1ECON1010 
Introductory Microeconomics 
LECTURE 12 
Economics of Information 
Q1. The clearest example of a good or service produced by  
the private sector that has public good characteristics is:  
b. education. 
Last lecture feedback  
e. bouncers at a nightclub. 
d. MotoGP on Fox Sports (pay TV). 
a. Weather report on the radio 
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c. cars 
Q2. A public good that would benefit Karen, Tammy and Max has  
a one-time installation cost of $900. These three voters must 
approve any tax plan by simple majority and all three will cast a 
vote. Since the government does not know and cannot discover 
the voters’ reservation prices, it proposes a head tax of $300 per 
voter. The result of the referendum is: 
Last lecture feedback  
b. Max votes for the tax but Karen and Tammy 
vote against it and it fails. 
a. the tax passes and the public good is provided. 
Voter Reservation  
Price 
Income 
Karen $100 $1,000 
Tammy $200 $5,000 
Max $700 $6,000 
c. Max votes for the tax, Karen votes against 
it but Tammy’s vote is uncertain. 
d. all three voters vote against the tax. 
e. only Max casts a vote and the tax passes 
Extra Question: Is the good  
socially efficient? Yes $1000 > $900 
Lecture 12 - overview 
Lecture 12 ECON1010 4 
Another context where economists know competitive  
markets can produce an inefficient outcome in the  
presence of costly and / or imperfect information. 
Economists know that perfectly competitive markets  
may not produce efficient outcomes. The list of  
situations where this is seen to occur continues to grow.  
The model of perfect competition assumes that  
buyers and sellers have perfect information, or at the  
very least are “well informed”.  
What happens when this assumption doesn’t apply  
in the real world? 
In reality then: 
The invisible hand theory assumes buyers are  
fully informed, but this is rarely true. 
Some market signals are false and misleading. 
Given that consumers are not fully informed,  
they must employ strategies for gathering  
information. 
Gathering the optimal amount of information 
Having more information is better than less, but 
more information is costly to acquire. 
There can be rising marginal costs associated with  
collecting information and diminishing returns. 
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Cost-benefit principle indicates a rational consumer  
will continue gathering information as long as  
marginal benefit exceeds the marginal cost. 
2The optimal amount of information. 
M 
B, 
M 
C 

($ 
/u 
ni 
t) 
Units of information 
Marginal cost 
of information 
Marginal benefit 
of information 
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Ioptimal 
The optimal amount of 
information occurs  
where MB = MC 
Expert Advice 
Lecture 12 ECON1010 8 
“Experts” often say that good decision-making  
means collecting as much information as possible  
before making a decision. Is this sound advice? 
Internet dating 
Dating can be viewed as a search for information 
regarding a potential spouse. What impact have on- 
line dating sites (such as rsvp.com.au) had on the  
spouse search process today compared to previous  
generations? 
9 
Search risks 
Search often involves both uncertain benefits and costs. 
In such situations, economists advocate calculating an 
expected value which is based on probabilities.  
= X * P(X) + Y * P(Y) + …………. 
where 
P(X) = probability of outcome X 
P(Y) = probability of outcome Y 
Expected value of a gamble 
= the average outcome you would win (or  
lose) if you played a particular gamble an  
infinite number of times. 
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Example 1. Expected Value (or outcome) 
What is the expected value of tossing a coin if: 
1. you win $1 if it lands heads 
2. you lose $1 if it lands tails 
Expected value = X * P(X) + Y * P(Y) 
= 1* 0.5 + -1* 0.5 
= $ 0 
P(heads) = 0.5 P(tails) = 0.5 
Outcome if get heads, X = win $1 (+)  
Outcome if get tails, Y = lose $1 (-)  
Lecture 12 ECON1010 11 
Search risks 
Fair gamble – a gamble whose expected value is zero. 
Better than fair gamble – a gamble that has an  
expected value that is positive. 
Risk neutral person – someone who would accept any 
gamble that is fair or better. 
Risk averse person – someone who would refuse any 
fair gamble. 
Lecture 12 ECON1010 12 
Example 2 
You are a risk-neutral person looking for an apartment. 
The distribution of apartments for rent is as follows:  
50 % rent for $700 per month, 
30 % rent for $600 per month,  
20 % rent for $500 per month. 
Your marginal cost increases by $20 for each additional  
search (ie: marginal cost = $20, $40, $60 for the first,  
second, third apartment etc. that you look at). What  
would be your optimal number of searches?  
3Example 2. 
Keep searching up to the point where MB >= MC 
The expected value of the MB from searching is 
Finding a $700 apartment gives MB = 0 
Finding a $600 apartment gives MB = $100  
= 0.5 x 0 + 0.3 x 100 + 0.2 x 200 
= 0 + 30 + 40 = $70/apartment 
Looking at 3 apartments, MC = $60/apartment 
Looking at 4 apartments, MC = $80/apartment 
Conclusion: look at 3 apartment so that MB > MC 
Finding a $500 apartment gives MB = $200  
marginal cost =  
$20, $40, $60 for  
the first, second,  
third apartments  
etc. 
Lecture 12 ECON1010 14 
Asymmetric Information  
Definition: 
Situations in which buyers, and sellers, are  
not equally well informed about the  
characteristics of goods and services for sale  
in the market place. 
