Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Managerial Economics &
Business Strategy
Chapter 12
The Economics of Information
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Overview
I,The Mean and the Variance
II,Uncertainty and Consumer Behavior
III,Uncertainty and the Firm
IV,Uncertainty and the Market
V,Auctions
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
The Mean
? The expected value or average of a random variable
? Computed as the sum of the probabilities that different
outcomes will occur multiplied by the resulting payoffs,
E[x] = q1 x1 + q2 x2 +…+qn xn,
where xi is payoff i,qi is the probability that payoff i
occurs,and q1 + q2 +…+qn = 1,
? The mean provides information about the average value of
a random variable but yields no information about the
degree of risk associated with the random variable,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
The Variance & Standard
Deviation
Variance
? A measure of risk,
? The sum of the probabilities that different
outcomes will occur multiplied by the squared
deviations from the mean of the random variable,
s2 = q1 (x1- E[x])2 + q2 (x2- E[x])2 +…+q n(xn- E[x])2
Standard Deviation
? The square root of the variance,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Uncertainty and Consumer
Behavior
Risk Aversion
? Risk Averse,An individual who prefers a sure amount of
$M to a risky prospect with an expected value,E[x],of
$M,
? Risk Loving,An individual who prefers a risky prospect
with an expected value,E[x],of $M to a sure amount of
$M,
? Risk Neutral,An individual who is indifferent between a
risky prospect where E[x] = $M and a sure amount of $M,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Examples of How Risk
Aversion Influences Decisions
? Product quality
? Informative advertising
? Free samples
? Guarantees
? Chain stores
? Insurance
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Consumer Search
The Optimal
Search Strategy,
c c
EB
Reservation
Price
Accept Reject R
$
P 0
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Consumer Search
c c
EB
R
$
P 0
An increase in
search costs
raises the
reservation
price,
R*
c* c*
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Uncertainty and the Firm
? Risk Aversion
? Are managers risk averse or risk neutral?
? Diversification
?,Don’t put all your eggs in one basket”
? Profit Maximization
? When demand is uncertain,expected profits are
maximized at the point where expected marginal
revenue equals marginal cost,E[MR] = MC
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Asymmetric Information
? Situation that exists when some people have
better information than others,
? Example,Insider trading
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Two Types of Asymmetric
Information
? Hidden characteristics
? Things one party to a transaction knows about itself,
but which are unknown by the other party,
? Hidden actions
? Actions taken by one party in a relationship that cannot
be observed by the other party,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Adverse Selection
? Situation where individuals have hidden
characteristics and in which a selection
process results in a pool of individuals with
undesirable characteristics,
? Examples
? Choice of medical plans
? High-interest loans
? Auto insurance for drivers with bad records
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Moral Hazard
? Situation where one party to a contract takes
a hidden action that benefits him or her at
the expense of another party,
? Examples
? The principal-agent problem
? Care taken with rental cars
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Possible Solutions
1,Signaling
? Attempt by an informed party to send an observable
indicator of his or her hidden characteristics to an
uninformed party,
? To work,the signal must not be easily mimicked by
other types,
? Example,Education
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Possible Solutions
2,Screening
? Attempt by an uninformed party to sort individuals
according to their characteristics,
? Often accomplished through a self-selection device
? A mechanism in which informed parties are presented
with a set of options,and the options they choose reveals
their hidden characteristics to an uninformed party,
? Example,Price discrimination
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Auctions
? Uses
? Major types of Auction
? English
? First-price,sealed-bid
? Second-price,sealed-bid
? Dutch
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
English Auction
? An ascending sequential
bid auction,
? Bidders observe the bids
of others and decide
whether or not to increase
the bid,
? The item is sold to the
highest bidder,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
First-Price,Sealed-bid
? An auction whereby
bidders simultaneously
submit bids on pieces of
paper,
? The item goes to the
highest bidder,
? Bidders do not know the
bids of other players,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Second Price,Sealed-bid
? The same bidding process
as a first price auction,
? However,the high bidder
pays the amount bid by the
2nd highest bidder,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Dutch Auction
? A descending price
auction,
? The auctioneer begins
with a high asking price,
? The bid decreases until
one bidder is willing to
pay the quoted price,
? Strategically equivalent
to a first-price auction
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Information Structures
? Independent private values
? Bidders know their own valuation of the item,but not other
bidders’ valuations
? Bidders’ valuations do not depend on those of other bidders
? Affiliated (or correlated) value estimates
? Bidders do not know their own valuation of the item or the
valuations of others
? Bidders use their own information to form a value estimate
? Value estimates are affiliated,the higher a bidder’s estimate,the
more likely it is that other bidders also have high value estimates,
? Common values is the special case in which the true (but
unknown) value of the item is the same for all bidders
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Optimal Bidding Strategy in an
English Auction
? With independent private valuations,the
optimal strategy is to remain active until the
price exceeds your own valuation of the
object,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Optimal Bidding Strategy in a
Second-Price Sealed-Bid Auction
? The optimal strategy is to bid your own
valuation of the item,
? This is a dominant strategy,
? You don’t pay your own bid,so bidding less than your
value only increases the chance that you don’t win,
? If you bid more than your valuation,you risk buying
the item for more than it is worth to you,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Optimal Bidding Strategy in a
First-Price,Sealed-Bid Auction
? If there are n bidders who all perceive
valuations to be evenly (or uniformly)
distributed between a lowest possible valuation
of L and a highest possible valuation of H,then
the optimal bid for a risk-neutral player whose
own valuation is v is
b v
v L
n
= ?
