Prof. Bryan Caplan

Econ 370


Week 9: Markets for Information

I.                     Search Theory

A.                 Must economists assume "perfect information"? Not at all: there is an extremely general theory of economic action under uncertainty, known as "search theory."

B.                 Basic assumptions of search theory:

1.                  More time and effort spent "searching" increase your probability of successful discovery.

2.                  Searching ability differs between people.

3.                  People can make a reasonable guess about the probabilities of different events and their ability to influence those probabilities.

C.                Main conclusion: People search so that the marginal cost of searching equals the expected marginal gain of searching.

D.                The (endless) applications:

1.                  Doing R&D.

2.                  Hunting and fishing.

3.                  Prospecting for gold.

4.                  Looking for investment opportunities.

5.                  Searching for a job.

6.                  Dating.

7.                  Rational amnesia.

E.                 What if people don't search much for a good price? Then sellers search for consumers.

1.                  A tale of Istanbul.

F.                 Who is overpaid/underpaid? Look at who is investing more in search.

1.                  Head-hunters vs. pavement-hitters.

G.                Main conclusion: If the economics of perfect information doesn't make sense, try search theory. It explains almost everything else.

II.                   Advertising

A.                 Two theories of advertising:

1.                  Providing information

2.                  Changing preferences

B.                 Advertising informs along many dimensions, reducing search costs for consumers.

1.                  Alerting (or reminding) people to the existence of the product.

2.                  Price.

3.                  Product features.

C.                Changing preferences - what is it good for?

1.                  Easier to appeal to existing preferences than to change people's minds, so you would expect this to be rare.

2.                  Sometimes, especially for luxury products, the "image" matters. Advertising is part of the product you are buying. You can call this "changing preferences" if you want...

3.                  What's so bad about trying to change preferences?

D.                Regulations on advertising: a few examples

1.                  Ban on eyeglass price ads.

2.                  Ban on airline safety ads.

3.                  Forced disclosure/warnings/disclaimers.

III.                  Insurance and Moral Hazard

A.                 Insurance markets let people pool risk. You buy a premium that you expect (hope?) will give you nothing; but if something bad happens to you, the insurance pays off.

B.                 The main cost of supplying insurance is paying off claims. The "actuarially fair premium" is defined as the probability of a payoff times the amount paid out. Insurance firms have to charge more than the actuarially fair premium to cover their overhead (buildings, adjusters, advertising, etc.) Important implications:

1.                  Riskier people will be charged more on the free market.

2.                  If you definitely have a specific problem, it's no longer possible to "insure" against it.

C.                One obvious problem with insurance: "moral hazard." This just means that when someone pays for your accidents and problems, you take less effort to avoid accidents and problems.

D.                Insurance companies have a couple of ways to deal with the moral hazard problem:

1.                  Deductibles. You still have to pay for a share of the problem (ranges from a small fee to 20% of the cost)

2.                  Limiting the range of insurance. If someone takes a dumb risk, they aren't covered. The tale of the jeweler.

IV.               Adverse Selection

A.                 Sometimes one party to a transaction knows more about the product than the other.

B.                 This can lead to "adverse selection" If everyone receives the average price because they cannot identify qualify, people with above-average products leave the market, while those with below-average products eagerly sell.

1.                  Used car seller and buyer

2.                  Worker looking for a job

3.                  Restaurant

4.                  Life insurance

C.                This can push the high quality goods out of the market, or even close the market entirely.

D.                But the problem can often be solved with warrantees, reputation, or testing.

1.                  Ex: CarMax

E.                 Many economists think adverse selection is a big market failure, above all in insurance markets. But in the absence of regulation, insurance companies have effective ways to deal with it.

F.                 How? Insurers classify people by both personal characteristics (sex, age) and past behavior (accident records, medical history).

G.                In the real world, most insurance regulation focuses on banning the market's solutions to adverse selection problems in order to force equal terms for unequal products.

1.                  Banning pre-existing conditions clauses

2.                  Subsidizing auto insurance for the reckless

H.                 These regulations can easily make the adverse selection problem severe.

V.                 Advantageous Selection

A.                 In recent years, economists have uncovered interesting evidence of advantageous selection. In many cases, people with insurance actually have lower hazard rates than the uninsured.

1.                  Ex: Insured credit cards in the UK

B.                 Simple mechanism: Suppose some people are cautious by nature, so they:

1.                  Take fewer risks.

2.                  Make sure they have lots of insurance.

C.                Then when a firm offers a new policy, the most eager buyers actually have unusually low expected payouts. These low rates encourage marginal buyers to get insurance too.