Information economics

Not to be confused with Information economy.

Information economics or the economics of information is a branch of microeconomic theory that studies how information and information systems affect an economy and economic decisions. Information has special characteristics: It is easy to create but hard to trust. It is easy to spread but hard to control. It influences many decisions. These special characteristics (as compared with other types of goods) complicate many standard economic theories.

The subject of "information economics" is treated under Journal of Economic Literature classification code JEL D8 – Information, Knowledge, and Uncertainty. The present article reflects topics included in that code. There are several subfields of information economics. Information as signal has been described as a kind of negative measure of uncertainty. It includes complete and scientific knowledge as special cases. The first insights in information economics related to the economics of information goods.

In recent decades, there have been influential advances in the study of information asymmetries and their implications for contract theory, including market failure as a possibility.

Information economics is formally related to game theory as two different types of games that may apply, including games with perfect information, complete information, and incomplete information. Experimental and game-theory methods have been developed to model and test theories of information economics, including potential public-policy applications such as mechanism design to elicit information-sharing and otherwise welfare-enhancing behavior.

Value of information

The starting point for economic analysis is the observation that information has economic value because it allows individuals to make choices that yield higher expected payoffs or expected utility than they would obtain from choices made in the absence of information.

Information, the price mechanism and organizations

Much of the literature in information economics was originally inspired by Friedrich Hayek's "The Use of Knowledge in Society" on the uses of the price mechanism in allowing information decentralization to order the effective use of resources. Although Hayek's work was intended to discredit the effectiveness of central planning agencies over a free market system, his proposal that price mechanisms communicate information about scarcity of goods inspired Abba Lerner, Tjalling Koopmans, Leonid Hurwicz, George Stigler and others to further develop the field of information economics. Next to market coordination through the price mechanism, transactions can also be executed within organizations. The information requirements of the transaction are the prime determinant for the actual (mix of) coordination mechanism(s) that we will observe.

Information asymmetry

Information asymmetry means that the parties in the interaction have different information, e.g. one party has more or better information than the other. Expecting the other side to have better information can lead to a change in behavior. The less informed party may try to prevent the other from taking advantage of him. This change in behavior may cause inefficiency. Examples of this problem are adverse selection and moral hazard.

A classic paper on adverse selection is George Akerlof's The Market for Lemons. There are two primary solutions to this problem, signalling and screening.

For moral hazard, contracting between principal and agent may be describable as a second best solution where payoffs alone are observable with information asymmetry.

Signaling

Michael Spence originally proposed the idea of signaling. He proposed that in a situation with information asymmetry, it is possible for people to signal their type, thus believably transferring information to the other party and resolving the asymmetry.

This idea was originally studied in the context of looking for a job. An employer is interested in hiring a new employee who is skilled in learning. Of course, all prospective employees will claim to be skilled at learning, but only they know if they really are. This is an information asymmetry.

Spence proposed that going to college can function as a credible signal of an ability to learn. Assuming that people who are skilled in learning can finish college more easily than people who are unskilled, then by attending college the skilled people signal their skill to prospective employers. This is true even if they didn't learn anything in school, and school was there solely as a signal. This works because the action they took (going to school) was easier for people who possessed the skill that they were trying to signal (a capacity for learning).

Screening

Joseph E. Stiglitz pioneered the theory of screening. In this way the underinformed party can induce the other party to reveal their information. They can provide a menu of choices in such a way that the optimal choice of the other party depends on their private information. By making a particular choice, the other party reveals that he has information that makes that choice optimal. For example, an amusement park wants to sell more expensive tickets to customers who value their time more and money less than other customers. Asking customers their willingness to pay will not work - everyone will claim to have low willingness to pay. But the park can offer a menu of priority and regular tickets, where priority allows skipping the line at rides and is more expensive. This will induce the customers with a higher value of time to buy the priority ticket and thereby reveal their type.

Information goods

Buying and selling information is not the same as buying and selling most other goods. There are three factors that make the economics of buying and selling information different from solid goods:

First of all, information is non-rivalrous, which means that consuming information does not exclude someone else from also consuming it. A related characteristic that alters information markets is that information has almost zero marginal cost. This means that once the first copy exists, it costs nothing or almost nothing to make a second copy. This makes it easy to sell over and over. However, it makes classic marginal cost pricing completely infeasible.

Second, exclusion is not a natural property of information goods, though it is possible to construct exclusion artificially. However, the nature of information is that if it is known, it is difficult to exclude others from its use. Since information is likely to be both non-rivalrous and non-excludable, it is frequently considered an example of a public good.

Third is that the information market does not exhibit high degrees of transparency. That is, to evaluate the information, the information must be known, so you have to invest in learning it to evaluate it. To evaluate a bit of software you have to learn to use it; to evaluate a movie you have to watch it.

