Economics of Information (ECON3016) Presentation and introduction

    Lecturer: Dr. Marcos Vera Hernández Office: Drayton House, 203 Office hours: Note: My office hours are for the purpose of addressing questions relating to the course. I will not deal with those over email.

Why is Economics of Information (E.I.) an important branch of economics?

  Standard economic theory assumes that firms and consumers are fully informed about the commodities that they trade.

However this is not always realistic for some markets. Some examples…

Why is (E.I.) an important branch of Economics?

   Medical services: A doctor knows more about medical services than does the patient.

Insurance: An insurance buyer knows more about his riskiness than does the insurance company. Used cars: The owner of a used car knows more about it than does a potential buyer.

Why is (E.I.) an important branch of Economics?

  Markets in which one or both sides are imperfectly informed are markets with imperfect information .

Imperfectly informed markets in which with one side is better informed than the other are markets with Asymmetric Information (AI) .

Why is (E.I.) an important branch of Economics?

    The First Theorem of Welfare Economics (studied in Microeconomics ECON2001) proved that under some assumptions, the market leads to an efficient solution Symmetry of information is one of those assumptions The market does not necessarily lead to an efficient solution when information is asymmetric AI. is a market failure. It might justify policy intervention, e.g. compulsory car insurance.

Why is (E.I.) an important branch of Economics?

 When AI is present, if participants have opposing objectives, it is natural to think that:  The more informed party will act in a way so as to benefit from her informational advantage   The less informed party will also act in a way so as to overcome her informational disadvantage These actions will have implications for the contracts that they agree to sign   This will have consequences on the efficiency and existence of the market The existence of markets and their efficiency are important topics in economics

Other terms for EI?

 You might also hear EI being referred to as:  Contract Theory  Agency Theory

What does EI study?

  EI studies the types of contracts that will emerge in equilibrium in relationships (markets, contracts) in which:  one party has more information than another over at least one variable that influences how much they value their mutual relationship (profits, utility)  Consumer knows more about their health risk than the medical insurance company  The participants in the relationship have opposing objectives  If ill, the insured consumer would like to go to the best hospitals, receive the best treatments etc.; insurance company on the other hand would like to minimize payments EI also studies the implications that the information asymmetry has on the efficiency of the relationship and the existence of the market

What does EI study?

  Many managers are paid according to their firm’s profits. This is their remuneration contract. We will see that AI can explain why contracts with variable payments are used.

When renting a car, one can choose to pay the standard insurance premium and be liable for the first £600 in case of damage to the car or to pay a higher premium and be liable for 0 (fully insured). We will see that AI can explain why insurance companies offer not just one but several contracts.

Is AI important in Economics?

    Information Asymmetry is likely to be an important feature in many markets and fields: labour, health, insurance, agriculture, quality of goods, regulation… Possibly the area of economic theory that has evolved most over the past 20 years 2001 Nobel prize in Economics was awarded to Professors Akerlof, Spence, and Stiglitz for their analyses of markets with asymmetric information See: this link

Syllabus: Parts 1 to 8

     Part 1. Presentation and overview (this one) Part 2. Review of decision theory under uncertainty (Read your microeconomics book from last year) Part 3-7. Theory of EI. Most relevant book: Macho Stadler, I. and Pérez-Castrillo, J.D. “An Introduction to the Economics of Information. Incentives and Contracts”. Oxford University Press. 2001. Second edition.

The book includes solutions to many exercises Part 8. The empirical relevance of incentives and asymmetric information: development, insurance, and health economics. The reading list for this part might change.