SELECTED ANSWERS: QUESTIONS ON ECONOMICS OF INFORMATION

A distribution of prices means that some sellers charge higher prices than others. When some customers are uninformed and have high search costs, the equilibrium can have a distribution of prices.
 

3. Why do firms charge high prices for new products, then later put them on sale at reduced prices?

The customers who are willing to pay the most for a product are often those least willing to wait to buy the product.  So firms can gain by charging a high price initially to those consumers and lower prices later on to other customers, who are more willing to wait and are not willing to pay as much.
 

4. Why do tourists often pay more than local residents for the same good?

Tourists have less information than local residents about what stores are in a city, where they are located, and what prices they charge.  Tourists may also have less time to search for a store with a low price. So some stores charge higher prices and locate where tourists can easily find them.  These stores sacrifice business of local residents (because they charge high prices) for tourist business.
 

5. Calculate expected values in two situations:
a.  You bought a raffle ticket. The chance is 999/1,000 that your ticket will not win anything, and 1/1,000 that it will win a stereo system valued at $500. What is the expected benefit from your raffle ticket?
b. There is a one-half chance that you will lose $100 on an investment, a one-quarter chance that you will break even (your profit will be zero,) and a one-quarter chance that your profit will be $400. What is the expected profit on your investment?

a. The expected benefit from the raffle ticket is (999/1,000)(O) + (1/1,000)($500) = $0.50
b. The expected profit on the investment is (1/2)(-$100) + (1/4)(0) + (1/4)($400) = $50
 

6. You are shopping for a television set and you learn the price at a local store. You could visit other stores, with a 1/10 chance that the next store you visit will charge $25 less for the same television set, and a 9/10 chance it will charge the same price as the current store. What is your expected benefit from visiting the other store to check the price?

The expected benefit from visiting the other store is (1/10)($25) + (9/10)(0) = $2.50
 

7 Explain how diversification can reduce risk.

Diversification means "not putting all your eggs in one basket," that is, spreading risks across many different and unrelated investments.  This reduces risk because it is less likely that all your investments will perform badly  than that a few will perform badly.  (If you are diversified, your other investments  help keep your overall wealth from plummeting when a few will perform badly.  If you are not diversified, you might be unlucky enough to have chosen one of the few investments that performed badly; diversification reduces this risk.)
 

8. Explain moral hazard and present an example, identifying the principal and the agent.

A principal is a person who hires someone else -- an agent -- to do something.  Moral hazard occurs when the agent lacks the incentive to act in the principal's best interests, and the principal cannot observe the agent's actions.  For example, a firm may not know whether its employees work hard or shirk (not work hard).  In this case the firm's owner is the principal and each worker is an agent.  See pages 456-8 of the textbook for more examples.

9. Explain why a person's incentive to shirk depends on how the person is paid.

A guaranteed hourly wage can give an agent an incentive to shirk because the principal may never know.  (In some cases, the principal can see how much work got accomplished after a few hours and then infer whether the agents was working hard or shirking.  But in other cases, the principal cannot tell.  (For example, the owner of a store may not know whether sales are low on a particular day because few people came to the store to buy things, or because a cashier worked slowly, creating long lines that drove some potential customers away.)  If an agent collects pay based on results (amount of work done, number of trees planted, total sales at a store, number of customers signed up, etc.) rather than an hourly wage, then the agent has a stronger incentive to work hard.

10. With an optimal contract in a moral hazard situation, do agents have an incentive to try as hard as the principal would like? Why or why not?

Pay based on  results has the benefit -- discussed in the answer to question 9 -- of providing an incentive for the agent to act in the principal's interest.   But pay based on results also creates risk for agents.  If a sales representative paid solely on commission is unlucky enough to contact people who simply don't want the product, then that salesperson earns no income!  Similar elements of luck can enter into many kinds of jobs -- good results often come from hard work and good luck.  Therefore, pay based on results creates risk that agents usually dislike.  While an hourly wage eliminates that risk for the agent, the hourly wage does not provide an incentive for the agent to work hard.

An optimal contract is a compromise between the benefits of

1. pay for results, which provides good incentives for the agent but creates risk, and
2. an hourly wage, which reduces risk for the agent but does not create good incentives.

