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Chapter- 3 The Role of Information in an Economy

Chapter- 3 The Role of Information in an Economy. Transaction Costs and Information Costs. Those costs associated with bringing buyers and sellers together. Travel cost Negotiation cost Property rights enforcement cost Cost of acquiring information. Transaction Costs and Information Costs.

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Chapter- 3 The Role of Information in an Economy

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  1. Chapter- 3The Role of Information in an Economy Baikuntha Sigdel

  2. Transaction Costs and Information Costs. • Those costs associated with bringing buyers and sellers together. • Travel cost • Negotiation cost • Property rights enforcement cost • Cost of acquiring information Baikuntha Sigdel

  3. Transaction Costs and Information Costs. • Uncertainty about current or future prices and product quality. • Costs of acquiring information on prices, product qualities, and product performance. • Telephone, shopping, checking credentials, inspecting goods, monitoring honesty, placing ads, consumers reports etc. Baikuntha Sigdel

  4. Transaction Costs and Information Costs. • Limited capacity to acquire, process, store and retrieve facts and figures about prices, qualities and location of products. • Internet • Reduced information cost Baikuntha Sigdel

  5. Transaction Costs and Information Costs. • TC are affected by IC. • Economic transactions cannot take place without information about buyer and seller. • Microprocessor • If information cost were zero, the billions made by BG would have been spread over millions of people. Baikuntha Sigdel

  6. Transaction Costs and Information Costs. • Each individual has unique information of which beneficial use might be made. • Information is typically a scare and valuable commodity. Baikuntha Sigdel

  7. The Economy of Search • All buyers pay the same price for same product: competitive market. • Prices of homogenous goods differ from store to store. • Transaction costs of going to cheapest store may exceed the advantage of lower price. Baikuntha Sigdel

  8. The Economy of Search • Same good in a different location is considered a different product. • Information gathering and price dispersion • Optimal search rule Baikuntha Sigdel

  9. Optimal search rule • People will continue to acquire economic information as long as the marginal benefits of gathering information exceed the marginal costs. Baikuntha Sigdel

  10. Marginal Benefits of search Benefits and Costs of search (Rs. Per visit) Marginal Cost of search Reservation Price 4 5 6 Lowest Price Sampled (Rs) Optimal search rule Baikuntha Sigdel

  11. Reservation Price • Is the highest price at which the consumer will buy a product. Although the consumer will buy any product with a lower price than it, s/he will continue to search for lower price only if lower price found exceed the reservation price. Baikuntha Sigdel

  12. Reservation Price • It occurs at a sampled price at which the marginal benefit of search equals the marginal cost of search. • Information cost can be minimized by • Consumer unions • governments Baikuntha Sigdel

  13. Information Problems • Governed by contracts e.g. insurance contracts. • The moral hazard problem • The adverse selection problem Baikuntha Sigdel

  14. The Moral Hazard problem • Exists when one of the parties to a contract has an incentive to alter his or her behavior after the contract is made at the expense of the second party. • Too costly to acquire information about others post contractual behavior. Baikuntha Sigdel

  15. The Moral Hazard problem • E.g. car: first four years or 50,000 kms • Smoking • Automobile insurance for collision • Life insurance Baikuntha Sigdel

  16. The Adverse Selection problem • Occurs prior to making of the contract. • When a buyer or seller enters a disadvantageous contract on the basis of incomplete or inaccurate information. • Not knowing the real intension of other party. Baikuntha Sigdel

  17. The role of intermediaries • Exchange opportunities between Buyers and Sellers. • Variety and qualities of different products. • Channels of marketing distribution for produced goods. Baikuntha Sigdel

  18. The role of intermediaries • Intermediaries buy in order to sell again or simply bring together a buyer and seller. • Real state broker, grocery stores, used car dealers, auctioneers, stockbrokers. • Mediate • Misunderstood Baikuntha Sigdel

  19. The role of intermediaries • Is to certify the quality of goods. • Fee depends on the • amount of competition • on the degree of freedom of entry into the business • Opportunity costs of bringing goods to the market. Baikuntha Sigdel

  20. Speculation and Risk Bearing • Changes in market conditions- imp • Speculators are those who buy or sell in the hope of profiting from market fluctuations. • Profit from misfortunes of others. • Perform useful economic function: engaging in Arbitrage through time. Baikuntha Sigdel

