Information economics

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Information economics or the economics of information is the branch of microeconomics that studies how information and information systems effect an economy and economic decisions. [1]

Contents

One application considers information embodied in certain types of commodities that are "expensive to produce but cheap to reproduce." [2] Examples include computer software (e.g., Microsoft Windows), pharmaceuticals, and technical books. Once information is recorded "on paper, in a computer, or on a compact disc, it can be reproduced and used by a second person essentially for free." [2] Without the basic research, initial production of high-information commodities may be too unprofitable to market, a type of market failure. Government subsidization of basic research has been suggested as a way to mitigate the problem. [2]

The subject of "information economics" is treated under Journal of Economic Literature classification code JEL D8 – Information, Knowledge, and Uncertainty. The present article reflects topics included in that code. There are several subfields of information economics. Information as signal has been described as a kind of negative measure of uncertainty. [3] It includes complete and scientific knowledge as special cases. The first insights in information economics related to the economics of information goods.

In recent decades, there have been influential advances in the study of information asymmetries [4] and their implications for contract theory, including market failure as a possibility. [5]

Information economics is formally related to game theory as two different types of games that may apply, including games with perfect information, [6] complete information, [7] and incomplete information. [8] Experimental and game-theory methods have been developed to model and test theories of information economics, [9] including potential public-policy applications such as mechanism design to elicit information-sharing and otherwise welfare-enhancing behavior. [10]

In game theory if for example, two potential employees are going for the same promotion at work and are conversing with their employee about the job, one employee may have more information about what the role would entail then the other. [11] Whilst one may be willing to accept a lower pay rise for the new job, the other may have more information on what the role’s hours and commitment would take and would expect a higher pay. This is a clear use of incomplete information to give one person the advantage in a given scenario. If they talk about the promotion with each other in a process called colluding there may be the expectation that both will have equally informed knowledge about the job. However the employee with more information may mis-inform the other one about the value of the job for the work that’s involved and make the promotion appear less appealing and hence not worth it. This brings into action the incentives behind information economics and highlights non-cooperative games. [11]

Value of information

The starting point for economic analysis is the observation that information has economic value because it allows individuals to make choices that yield higher expected payoffs or expected utility than they would obtain from choices made in the absence of information. Data valuation is an emerging discipline that seeks to understand and measure the economic characteristics of information and data. [12]

Information, the price mechanism and organizations

Much of the literature in information economics was originally inspired by Friedrich Hayek's "The Use of Knowledge in Society" on the uses of the price mechanism in allowing information decentralization to order the effective use of resources. [13] Although Hayek's work was intended to discredit the effectiveness of central planning agencies over a free market system, his proposal that price mechanisms communicate information about scarcity of goods inspired Abba Lerner, Tjalling Koopmans, Leonid Hurwicz, George Stigler and others to further develop the field of information economics.[ citation needed ] Next to market coordination through the price mechanism, transactions can also be executed within organizations. The information requirements of the transaction are the prime determinant for the actual (mix of) coordination mechanism(s) that we will observe. [14]

Information asymmetry

Information asymmetry means that the parties in the interaction have different information, e.g. one party has more or better information than the other. Expecting the other side to have better information can lead to a change in behavior. The less informed party may try to prevent the other from taking advantage of him. This change in behavior may cause inefficiency. Examples of this problem are selection (adverse or advantageous) and moral hazard. [15]

Adverse selection occurs when one side of the partnership has information the other does not and this can occur deliberately or by accident due to poor communication. [16] A classic paper on adverse selection is George Akerlof's The Market for Lemons. [17]

The most common example of the Lemons Market is in the automobile industry. As suggested by Akerlof, there are four car types that a buyer could consider. [17] This includes choosing either a new or used car, and choosing a good or bad car, or Lemon as it is more commonly known. When considering the market options there is possibility of purchasing a new lemon car as there is a used good car. [17] The uncertainty that arises from the probably of purchasing a lemon due to asymmetric information can cause the buyer to have doubts about the car's quality and inherent outcome when purchased. [18] This same dilemna exists in a multitude of markets where sellers have an incentive to not disclose information about their product if it is poor quality due to knowledge that the average standard across the industry from good products existing will boost their selling power. [17] The asymmetrical information known about the car's quality can lead to a breakdown in the autombile industry's overall efficiency. [19] This is due to two reasons. Firstly, uncertainty between the buyers and sellers and secondly in the broader market where only sellers with below average vehicles will be willing to sell due to the reduced quality being represented. [17] There are two primary solutions for adverse selection; signaling and screening.