11. Explain adverse selection and present an example of it. Explain how adverse selection differs from moral hazard.

Adverse selection occurs when two people might trade with each other and one person has relevant information about some aspect of the product's quality that the other person lacks. Moral hazard occurs when a principal cannot observe the actions of an agent who has an incentive to act in the best interests of the principal.

Examples of adverse selection:

• selling a product, such as a used car,  when the seller may know more than the buyer about its quality
• buying a service, such as health insurance, when the buyer may know more about his risk of becoming ill than the insurance company knows

Adverse selection: Customers often don't know if a firm sells high-quality or low-quality goods.  A firm that sells high-quality goods can try to get around this problem (limit the adverse selection problem) by issuing money-back guarantees, free repairs or replacement for products with defects, and so on.  Such guarantees can give buyers information about quality because a firm selling low-quality products would probably not issue such a guarantee.  Therefore guarantees reduce the adverse-selection problem by allowing high-quality producers to sell their products for higher prices. But guarantees cannot totally eliminate adverse selection problems because guarantees are only good if they are enforceable.  Low-quality firms may issue guarantees and then (try to) refuse to honor them (or may even go out of business).

Moral hazard: A guarantee does not create a moral hazard problem if the principal can tell whether a problem results from a defect or poor care by the owner.  Moral hazard arises, however, when the principal cannot tell why a problem occurs.  Moral hazard limits the use of guarantees because a guarantee reduces the incentive of the agent (the owner of the product) to take good care of the product and use it properly.  An optimal contract  involves a compromise between a complete guarantee (which would eliminate a consumer’s risk) and no guarantee (which would give the consumer a strong incentive to care properly for the good).
 

13. Discuss this statement: "Adverse selection means that all products will be of the lowest possible quality."

While adverse selection tends to drive high-quality products out of the market, some firms may continue to sell high-quality goods. These firms limit adverse selection problems by issuing guarantees or similar assurances of their products' quality.
 

14. Firms that sell medical insurance try to judge the risks of applicants by investigating their current health indicators (such as their blood pressure readings) family medical histories (to look for diseases that might run in a family), and personal habits (such as smoking.) The firms charge higher prices to insure higher-risk applicants. Suppose that the government requires firms to offer the same price to everyone who lives in a community, with the price based on the average risks of people in that community. How would this affect the decisions of people to buy medical insurance?

If the government required firms to charge the same price for medical insurance to everyone in a community, then high-risk people would tend to buy insurance and low-risk people would tend not to buy insurance.  This would occur because high-risk people have more to gain from the insurance, while low-risk people have less to gain from insurance but have to pay the same price as high-risk people.   (As a result, any low-risk people who continued to buy insurance would pay more than the costs to the insurance company of insuring them, while high-risk people would pay less than the costs of insuring them.)
 

15. A new business has a one-tenth chance of succeeding and earning a profit with a discounted present value of $500,000. It has nine-tenths chance of failing and incurring a loss with a discounted present value of $40,000. What is the discounted present value of the expected profit from starting this business? What would it be if the $40,000 loss were to change to $60,000?

The discounted present value of the expected profit is (1/10)($500,000) + (9/10)(-$40,000) = $14,000.

If the loss were  $60,000, the expected profit would be $50,000 + (9/10)(-$60,000) =  - $4,000  (that is, a loss of $4,000).
 

16. Explain two ways that firms price-discriminate when some consumers are uninformed. Why does more consumer information lead to lower prices?

(1) Firms sometimes sell the same good at different prices under different brand names, and try to get less informed customers to buy the higher-priced brand.
(2) Firms sometimes operate more than one store, and charge different prices at different stores for the same good.  Less-informed customers may buy at the higher-priced stores rather than shop around for the lowest price.

More consumer information leads to lower prices because with better information, more buyers go to low-price stores and fewer to high-price stores.  This gives high-price stores incentives to reduce their prices.  Better information can reduce prices even if all consumers are equally well-informed because the information improves consumer's guesses about which stores charge lower prices.
 

17. Why do moral hazard problems not arise when monitoring costs are very low?

When monitoring costs are low, principals can obtain more information about the agent's actions.
 