The importance of these properties is explained by De Long and Froomkin in The Next Economy.

Bundling

One method of taking advantage of information goods is bundling. That is the strategy of grouping multiple items together and selling them as a group. Bundling allows sellers to better predict the demand for the bundle. While it is difficult to know which items in the group an individual person wants, they are likely to value some of the items enough to purchase the bundle, even if they don't value any of the items enough to buy it separately. However, this only works when it doesn't cost much to sell extra items in a bundle that are unwanted. Information goods fit this profile since it doesn't cost anything to make extra copies.

More information

In 2001, the Nobel prize in economics was awarded to George Akerlof, Michael Spence, and Joseph E. Stiglitz "for their analyses of markets with asymmetric information."

See also

• Infonomics
• Contract theory
• Adverse selection
• Moral hazard

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• Signaling
• Screening
• Information economy

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• Single crossing condition
• Product bundling
• Game theory

Further reading

• Bakos, Yannis and Brynjolfsson, Erik 2000. "Bundling and Competition on the Internet: Aggregation Strategies for Information Goods" Marketing Science Vol. 19, No. 1 pp. 63–82.
• Bakos, Yannis and Brynjolfsson, Erik 1999. "Bundling Information Goods: Pricing, Profits and Efficiency" Management Science, Vol. 45, No. 12 pp. 1613–1630
• Birchler, Urs, and Monika Bütler, 2007. Information Economics. London, Routledge. ISBN 978-0-415-37346-3. Description and chapter-arrow-page links, pp. vii-xi.
• Brynjolfsson, Erik, and Saunders, Adam, 2009. "Wired for Innovation: How information technology is reshaping the economy", [1], ISBN 0-262-01366-5 ISBN 978-0-262-01366-6
• Douma, Sytse and Hein Schreuder, 2013. "Economic Approaches to Organizations". 5th edition. London: Pearson [2] ISBN 0273735292 • ISBN 9780273735298
• Maasoumi, Esfandiar, 1987. "Information theory," The New Palgrave: A Dictionary of Economics, v. 2, pp. 846–51.
• Mas-Colell, Andreu; Michael D. Whinston, and Jerry R. Green, 1995, Microeconomic Theory. Oxford University Press. Chapters 13 and 14 discuss applications of adverse selection and moral hazard models to contract theory.
• Milgrom, Paul R., 1981. "Good News and Bad News: Representation Theorems and Applications," Bell Journal of Economics, 12(2), pp. 380–391.
• Nelson, Phillip, 1970. "Information and Consumer Behavior," Journal of Political Economy, 78(2), p p. 311–329.
• _____, 1974. "Advertising as Information," Journal of Political Economy, 82(4), pp. 729–754.
• The New Palgrave Dictionary of Economics, 2008. 2nd Edition, selected entries and abstract links:

"bubbles" by Markus K. Brunnermeier

"information aggregation and prices" by James Jordan.

"information cascades," by Sushil Bikhchandani, David Hirshleifer and Ivo Welch.

"information sharing among firms" by Xavier Vives.

"information technology and the world economy" by Dale W. Jorgenson and Khuong Vu.

"insider trading" by Andrew Metrick.

"learning and information aggregation in networks" by Douglas Gale and Shachar Kariv.

"mechanism design" by Roger B. Myerson.

"revelation principle" by Roger B. Myerson.

"monetary business cycles (imperfect information)" by Christian Hellwig.

"prediction markets" by Justin Wolfers and Eric Zitzewitz.

"social networks in labour markets" by Antoni Calvó-Armengol and Yannis M. Ioannides.

"strategic and extensive form games" by Martin J. Osborne.

• Marilyn M. Parker, Robert J. Benson, H.E. Trainor, 1988, Information Economics: Linking Business Performance to Information Technology, 978-0134645957
• Pissarides, C. A., 2001. "Search, Economics of," International Encyclopedia of the Social & Behavioral Sciences, pp. 13760–13768. Abstract.
• Rothschild, Michael and Joseph Stiglitz, 1976. "Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information," Quarterly Journal of Economics, 90(4), pp. 629–649.
• Shapiro, Carl, and Hal R. Varian, 1999. Information Rules: A Strategic Guide to the Network Economy. Harvard University Press. Description and scroll to chapter-preview links.
• Stigler, George J., 1961. “The Economics of Information,” Journal of Political Economy, 69(3), pp. 213–225.
• Stiglitz, Joseph E. and Andrew Weiss, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, 71(3), pp. 393–410.
• Theil, Henri, 1967. Economics and Information Theory. Amsterdam, North Holland.