Moral hazard includes a partnership between a principal and agent and occurs when the agent may change their behaviour or actions after a contract has been finalised which can cause adverse consequences for the principal. [16]

Moral hazard is present when their is a change in the agents behaviour after taking out insurance cover to protect them. [20] For example if someone purchased car insurance for their vehicle and afterwards held their responsibility to a lower standard by going over the speed limit for example or generally driving recklessly. The Global Financial Crisis of 2008 is another example, where Mortgage-backed securities were formed through the collation of subprime morgages and sold to investors without disclosing the risk involved. [21] For moral hazard, contracting between principal and agent may be describable as a second best solution where payoffs alone are observable with information asymmetry. [22] Insurance covers will often include a waiting period clause to refrain agents from changing their attitude.

Signaling

Michael Spence originally proposed the idea of signaling. He proposed that in a situation with information asymmetry, it is possible for people to signal their type, thus credibly transferring information to the other party and resolving the asymmetry.

This idea was originally studied in the context of looking for a job. An employer is interested in hiring a new employee who is skilled in learning. Of course, all prospective employees will claim to be skilled at learning, but only they know if they really are. This is an information asymmetry.

Spence proposed that going to college can function as a credible signal of an ability to learn. Assuming that people who are skilled in learning can finish college more easily than people who are unskilled, then by attending college the skilled people signal their skill to prospective employers. This is true even if they didn't learn anything in school, and school was there solely as a signal. This works because the action they took (going to school) was easier for people who possessed the skill that they were trying to signal (a capacity for learning). [23]

Screening

Joseph E. Stiglitz pioneered the theory of screening. [24] In this way the underinformed party can induce the other party to reveal their information. They can provide a menu of choices in such a way that the optimal choice of the other party depends on their private information. By making a particular choice, the other party reveals that he has information that makes that choice optimal. For example, an amusement park wants to sell more expensive tickets to customers who value their time more and money less than other customers. Asking customers their willingness to pay will not work - everyone will claim to have low willingness to pay. But the park can offer a menu of priority and regular tickets, where priority allows skipping the line at rides and is more expensive. This will induce the customers with a higher value of time to buy the priority ticket and thereby reveal their type.

Information goods

Buying and selling information is not the same as buying and selling most other goods. There are three factors that make the economics of buying and selling information different from solid goods:

First of all, information is non-rivalrous, which means consuming information does not exclude someone else from also consuming it. A related characteristic that alters information markets is that information has almost zero marginal cost. This means that once the first copy exists, it costs nothing or almost nothing to make a second copy. This makes it easy to sell over and over. However, it makes classic marginal cost pricing completely infeasible.

Second, exclusion is not a natural property of information goods, though it is possible to construct exclusion artificially. However, the nature of information is that if it is known, it is difficult to exclude others from its use. Since information is likely to be both non-rivalrous and non-excludable, it is frequently considered an example of a public good.

Third is that the information market does not exhibit high degrees of transparency. That is, to evaluate the information, the information must be known, so you have to invest in learning it to evaluate it. To evaluate a bit of software you have to learn to use it; to evaluate a movie you have to watch it.

The importance of these properties is explained by De Long and Froomkin in The Next Economy.

Network effects

Carl Shapiro and Hal Varian described Network effect (also called network externalities) as products gaining additional value from each additional user of that good or service. [25] Network effects are externalities in which they provide an immediate benefit when an additional user joins the network, increasing the network size. The total value of the network depends upon the total adopters but carries only a marginal benefit for new users. This leads to a direct network effect for each user's adoption of the good, with an increased incentive for adoption as other user's adopt and join the network. [26] The indirect network effect occurs as a complementary goods benefit from the adoption of the initial product. [26]

The growth of data is constantly expanding and growing at an exponential rate, however, the application of this data is far lower than the creation of it. [27] [28]

New data brings about a potential increase in bad information which can crowd out the good information. This increase in unverified information is due to the easy and free nature of creating online data, disrupting potential for users from finding sourced and verified data. [29]

Critical mass

As new networks are developed, early adopters form the social dynamics of the greater population and develop product maturity known as Critical mass. Product maturity is when they become self-sustaining and is more likely to occur when there are positive cash flows, consistent revenue flows, customer retention and brand engagement. [30] To form a following, low initial prices need to be offered, along with wide-spread marketing to help create the snowball effect.