18. Explain how adverse selection applies to:
a. Medical and life insurance.
b. Firms hiring workers.
c. Credit cards

a. When people have more knowledge than insurance companies about their likelihood of getting sick, then high-risk people are more likely to buy insurance than low-risk people.  (Also, high-risk people tend to buy more insurance than low-risk people.)  As a result, insurance companies end up selling  more insurance to high-risk people than to low-risk people.  The insurance company's costs are therefore higher than they would be if they had more low-risk customers, raising the equilibrium price of insurance.  (This higher price further reduces the benefit to low-risk people of insurance, and makes them even less likely to buy insurance.)

b. Firms try to obtain information on the quality of job applicants, but the information is never perfect.   So firms must offer a wage based on the expected performance of a  job applicant in a job.  Suppose this wage is $10 per hour.  Low-quality  job applicants are more likely to be attracted by this $10 wage than high-quality job applicants.  In other words, people who have better opportunities are unlikely to apply for this job, while people with only worse opportunities apply for the job.  High-quality job applicants tend to have better opportunities than low-quality job applicants, so the average person applying for this job will not be worth the $10 wage that the firm offers.  The harder time the firm has in distinguishing high-quality job applicants from low-quality  job applicants, the greater this adverse-selection problem.

c. Banks have limited information on which people are good credit risks (that is, whether they are likely to pay their debts on time, or even pay their debts at all).   As a result, banks charge an interest rate that reflects the average credit risk of their customers. This creates adverse selection because high-risk people find it more worthwhile to incur debt on a credit cards at this interest rate, while low-risk people find it less worthwhile.  This raises the fraction of credit-card debt attributable to high-risk borrowers, further raising the interest rate that banks must charge.
 

20. Describe the incentives of an investment advisor who earns a fraction of the profits of recommended investments.  How does your answer depend on whether the advisor has to pay for part of any looses form these investments?

An investment advisor who earns a fraction of the profits from the recommended investments has an incentive to recommend high-risk investments.  To see why, consider an example.  The advisor can suggest either a safe investment that pays a $100 profit for sure next year, or a risky investment with a 1/2 chance of paying a profit of $280 next year and a 1/2 chance of making a $100 loss.  The expected payoff from the risky investment is (1/2)($280)+(1/2)(-$100) = $90, so the risky investment has a lower expected payoff than the safe investment.  Although the investor would be better off with the safe investment, the advisor has an incentive to recommend the risky investment if he earns 10% of the profits (but is not responsible for losses).  The advisor would gain $10 (10% of $100) from the safe investment, and have an expected gain of $14 (10% of the one-half chance of $280) on the risky investment.  However, if the advisor were to share in the losses as well as the profits, then the advisor would have an incentive to recommend the safe investment in this example.
 

24 Monte Carlo, where Cooley sells ice cream on the beach, has hot days and normal days. On a hot day, he earns $1,000 profit. On a normal day, he earns a $200 profit. He always faces a one-half chance that tomorrow will be a hot day.
a. What is Cooley's expected profit from selling ice cream tomorrow?
b. Suppose the casino at Monte Carlo starts a new weather gambling game. Every day, the casino sells weather tickets for $100 each. If the next day is normal, the weather ticket pays $200. If the next day is hot, the weather ticket pays zero. What is the expected profit from buying a weather ticket?
c. Suppose that Cooley buys one weather ticket every day. What is his net profit on a normal day after selling ice cream and buying a weather ticket? What is his net profit on a hot day?
d. Could Cooley eliminate all risk by buying weather tickets? How many tickets would he have to buy each day to eliminate all of his risk? What would his income be?

a. Cooley's expected profit tomorrow is (1/2)($1,000) + (1/2)($200) = $600.
b. The expected profit from buying a weather ticket is (1/2)($200) + (1/2)(0) - $100 = 0
c. Cooley's net profit on a normal day after buying a weather ticket is $200 + $200 - $100 = $300.
His net profit on a hot day after buying a weather ticket is $1,000 + 0 - $100 = $900.
d. Cooley could eliminate all his risk by buying 4 weather tickets every day.  Then on normal days he would earn  $800 + $200 - $400  =  $600,   and on hot days he would earn  $0 + $1,000 - 400  =  $600.  So he would earn $600 per day regardless of the weather.