?
.
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Example
? Two bidders with independent private
valuations (n = 2)
? Lowest perceived valuation is unity (L = 1)
? Optimal bid for a player whose valuation is
two (v = 2) is given by
b v v an= ? ? = ? ? =2 2 12 50$1,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Optimal Bidding Strategies
with Affiliated Value Estimates
? Difficult to describe because
? Bidders do not know their own valuations of the item,
let alone the valuations others,
? The auction process itself may reveal information about
how much the other bidders value the object,
? Optimal bidding requires that players use
any information gained during the auction
to update their own value estimates,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
The Winner’s Curse
? In a common-values auction,the winner is
the bidder who is the most optimistic about
the true value of the item,
? To avoid the winner's curse,a bidder should
revise downward his or her private estimate
of the value to account for this fact,
? The winner’s curse is most pronounced in
sealed-bid auctions,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Expected Revenues in Auctions
with Risk Neutral Bidders
? Independent Private Values
? English = Second Price = First Price = Dutch
? Affiliated Value Estimates
? English > Second Price > First Price = Dutch
? Bids are more closely linked to other players
information,which mitigates players’ concerns about
the winner’s curse,
Managerial Economics &
Business Strategy
Chapter 12
The Economics of Information
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Overview
I,The Mean and the Variance
II,Uncertainty and Consumer Behavior
III,Uncertainty and the Firm
IV,Uncertainty and the Market
V,Auctions
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
The Mean
? The expected value or average of a random variable
? Computed as the sum of the probabilities that different
outcomes will occur multiplied by the resulting payoffs,
E[x] = q1 x1 + q2 x2 +…+qn xn,
where xi is payoff i,qi is the probability that payoff i
occurs,and q1 + q2 +…+qn = 1,
? The mean provides information about the average value of
a random variable but yields no information about the
degree of risk associated with the random variable,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
The Variance & Standard
Deviation
Variance
? A measure of risk,
? The sum of the probabilities that different
outcomes will occur multiplied by the squared
deviations from the mean of the random variable,
s2 = q1 (x1- E[x])2 + q2 (x2- E[x])2 +…+q n(xn- E[x])2
Standard Deviation
? The square root of the variance,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Uncertainty and Consumer
Behavior
Risk Aversion
? Risk Averse,An individual who prefers a sure amount of
$M to a risky prospect with an expected value,E[x],of
$M,
? Risk Loving,An individual who prefers a risky prospect
with an expected value,E[x],of $M to a sure amount of
$M,
? Risk Neutral,An individual who is indifferent between a
risky prospect where E[x] = $M and a sure amount of $M,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Examples of How Risk
Aversion Influences Decisions
? Product quality
? Informative advertising
? Free samples
? Guarantees
? Chain stores
? Insurance
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Consumer Search
The Optimal
Search Strategy,
c c
EB
Reservation
Price
Accept Reject R
$
P 0
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Consumer Search
c c
EB
R
$
P 0
An increase in
search costs
raises the
reservation
price,
R*
c* c*
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Uncertainty and the Firm
? Risk Aversion
? Are managers risk averse or risk neutral?