More information

In 2001, the Nobel prize in economics was awarded to George Akerlof, Michael Spence, and Joseph E. Stiglitz "for their analyses of markets with asymmetric information". [31]

See also

Related Research Articles

Economics Social science

Economics is "the social science that studies the production, distribution, and consumption of goods and services."

Microeconomics Behavior of individuals and firms

Microeconomics is a branch of mainstream economics that studies the behavior of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms. Microeconomics focuses on the study of individual markets, sectors, or industries as opposed to the national economy as whole, which is studied in macroeconomics.

Neoclassical economics is an approach to economics in which the production, consumption and valuation (pricing) of goods and services are observed as driven by the supply and demand model. According to this line of thought, the value of a good or service is determined through a hypothetical maximization of utility by income-constrained individuals and of profits by firms facing production costs and employing available information and factors of production. This approach has often been justified by appealing to rational choice theory, a theory that has come under considerable question in recent years.

Pareto efficiency or Pareto optimality is a situation where no individual or preference criterion can be better off without making at least one individual or preference criterion worse off or without any loss thereof. The concept is named after Vilfredo Pareto (1848–1923), Italian civil engineer and economist, who used the concept in his studies of economic efficiency and income distribution. The following three concepts are closely related:

Market failure Concept in public goods economics

In neoclassical economics, market failure is a situation in which the allocation of goods and services by a free market is not Pareto efficient, often leading to a net loss of economic value. Market failures can be viewed as scenarios where individuals' pursuit of pure self-interest leads to results that are not efficient – that can be improved upon from the societal point of view. The first known use of the term by economists was in 1958, but the concept has been traced back to the Victorian philosopher Henry Sidgwick. Market failures are often associated with public goods, time-inconsistent preferences, information asymmetries, non-competitive markets, principal–agent problems, or externalities.

This aims to be a complete article list of economics topics:

George Akerlof American economist (born 1940)

George Arthur Akerlof is an American economist who is a university professor at the McCourt School of Public Policy at Georgetown University and Koshland Professor of Economics Emeritus at the University of California, Berkeley. Akerlof was awarded 2001 Nobel Memorial Prize in Economic Sciences, jointly with Michael Spence and Joseph Stiglitz, "for their analyses of markets with asymmetric information."

<i>The Market for Lemons</i> 1970 economic paper

The Market for Lemons: Quality Uncertainty and the Market Mechanism is a widely-cited 1970 paper by economist George Akerlof which examines how the quality of goods traded in a market can degrade in the presence of information asymmetry between buyers and sellers, leaving only "lemons" behind. In American slang, a lemon is a car that is found to be defective after it has been bought.

From a legal point of view, a contract is an institutional arrangement for the way in which resources flow, which defines the various relationships between the parties to a transaction or limits the rights and obligations of the parties.

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Adverse selection Selective trading based on possession of hidden information

In economics, insurance, and risk management, adverse selection is a market situation where buyers and sellers have different information. The result is that participants with key information might participate selectively in trades at the expense of other parties who do not have the same information.

Information asymmetry Concept in contract theory and economics

In contract theory and economics, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This asymmetry creates an imbalance of power in transactions, which can sometimes cause the transactions to be inefficient, causing market failure in the worst case. Examples of this problem are adverse selection, moral hazard, and monopolies of knowledge.

Experimental economics is the application of experimental methods to study economic questions. Data collected in experiments are used to estimate effect size, test the validity of economic theories, and illuminate market mechanisms. Economic experiments usually use cash to motivate subjects, in order to mimic real-world incentives. Experiments are used to help understand how and why markets and other exchange systems function as they do. Experimental economics have also expanded to understand institutions and the law.