Lecture 12 ECON1010 15 
Asymmetric Information  
Examples: 
1. A person selling a car has more  
information about the car than the buyer. 
2. A radio station bids for a new license, but  
they do not have complete information  
about the value of the license. 
Asymmetric Information 
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The Lemons Model (by George Akerlof) 
Asymmetric information tends to reduce the  
average quality of used goods offered for sale. 
People who have below average cars  
(lemons) are more likely to want to sell them. 
Buyers know below average cars are likely to be  
on the market and lower their reservation price. 
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Example 3.  
1. What would be the most a risk-neutral buyer  
be willing to pay for a used car? 
2. Over time, what price will all used cars be  
traded at and what will their quality be? 
Assume good quality used cars are worth  
$10,000 to their owners while “lemons” are  
only worth $5,000 to their owners. Buyers know  
that some proportion of used cars for sale are  
lemons, say 25%, but are unable to tell whether  
a specific car is a lemon or not. In this situation: 
Example 3. 
A risk neutral buyer will take a gamble as long as it is fair  
or better than fair. Unable to tell the difference between  
a good car and a lemon, the expected value for the car  
would be the price the risk neutral person would pay. 
1. The expected value of the car is: 
E(car) = 0.75 x 10,000 + 0.25 x 5,000 
= 7,500 + 1,250 
= $8,750 
Note: those with good cars wanting $10,000 ….. no sale! 
those with lemons wanting $5,000….. make $3,750  
2. In the end, only lemons will be for sale at $5,000. 
419 
used car prices are low, so people with 
good cars keep them longer 
The Lemons Model (cont.) 
Information problems reduce  
economic efficiency in a market 
the average quality of used cars falls even further 
eventually only lemons are for sale 
Asymmetric Information – what’s the point? 
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rarely true  
reduces the argument that  
“the free market works best” 
some market signals are false and misleading 
Asymmetric information is a  
form of market failure 
The Invisible Hand theory assumes  
buyers are fully informed  
Asymmetric Information – what’s the point? 
Information has economic value 
Imperfect information can affect consumer decisions 
Need strategies for gathering reliable information 
Less than efficient outcomes 
Recommendations and government policies formed to  
improve the information provided 
More efficient choices can be made in allocating 
scarce resources 
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1. Principal - Agent Problem 
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= a situation where an agent, whose actions are  
costly to monitor and whose objectives are not  
aligned with those of the principal, takes actions  
that do not result in the best outcome for the  
Principal. 
A classic example of the principal-agent problem  
occurs with publicly-listed companies. 
Inefficiencies and Information Issues.  
Principal - Agent Problem 
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Example:  
Shareholders are owners of a firm (principals)  
while managers run the firm (agents). 
Principals want to maximise profits.  
Agents would like to maximise their salaries,  
enjoy spacious well furnished offices etc. (at  
the expense of the principal). 
Other examples?  
2. Adverse Selection Problem 
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Those on the informed side of the market self  
select in a way that tends to reduce the  
average quality of the good or service sold. 
eg: in the used car market, most used cars offered  
for sale will be lemons (the average quality of  
used cars for sale is reduced). 
eg: insurance markets (can result in only  
those likely to make a claim continuing to  
remain insured).  
5Adverse Selection 
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Example: Health Insurance Market 
Insurance tends to be purchased disproportionately  
by those most costly for companies to insure 
raises premiums 
increases the risk level of the fund  
reduces the number of low-risk policy holders 
3. Moral Hazard Problem 
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The tendency of people to change their behaviour  
once they become party to a contract. 
The classic example = the insurance market.  
Lecture 12 ECON1010 
How might your behaviour change if your car  
was insured versus if it was not insured? 
Moral Hazard 
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Insurance companies take steps to reduce the  
moral hazard problem by offering incentives. 
1. lower annual rates for no claims 
3. offer co-payments so the insurer pays only  
a percentage of the claim 
2. lower excess for no claims 
Moral Hazard 
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Road safety: 
Studies have shown that the introduction of  
certain road safety initiatives, such as the  
compulsory wearing of seatbelts, coincided with  
a reduction in the number of car occupants  
dying on the roads. 
However, there was a rise in the number of 
some other user groups, such as motorcyclists. 
Thinking like an economist how might you  
explain such findings? 
Moral Hazard 
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Marriage and weight gain. 
Research shows people tend to put on weight  
after they get married. This is true even after  
controlling for factors such as age and having  
children.  
Thinking as an economist, how would you  
explain these finding? 
The Costly to Fake Principle 
= the idea that to communicate information  
credibly to a potential rival, a signal must be given  
that is costly, or difficult, to fake. 
Example: 
New car warranty verses a used car warranty. 
A used car warranty can result in costs that are  
much higher than offering a new car warranty. 
A new car warranty provides a signal of product  
quality. The costly to fake principle is one way  
in which the problems created by imperfect  
information can partly be dealt with. 
6Conclusions. 
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2. Inefficiencies result from the principal-agent  
problem, the moral hazard problem, and the  
adverse selection problem. 
1. In the presence of imperfect and / or costly  
information, competitive markets can produce  
inefficient outcomes. 
3. The costly to fake principle is one way in  
which the problems created by imperfect  
information can in part be dealt with. 
Next Lecture 
Lecture 13 = last lecture! 
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