? Diversification
?,Don’t put all your eggs in one basket”
? Profit Maximization
? When demand is uncertain,expected profits are
maximized at the point where expected marginal
revenue equals marginal cost,E[MR] = MC
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Asymmetric Information
? Situation that exists when some people have
better information than others,
? Example,Insider trading
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Two Types of Asymmetric
Information
? Hidden characteristics
? Things one party to a transaction knows about itself,
but which are unknown by the other party,
? Hidden actions
? Actions taken by one party in a relationship that cannot
be observed by the other party,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Adverse Selection
? Situation where individuals have hidden
characteristics and in which a selection
process results in a pool of individuals with
undesirable characteristics,
? Examples
? Choice of medical plans
? High-interest loans
? Auto insurance for drivers with bad records
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Moral Hazard
? Situation where one party to a contract takes
a hidden action that benefits him or her at
the expense of another party,
? Examples
? The principal-agent problem
? Care taken with rental cars
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Possible Solutions
1,Signaling
? Attempt by an informed party to send an observable
indicator of his or her hidden characteristics to an
uninformed party,
? To work,the signal must not be easily mimicked by
other types,
? Example,Education
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Possible Solutions
2,Screening
? Attempt by an uninformed party to sort individuals
according to their characteristics,
? Often accomplished through a self-selection device
? A mechanism in which informed parties are presented
with a set of options,and the options they choose reveals
their hidden characteristics to an uninformed party,
? Example,Price discrimination
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Auctions
? Uses
? Major types of Auction
? English
? First-price,sealed-bid
? Second-price,sealed-bid
? Dutch
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
English Auction
? An ascending sequential
bid auction,
? Bidders observe the bids
of others and decide
whether or not to increase
the bid,
? The item is sold to the
highest bidder,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
First-Price,Sealed-bid
? An auction whereby
bidders simultaneously
submit bids on pieces of
paper,
? The item goes to the
highest bidder,
? Bidders do not know the
bids of other players,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Second Price,Sealed-bid
? The same bidding process
as a first price auction,
? However,the high bidder
pays the amount bid by the
2nd highest bidder,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Dutch Auction
? A descending price
auction,
? The auctioneer begins
with a high asking price,
? The bid decreases until
one bidder is willing to
pay the quoted price,
? Strategically equivalent
to a first-price auction
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Information Structures
? Independent private values
? Bidders know their own valuation of the item,but not other
bidders’ valuations
? Bidders’ valuations do not depend on those of other bidders
? Affiliated (or correlated) value estimates
? Bidders do not know their own valuation of the item or the
valuations of others
? Bidders use their own information to form a value estimate
? Value estimates are affiliated,the higher a bidder’s estimate,the
more likely it is that other bidders also have high value estimates,
? Common values is the special case in which the true (but
unknown) value of the item is the same for all bidders
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Optimal Bidding Strategy in an
English Auction
? With independent private valuations,the
optimal strategy is to remain active until the
price exceeds your own valuation of the
object,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Optimal Bidding Strategy in a
Second-Price Sealed-Bid Auction
? The optimal strategy is to bid your own
valuation of the item,
? This is a dominant strategy,
? You don’t pay your own bid,so bidding less than your
value only increases the chance that you don’t win,
? If you bid more than your valuation,you risk buying
the item for more than it is worth to you,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Optimal Bidding Strategy in a
First-Price,Sealed-Bid Auction
? If there are n bidders who all perceive
valuations to be evenly (or uniformly)
distributed between a lowest possible valuation
of L and a highest possible valuation of H,then
the optimal bid for a risk-neutral player whose
own valuation is v is
b v
v L
n
= ?
?
.
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Example
? Two bidders with independent private
valuations (n = 2)
? Lowest perceived valuation is unity (L = 1)
? Optimal bid for a player whose valuation is
two (v = 2) is given by
b v v an= ? ? = ? ? =2 2 12 50$1,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Optimal Bidding Strategies
with Affiliated Value Estimates
? Difficult to describe because
? Bidders do not know their own valuations of the item,
let alone the valuations others,
? The auction process itself may reveal information about
how much the other bidders value the object,
? Optimal bidding requires that players use
any information gained during the auction
to update their own value estimates,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
The Winner’s Curse
? In a common-values auction,the winner is
the bidder who is the most optimistic about
the true value of the item,
? To avoid the winner's curse,a bidder should
revise downward his or her private estimate
of the value to account for this fact,
? The winner’s curse is most pronounced in
sealed-bid auctions,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Expected Revenues in Auctions
with Risk Neutral Bidders
? Independent Private Values
? English = Second Price = First Price = Dutch
? Affiliated Value Estimates
? English > Second Price > First Price = Dutch
? Bids are more closely linked to other players
information,which mitigates players’ concerns about
the winner’s curse,