<i>Quarterly Journal of Economics</i> Academic journal from Oxford University

The Quarterly Journal of Economics is a peer-reviewed academic journal published by the Oxford University Press for the Harvard University Department of Economics. Its current editors-in-chief are Robert J. Barro, Lawrence F. Katz, Nathan Nunn, Andrei Shleifer, and Stefanie Stantcheva. It is the oldest professional journal of economics in the English language, and covers all aspects of the field—from the journal's traditional emphasis on microtheory, to both empirical and theoretical macroeconomics. According to the Journal Citation Reports, the journal has a 2015 impact factor of 6.662, ranking it first out of 347 journals in the category "Economics". It is generally regarded as one of the top 5 journals in economics, together with the American Economic Review, Econometrica, the Journal of Political Economy, and the Review of Economic Studies.

Sanford "Sandy" Jay Grossman is an American economist and hedge fund manager specializing in quantitative finance. Grossman’s research has spanned the analysis of information in securities markets, corporate structure, property rights, and optimal dynamic risk management. He has published widely in leading economic and business journals, including American Economic Review, Journal of Econometrics, Econometrica, and Journal of Finance. His research in macroeconomics, finance, and risk management has earned numerous awards. Grossman is currently Chairman and CEO of QFS Asset Management, an affiliate of which he founded in 1988. QFS Asset Management shut down its sole remaining hedge fund in January 2014.

Market (economics) System in which parties engage in transactions according to supply and demand

A market is a composition of systems, institutions, procedures, social relations or infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services to buyers in exchange for money. It can be said that a market is the process by which the prices of goods and services are established. Markets facilitate trade and enable the distribution and allocation of resources in a society. Markets allow any tradeable item to be evaluated and priced. A market emerges more or less spontaneously or may be constructed deliberately by human interaction in order to enable the exchange of rights of services and goods. Markets generally supplant gift economies and are often held in place through rules and customs, such as a booth fee, competitive pricing, and source of goods for sale.

Screening in economics refers to a strategy of combating adverse selection – one of the potential decision-making complications in cases of asymmetric information – by the agent(s) with less information.

Credit rationing is the limiting by lenders of the supply of additional credit to borrowers who demand funds at a set quoted rate by the financial institution. It is an example of market failure, as the price mechanism fails to bring about equilibrium in the market. It should not be confused with cases where credit is simply "too expensive" for some borrowers, that is, situations where the interest rate is deemed too high. With credit rationing, the borrower would like to acquire the funds at the current rates, and the imperfection is the absence of supply from the financial institutions, despite willing borrowers. In other words, at the prevailing market interest rate, demand exceeds supply, but lenders are willing neither to lend enough additional funds to satisfy demand, nor to raise the interest rate they charge borrowers because they are already maximising profits, or are using a cautious approach to continuing to meet their capital reserve requirements.

History of microeconomics History of the development of microeconomics as a study

Microeconomics is the study of the behaviour of individuals and small impacting organisations in making decisions on the allocation of limited resources. The modern field of microeconomics arose as an effort of neoclassical economics school of thought to put economic ideas into mathematical mode.

Economic transparency refers to banks and other financial institutions that have made data available about their financial position and condition. However, the definition depends on the perspective of different research areas through which it is examined, mainly monetary economics, international finance, corporate finance, and others. The WTO defines economic transparency as a “degree to which trade policies and practices, and the process by which they are established, are open and predictable.”. United Nations Conference on Trade and Development relates to transparency as to “a state of affairs in which the participants in the investment process are able to obtain sufficient information from each other in order to make informed decisions and meet obligations and commitments”. According to the National Bureau of Economic Research (NBER) there are three main branches: transparency in economic policy, in the institutional structures surrounding the markets, and in the corporate sector.

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Further reading

Papers

Technology], 978-0134645957

Monographs

Dictionaries

"bubbles" by Markus K. Brunnermeier
"information aggregation and prices" by James Jordan.
"information cascades,"] by Sushil Bikhchandani, David Hirshleifer, and Ivo Welch.
"information sharing among firms" by Xavier Vives.
"information technology and the world economy"] by Dale W. Jorgenson and Khuong Vu.
"insider trading" by Andrew Metrick.
"learning and information aggregation in networks"] by Douglas Gale and Shachar Kariv.
"mechanism design" by Roger B. Myerson.
"revelation principle" by Roger B. Myerson.
"monetary business cycles (imperfect information)"] by Christian Hellwig.
"prediction markets" by Justin Wolfers and Eric Zitzewitz.
"social networks in labour markets" by Antoni Calvó-Armengo and Yannis M. Ioannides.
"strategic and extensive form games" by Martin J. Osborne.