Unit 3:The Role of Information in an Economy

Transaction Costs and Information Costs

Transaction costs are those costs associated with bringing buyers and sellers together.The costs associated with making exchange possible are transaction costs such as

• Travel cost
• Negotiation cost
• Property rights enforcement cost
• Cost of acquiring information
• Information costs

In real world markets-even those that are highly competitive- there is a considerable uncertainty about current or future prices and even about product qualities.If such information were available instantaneously at no cost of time or money, such information typically does have its costs, and information costs have a substantial effect on real-world markets.
Information costs are the costs of acquiring information on prices, product qualities, and product performance. Information costs include the costs of telephone, shipping, checking credentials, inspecting goods, monitoring the honesty of workers or customers, placing ads and reading ads and consumers reports etc. in order to acquire more economic information.
Information is costly because we have a limited capacity to acquire, process, store and retrieve facts and figures about prices, qualities and location of products.Information is distributed over the populations in bits and pieces.Internet has, of course, reduced information costs.

The economy of search

A perfectly competitive market is one in which all buyers pay the same price for the same product.In many real-world markets, however, the prices of even homogenous goods (milk, bread, gasoline, etc) differ from store to store.
In these real-world markets, it is more difficult for consumers to know the prices charged for the same items in different stores- even if consumers are aware of price differences, the transaction costs of always going to the cheapest store my outweigh the advantages of the lower price.Such markets are usually imperfect because different buyers appear to pay different prices for the same product.From an economic point of viewpoint, the same good in a different location is considered a different product.
Information gathering and price dispersion
A consumer incurs search costs while shopping, reading, or consulting experts in order to acquire pricing or quality information. Search costs explain why homogeneous products sell for different prices in different locations. A 32-inch Sony TV set may sell for different prices in stores one block apart, the same brand of milk may sell for different prices in adjacent grocery stores, and the same brand of dealerships located in the same part of town.
In gathering costly information, people follow the optimal search rule. 

• The optimal-search rule states that people will continue to acquire economic information as long as the marginal benefits of gathering information exceed the marginal costs.

Figure 1 illustrates the optimal search rule. Suppose a consumer has just moved to a new town and is looking for the best place to buy a particular product. The consumer might visit several stores to collect valid price information. Thus, after some comparison shopping, the consumer will have a sample of the various price charged. The vertical axis measures the benefits and costs of search per visit. The horizontal axis measures the lowest known prices (S) that the consumer has collected through search. If the lowest known price is very small, the marginal benefit of search for that consumer will be low; if the lowest known price is very high, the marginal benefits of search will be high. The upward-sloping curve in Fig 1 shows the marginal benefits of search for different values of the lowest sampled price. Since the marginal cost of search is assumed to be independent of the lowest price sampled, it will remain unchanged over the range of S values. The price at which the marginal benefit of search (at point e) is the consumer’s reservation price.

