Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Managerial Economics &
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
? 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
? 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,
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
? 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
? 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,
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