Chapter 14

Transaction Costs, Imperfect Information, and Market Behavior

The Firm Reduces Transaction CostsThe Firm Reduces Transaction Costs

• Why do firms exist?• Why do people organize in the hierarchical

structure of the firm and coordinate their decisions through a manager rather than simply rely on market exchange?– Organizing activities through the hierarchy of the

firm is usually more efficient than market exchange because production requires the coordination of many transactions among many resources suppliers.

Competitive Firm and InformationCompetitive Firm and Information

• In a competitive firm, all participants in the market know everything they need to about the price and availability of all inputs, outputs, and production process.

• But what about the other firms?– Is this true for monopolistic competition,

oligopolies, and a monopoly.

The Firm Reduces Transaction CostsThe Firm Reduces Transaction Costs

• Firms are superior to markets when production is complicated!

• Using resource markets directly involves:– The cost of determining what inputs are needed and

how they should be combined– The cost of reaching an agreement with each resource

supplier over and above the inputs• The more complicated the task, the greater the

ability to economize on transaction costs through specialization and centralized control.

The Boundaries of the FirmThe Boundaries of the Firm

• Vertical integration is the expansion of a firm into stages of production earlier or later than those in which it specializes.

• Should a manufacturer own its input providers’ companies?– It depends on the benefits and costs of internal

production versus market purchases.– Remember specialization and comparative

advantage

Bounded Rationality of the ManagerBounded Rationality of the Manager

• The notion that there is a limit to the information that a firm’s manager can comprehend and act on.– As the firms takes on more and more functions,

coordination and communication become more difficult.

– Diseconomies of scale can develop

Minimum Efficient ScaleMinimum Efficient Scale

• The minimum rate of output at which economies of scale are fully exploited.– The firm should buy an input if the market price is

below what it would cost the firm to make.

Easily Observable QualityEasily Observable Quality

• If an input is well defined and its quality is easily determined at the time of purchase, that input is more likely to be purchased in the market than produced internally.

• However, sometimes the quality of a certain input can be determined only during production.

Many SuppliersMany Suppliers

• If there are many suppliers of the input, the company is more likely to buy the input than make it. – Dependable supply of resources

The Trend Toward OutsourcingThe Trend Toward Outsourcing

• Outsourcing is when a firm buys inputs from outside suppliers.– Comparative advantage of the good or service

• Core competency is the area of specialty– What the company does best!

Economies of ScopeEconomies of Scope

• Some firms branch into product lines that do not have a vertical relationship– Sara Lee

• Economies of scope exit when it’s cheaper to produce two or more different items in one firm than to produce them in separate firms.– Product and Gamble– Average cost per unit falls as the firm supplies

more types of products (the scope of the firm increases)

Market Behavior with Imperfect Information

Market Behavior with Imperfect Information

• Information is COSTLY for both the consumer and the producer.

• What is the cost to the Consumer?• What is the cost to the Producer?

Marginal Cost and Marginal Benefit of the Search

Marginal Cost and Marginal Benefit of the Search

• As you increase your search, the cost increases– Common knowledge= MC=0

• The marginal benefit from the additional information is a better quality product at a given price or a lower price for a given quality level (it may be less quality).

LO2

Optimal Search with Imperfect Information

If I* Ip0Quantity of

information

Info

rmat

ion

cost

s an

d be

nefit

s (d

olla

rs)

Marginal cost

of information

Marginal benefit

of information

When information is not free, additional information is acquired as long as its marginal benefit exceeds its marginal cost.

Equilibrium, or optimal search, occurs where marginal benefit equals marginal cost.

I* is the optimal quantity of information.

Exhibit 2

Optimal SearchOptimal Search

• As long as the MB> MC of additional information the individual will continue the search.

• The search will continue until MB=MC.– Example

The Winner’s CurseThe Winner’s Curse

• Why do so many “winners” end up losers?– The plight of the winning bidder who

overestimates an asset’s true value.– Paying the price of being overly optimistic.– Applies to all cases where the true value is not

known.

Asymmetric InformationAsymmetric Information

• One side of the market has better information about the product than does the other side.– Health and car insurance

• Two types of information that a market participant may want but lack– Lack information on the product’s characteristics– Lack information on the information about actions

taken by the other party of the transaction

Hidden Characteristics: Adverse Selection

Hidden Characteristics: Adverse Selection

• The “Lemon” Problem– The proportion of good cars on the market will fall

and the proportion of lemons will rise.– When sellers have better information about a

product’s quality than buyers do, lower-quality products dominate the market.

• Adverse Selection– The informed side will self-select, meaning they

decide whether or not to offer the item, i.e. increasing the chances of a lemon.

Hidden Actions: The Principal-Agent Problem

Hidden Actions: The Principal-Agent Problem

• Hidden Actions– One side of the transaction can not observe the

action of the other side.

• The Principal-Agent Problem– Principal: the party that contracts with another

party known as The Agent in the expectation that the agent will act on behalf of the principal.

– Problem: Sometimes the goals of the agent are incompatible with those of the principal and the agent will pursue hidden actions.

Asymmetric Information in Insurance Markets

Asymmetric Information in Insurance Markets

• As a health insurance company, who do you want as a consumer?– The runner or– The TV watcher

• Moral hazard occurs when an individual’s behavior changes in a way that increase the likelihood of an unfavorable outcome.– Bank Bailout

Coping with Asymmetric InformationCoping with Asymmetric Information

• Incentive structure– Warranties

• Information-revealing system– Physical exams

Adverse Selection in Labor MarketsAdverse Selection in Labor Markets

• The higher the wage, the more attractive the job is to more-qualified workers.

• Efficiency wages– Paying above-market wages to attract and retain

more productive workers

Signaling and ScreeningSignaling and Screening

• Signaling is the attempt by the informed side of the market to communicate information that the other side would find valuable– Years of education

• Screening is the attempt by the uninformed side of the market to uncover the relevant but hidden characteristics of the informed party.– Spelling errors in resumes