Information problems

• Moral hazard problem
• Adverse selection

i) Moral-hazard problem
A moral-hazard problem exists when one of the parties to a contract has an incentive to alter his or her behavior after the contract is made at the expense of the second party. It arises because it is too costly for the second party to obtain information about the first party’s post contractual behavior.
Moral hazard is the reason why every fire insurance policy contains a provision that fires deliberately set by a policy owner (or agent of the owner) are not covered.Indeed, insurance companies spend millions to investigate fires to determine if there was any foul play.
It is not possible to buy insurance against poverty. No insurance company will sell you a policy that will pay you in the event of bankruptcy or unemployment. Such insurance does not exist because it could provide an incentive for a person to quit working or seek bankruptcy.
As an illustration of the moral-hazard problem, consider the guarantees that are offered on products. When a car is purchased, the manufacturer often gives a warranty on a car such as “the first four years or 50,000 miles, whichever comes first.” The reason it does not offer a simple four-year warranty is moral hazard: there is little cost imposed on the person driving the car 200,000 miles the first year. Taxi drivers, for example, could easily take advantage of a simple four-year warranty: they would not have to worry about the car breaking down after 50,000 miles. Thus, in order for taxi drivers and the like to pay the cost of extraordinary usage, the limit of 50,000 miles in added to the basic warranty.
ii) Adverse-Selection Problem
The adverse-selection problem occurs when a buyer or seller enters a disadvantageous contract on the basis of incomplete or inaccurate information because the cost of obtaining the relevant information makes it difficult to determine whether the deal is a good one or bad one.
The adverse-selection problem is encountered by those who set automobile insurance rates. Good drivers are less likely than bad drivers to have accidents that lead to costly claims against the insurance company. With full information, good drivers would not have to subsidize bad drivers, because insurance companies would be able to differentiate between good drivers and bad drivers.
Insurance companies face a different world; Smith and Jones are exactly alike except that Smith is a good driver who has never had an accident and Jones is a terrible driver who has been lucky never to have had an accident. Smith knows she is a good driver; Jones knows she is an accident waiting to happen. What about the insurance company? Unless insurance agents were to follow Smith and Jones around town and interview friends and neighbors, the insurance company cannot differentiate between Smith and Jones at the same rate as Smith. If the insurance company knew more about Smith and Jones, Jones would have to pay higher insurance rates to compensate for the higher probability of an accident

Speculation

Speculators are those who buy or sell in the hope of profiting from market fluctuations.Information about changes in market conditions for any number of goods and services is important to speculators.Speculators buy or sell commodities in huge quantities hoping to profit from a frost, war, scare, bad news or good news.
The economic role of the speculator

• Speculators often profit from misfortunes of others.
• The popular view of speculators is that they do only harm; however, speculators are performing a useful economic function- that is engaging in arbitrage through time.

Arbitrage is buying in a market where a commodity is cheap and reselling in a market where a commodity is more expensive.Arbitrageur buys in one location and sells in other (not very risky)
Speculator buys at one time and resells at another time (Risky) .Speculation is a risky business because tomorrow’s prices cannot be known with certainty.The Speculator is bearing risk that others do not wish to carry.

• Profitable Speculation
• Unprofitable Speculation

a) Profitable Speculation

• The objective of the speculator is to make a profit by buying at low and selling at high.
• When there are enough speculators- low price will be driven up and the high prices will be driven down.
• Profitable speculation stabilizes prices and consumption over time by reducing fluctuation in prices and consumptions over time.

Profitable speculation shifts supplies from periods when supplies are relatively abundant and prices potentially low at periods when supplies are relatively scarce and prices potentially high. In this sense, profitable speculation provides the valuable economic service of stabilizing prices and consumption over time.
b)Unprofitable Speculation
Speculation is risky. Speculators cannot always guess correctly. They may buy when they think prices are low only to find that prices sink even lower. They may sell when they think prices are at their peak only to watch the prices rise
even further. In such cases, speculation destabilizes prices and consumption over time. When prices would otherwise be high, such speculators are buying and driving prices even higher; when prices would otherwise be low, such speculators are selling and driving prices even lower.

Unprofitable speculation is inefficiently for the economy as a whole.Unprofitable speculation is destabilizing because it creates artificial scarcity in some periods and artificial abundance in other periods.In this sense, speculation can be costly to society.

The Futures Market

A futures market is an organized market in which a buyer and sellers agree now on the price of a commodity to be delivered at some specified date in the future.Speculation has led to the development of future market.The buyer and seller must each put-up cash-called a margin requirement-equal to a small percentage of the value of the contracts.
The Spot Market:- The market in which a good is purchased today for immediate delivery is called a sport (or cash) market.In a spot (cash) market, arrangement between buyers and sellers are made now for payment and delivery of the product now.E.g. in the grocery store, consumers pay now for goods that are delivered now.
The seller of the future contracts is in a short position because something is being sold that is not owned.The buyer of the future contracts is in a long position because a claim on a good is being acquired.