid auctions
are strategically equivalent; that is, the optimal
bids by participants are identical for both types
of auctions.

© 2017 by McGraw-Hill Education. All Rights Reserved. 12-44

 Auctions

Information Structures
• While the four auction types differ with respect
to the information bidders have about the bids
of other bidders, bidders also have different
information structures about the value of their
own bids.
– Perfect information
– Independent private values
– Affiliated (or correlated) value estimates
• Special case: common-value auctions

© 2017 by McGraw-Hill Education. All Rights Reserved. 12-45

 Auctions

Optimal Bidding Strategies

for Risk-Neutral Bidders
• An optimal bidding strategy for risk-neutral
bidders is a strategy that maximizes a bidder’s
expected profit.
• Optimal bids depends on the
– type of auction.
– information available to bidders at the time of
bidding.

© 2017 by McGraw-Hill Education. All Rights Reserved. 12-46

 Strategies for Independent Auctions

Private Value Auctions

• With independent private values, bidders know his or her
own values prior to the auction start.
• English auction
– Remain active until the price exceeds his or her own valuation of
the object.
• Second-price, sealed-bid auction
– Bid his or her own valuation of the item. This is a dominant
strategy.
• First-price, sealed-bid auction (strategically equivalent to the
Dutch auction)
– Bid less than his or her valuation of the item. If there are bidders
who all perceive valuations to be evenly (or uniformly) distributed
between a lowest and highest possible valuations, and ,
respectively, then the optimal bid, , for a player whose own
© 2017 by McGraw-Hill Education. All Rights Reserved. 12-47
 Auctions

Strategies for Independent

Private Value Auctions In Action: Problem
• Consider an auction where bidders have
independent private values. Each bidder
perceives that valuations are evenly distributed
between and . Sam knows his own valuation is .
Determine Sam’s optimal bidding strategy in:
– A first-price, sealed-bid auction with two bidders.
– A Dutch auction with three bidders.
– A second-price, sealed-bid auction with 20 bidders.

© 2017 by McGraw-Hill Education. All Rights Reserved. 12-48

 Auctions
Strategies for Independent
Private Value Auctions In Action: Answer
• Sam’s optimal bid in a first-price, sealed-bid
auction with two bidders is .
• Sam’s optimal bid in a Dutch auction with three
bidders is .
• Sam’s optimal bid in a second-price, sealed-bid
auction with 20 bidders is to bid his true
valuation, which is .

© 2017 by McGraw-Hill Education. All Rights Reserved. 12-49

 Auctions

Strategies for Correlated Values Auctions

• Bidders do not know their own valuations for an item, nor
others’ valuations.
– Implication: makes bidders vulnerable to the winner’s curse,
which is the “bad news” conveyed to the winner that his or her
estimate of the item’s value exceeds the estimates of all other
bidders.
• To avoid the winner’s curve in a common-value auction, a
bidder should revise downward his or her private estimate
of the value to account for this fact.
• The auction process may reveal information about how
much the other bidders value the object.
– The winner’s curse is most pronounced in sealed-bid auctions
since bidders don’t learn about other player’s valuation.
– English auction, in contrast, provides bidders with information.
© 2017 by McGraw-Hill Education. All Rights Reserved. 12-50
 Auctions

Expected Revenues in
Alternative Types of Auctions
Comparison of expected revenue in auctions with
risk-neutral bidders

Information structure Expected revenues

Independent private values English=Second-price = First-Price = Dutch
Affiliated value estimates English > Second-price > First-price = Dutch

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