  21. Speculation and Risk Bearing • Arbitrage is buying in a market where a commodity is cheap and reselling in a market where a commodity is more expensive. • Arbitrageur buys in one location and sells in other. • Speculator buys at one time and resells at another time (Risky) Baikuntha Sigdel

  22. Speculation and Risk Bearing • Speculator is performing the economic function of sharing in the risky activities of producers and consumers. • Profitable Speculation • Unprofitable Speculation Baikuntha Sigdel

  23. Profitable Speculation • Many Speculator: low price goes high and vice versa. • Stabilizes prices and consumption over time by reducing fluctuation in prices and consumptions over time. • Buying low and selling high. Baikuntha Sigdel

  24. Supply with S2 Speculation Supply with S1 Speculation b 5 4 3 2 1 5 4 3 2 1 e e Price (Rs. per kilos) Price (Rs. per kilos) a Demand Demand 1 2 3 4 1 2 3 4 Quantity (Millions of Kgs) Period 1 Quantity (Millions of Kgs) Period 2 Profitable Speculation Baikuntha Sigdel

  25. Profitable Speculation • Shifts supplies from periods when supplies are relatively abundant and prices potentially low at periods when supplies are relatively scarce and prices potentially high. • Provides the valuable economic service of stabilizing prices and consumption over time. Baikuntha Sigdel

  26. Unprofitable Speculation • Destabilizes prices and consumption over time. • Is inefficiently for the economy as a whole. • Creates artificial scarcity in some periods and artificial abundance in other periods. • Can be costly to society. Baikuntha Sigdel

  27. Supply with S1= S2 Speculation Supply with S1= S2 Speculation 6 5 4 3 2 1 a 6 5 4 3 2 1 Price (Rs. per kilos) Price (Rs. per kilos) e e b Demand Demand 1 2 3 4 5 1 2 3 4 5 6 Quantity (Millions of Kgs) Period 1 Quantity (Millions of Kgs) Period 2 Unprofitable Speculation Baikuntha Sigdel

  28. The Futures Market • Is an organized market in which buyers and sellers agree now on the price of a commodity to be delivered at some specified date in the future. • Speculation has led to the development of future market. Baikuntha Sigdel

  29. The Spot Market • Good is purchase today for immediate delivery. • Arrangement between buyers and sellers are made now for payment and delivery of the product now. Baikuntha Sigdel

  30. The Future Market • Seller: is in short position : being sold that is not owned • Buyer: is in long position: claim on a good is being acquired. • Put up a cash- Margin Requirement: equal to a small percentage of the value of the contracts. Baikuntha Sigdel

  31. The Mechanics of Future Trading • Topsy-turvy world. • Traders can sell something before they buy it. • Future price, future date • Offsetting transaction • Seller: buying another future contract with the same date. • Buyer: selling another future contract with the same delivery date Baikuntha Sigdel

  32. The Mechanics of Future Trading • Topsy-turvy world. • Traders can sell something before they buy it. • Future price, future date • Offsetting transaction • Seller: buying another future contract with the same date. • Buyer: selling another future contract with the same delivery date • Example Baikuntha Sigdel

  33. Hedging • Is a temporary substitution of a future market transaction for an intended spot transaction. • H and S play highly complimentary roles in the economy. • H are interested in storing commodities to minimize risks of price fluctuation. Baikuntha Sigdel

  34. Information and Speculation in the Future Market. Baikuntha Sigdel

  35. Reference • Carl Shapiro and Hal R. Varian. Information Rules: A Strategic Guide for the Network Economy. Harvard Business School Press, Cambridge, MA, 1998. www.inforules.com • Roy J Ruffin and Paul R. Gregory. Principles of economics. 7th edition. Adision Wiley Publication. 2000. • Ines Macho-Stadler and J. David Perez-Castrillo. An introduction to the Economics of Information: Incentives and Contracts. 2nd edition. Oxford University Press Baikuntha Sigdel

  36. Questions • What are the transaction costs of selling a home? What effect do real estate brokers have on these costs? • If search costs in a market are zero and the market is competitively organized, what predication can we make about price in this market? Baikuntha Sigdel

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