CHAPTER 12

The Economics of Information

© 2017 by McGraw-Hill Education. All Rights Reserved. Authorized only for instructor use in the classroom. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 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.

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 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 𝑥1 , 𝑥2 , … , 𝑥𝑛 denote the possible outcomes of
the random variable and 𝑞1 , 𝑞2 , … , 𝑞𝑛 the
corresponding probabilities of the outcomes, then
the mean of 𝑥 is:
𝐸 𝑥 = 𝑞1 𝑥1 + 𝑞2 𝑥2 + … + 𝑞𝑛 𝑥𝑛
, where 𝑞1 + 𝑞2 , + ⋯ + 𝑞𝑛 = 1.
• The mean does not provide information about the
risk associated with the random variable.
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 The Mean and the Variance
Measuring Uncertain Outcomes:
Variance and Standard Deviation
• The variance of 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 𝑥1 , 𝑥2 , … , 𝑥𝑛 denote the possible outcomes of the
random variable, their corresponding probabilities are
𝑞1 , 𝑞2 , … , 𝑞𝑛 , and the expected value of 𝑥 is 𝐸 𝑥 , then
the variance of 𝑥 is:
𝜎2
= 𝑞1 𝑥1 − 𝐸 𝑥 2 + 𝑞2 𝑥2 − 𝐸 𝑥 2 + …
+ 𝑞𝑛 𝑥𝑛 − 𝐸 𝑥 2
• The variance is a common measure of risk.
• The standard deviation is the positive square root of the
variance: 𝜎 = 𝜎 2 . © 2017 by McGraw-Hill Education. All Rights Reserved.
12-5
 Uncertainty and Consumer Behavior

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

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 Uncertainty and Consumer Behavior
Managerial Decisions with
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.
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 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, 𝑐, 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 $100 and one-quarter charge $40.
– A consumer observing a price of $40 should stop
searching since there is no price below $40.
– What should a risk-neutral consumer do after observing
a price of $100, if search occurs with free recall and
with replacement?
• One-quarter of the time the consumer will save $100 − $40 =
$60.
• Three-quarters of the time the consumer will save nothing.
• The expected benefit from an additional search is: 𝐸𝐵 =
1 3
$100 − $40 + $100 − $100 = $15.
4 4
• 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 and
searching for a lower price.

Acceptance Price Region 𝑅 Rejection Price Region Price

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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, 𝑅, 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.

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 Uncertainty and Consumer Behavior

Increasing Cost of Search

Expected
benefits
and costs 𝐸𝐵

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

𝑅 𝑅∗ Price

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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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 Uncertainty and the Firm
Risk Aversion In Action: 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, and
why?
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
a
Safe (T-Bill) 3,000 3,000 3,000 0

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 Uncertainty and the Firm

Risk Aversion In Action: 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.

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 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:
𝐸 𝑀𝑅 = 𝑀𝐶

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 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
𝐶 = 200 + 0.0005𝑄2 , how much juice should be
produced to maximize expected profits? What are
the expected profits of Appleway Industries?
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 Uncertainty and the Firm

Profit Maximization and Uncertainty

In Action: Answer
• Appleway Industries’ profits are
𝜋 = 𝑝𝑄 − 200 − 0.0005𝑄2
• Since price is uncertain, the firm’s revenues and
profit are uncertain. To maximize expected profits,
the manager equates expected price with marginal
cost.
𝐸 𝑝 = 𝑀𝐶
• The expected price is: 𝐸 𝑝 = 0.3 × $2 + 0.7 ×
$1 = $1.30.
• Therefore, manager should produce output where
$1.30 = 0.001𝑄 ⟹ 𝑄 = 1,300 gallons.
• Expected profits are $645.
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 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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 Uncertainty and the Market

Asymmetric Information: Adverse

Selection
• Adverse selection refers to situations where
individuals have hidden characteristics and in
which a selection process results in a pool of
individuals with undesirable characteristics.
– In this context, a hidden characteristic is something
that one party to a transaction knows about itself
but which are unknown by the other party.

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 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.
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 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.

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 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)
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 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.

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 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.

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 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.

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 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.

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 Auctions
Strategic Equivalence of Dutch
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.

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 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

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 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.

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 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 𝑛 bidders
who all perceive valuations to be evenly (or uniformly) distributed
between a lowest and highest possible valuations, 𝐿 and 𝐻,
respectively, then the optimal bid, 𝑏, for a player whose own
valuation is 𝑣 is:
𝑣−𝐿
𝑏=𝑣−
𝑛
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 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 $1 and $10. Sam knows his own
valuation is $2. 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.
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 Auctions
Strategies for Independent
Private Value Auctions In Action: Answer
• Sam’s optimal bid in a first-price, sealed-bid
2−1
auction with two bidders is 𝑏 = 2 − =
2
$1.50.
• Sam’s optimal bid in a Dutch auction with three
2−1
bidders is 2 − = $1.67.
3
• Sam’s optimal bid in a second-price, sealed-bid
auction with 20 bidders is to bid his true
valuation, which is $2.00.
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 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. Therefore, bidders may have to revise up their
initial bids.
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 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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