Information economics

Information economics

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Encyclopedia
Information economics or the economics of information
is a branch of microeconomic theory
Microeconomics
Microeconomics is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources. Typically, it applies to markets where goods or services are being bought and sold...

 that studies how information affects an economy
Economy
An economy consists of the economic system of a country or other area; the labor, capital and land resources; and the manufacturing, trade, distribution, and consumption of goods and services of that area...

 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
Noise (electronics)
Electronic noise is a random fluctuation in an electrical signal, a characteristic of all electronic circuits. Noise generated by electronic devices varies greatly, as it can be produced by several different effects...

 has been described as kind of negative measure
Measurement uncertainty
In metrology, measurement uncertainty is a non-negative parameter characterizing the dispersion of the values attributed to a measured quantity. The uncertainty has a probabilistic basis and reflects incomplete knowledge of the quantity. All measurements are subject to uncertainty and a measured...

 of uncertainty
Uncertainty
Uncertainty is a term used in subtly different ways in a number of fields, including physics, philosophy, statistics, economics, finance, insurance, psychology, sociology, engineering, and information science...

 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
Information asymmetry
In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry, a kind of market failure...

 and their implications for contract theory
Contract theory
In economics, contract theory studies how economic actors can and do construct contractual arrangements, generally in the presence of asymmetric information. Because of its connections with both agency and incentives, contract theory is often categorized within a field known as Law and economics...

, including market failure
Market failure
Market failure is a concept within economic theory wherein the allocation of goods and services by a free market is not efficient. That is, there exists another conceivable outcome where a market participant may be made better-off without making someone else worse-off...

 as a possibility.

Information economics is formally related to game theory
Game theory
Game theory is a mathematical method for analyzing calculated circumstances, such as in games, where a person’s success is based upon the choices of others...

 as to different types of games that may apply, including games with perfect information
Perfect information
In game theory, perfect information describes the situation when a player has available the same information to determine all of the possible games as would be available at the end of the game....

, complete information
Complete information
Complete information is a term used in economics and game theory to describe an economic situation or game in which knowledge about other market participants or players is available to all participants. Every player knows the payoffs and strategies available to other players.Complete information...

, and incomplete information. Experimental
Experimental economics
Experimental economics is the application of experimental methods to study economic questions. Data collected in experiments are used to estimate effect size, test the validity of economic theories, and illuminate market mechanisms. Economic experiments usually use cash to motivate subjects, in...

 and game-theory methods have been developed to model and test theories of information economics, including potential public-policy
Public policy
Public policy as government action is generally the principled guide to action taken by the administrative or executive branches of the state with regard to a class of issues in a manner consistent with law and institutional customs. In general, the foundation is the pertinent national and...

 applications such as mechanism design
Mechanism design
Mechanism design is a field in game theory studying solution concepts for a class of private information games...

 to elicit information-sharing and otherwise welfare
Welfare economics
Welfare economics is a branch of economics that uses microeconomic techniques to evaluate economic well-being, especially relative to competitive general equilibrium within an economy as to economic efficiency and the resulting income distribution associated with it...

-enhancing behavior.

Value of information


The starting point for economic analysis is the observation that information has economic value
Value of information
Value of information is the amount a decision maker would be willing to pay for information prior to making a decision.-Similar terms:...

 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 and the price mechanism


Much of the literature in information economics was originally inspired by Friedrich Hayek
Friedrich Hayek
Friedrich August Hayek CH , born in Austria-Hungary as Friedrich August von Hayek, was an economist and philosopher best known for his defense of classical liberalism and free-market capitalism against socialist and collectivist thought...

's "The Use of Knowledge in Society
The Use of Knowledge in Society
"The Use of Knowledge in Society" is a scholarly article written by economist Friedrich Hayek, first published in the September 1945 issue of The American Economic Review Written as a rebuttal to fellow economist Oskar R...

" 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
Tjalling Koopmans
Tjalling Charles Koopmans was the joint winner, with Leonid Kantorovich, of the 1975 Nobel Memorial Prize in Economic Sciences....

, Leonid Hurwicz
Leonid Hurwicz
Leonid "Leo" Hurwicz was a Russian-born American economist and mathematician. His nationality of origin was Polish. He was Jewish. He originated incentive compatibility and mechanism design, which show how desired outcomes are achieved in economics, social science and political science...

, George Stigler
George Stigler
George Joseph Stigler was a U.S. economist. He won the Nobel Memorial Prize in Economic Sciences in 1982, and was a key leader of the Chicago School of Economics, along with his close friend Milton Friedman....

 and others to further develop the field of information economics.

Information asymmetry


Information asymmetry
Information asymmetry
In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry, a kind of market failure...

 deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance in power in transactions which can sometimes cause the transactions to go awry. Examples of this problem are adverse selection
Adverse selection
Adverse selection, anti-selection, or negative selection is a term used in economics, insurance, statistics, and risk management. It refers to a market process in which "bad" results occur when buyers and sellers have asymmetric information : the "bad" products or services are more likely to be...

 and moral hazard
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...

.

A classic paper on adverse selection is George Akerlof
George Akerlof
George Arthur Akerlof is an American economist and Koshland Professor of Economics at the University of California, Berkeley. He won the 2001 Nobel Prize in Economics George Arthur Akerlof (born June 17, 1940) is an American economist and Koshland Professor of Economics at the University of...

's The Market for Lemons
The Market for Lemons
"The Market for Lemons: Quality Uncertainty and the Market Mechanism" is a 1970 paper by the economist George Akerlof. It discusses information asymmetry, which occurs when the seller knows more about a product than the buyer. A lemon is an American slang term for a car that is found to be...

. 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 asymmmetry.

Signaling


Michael Spence
Michael Spence
Andrew Michael Spence is an American economist and recipient of the 2001 Nobel Memorial Prize in Economic Sciences, along with George A. Akerlof and Joseph E. Stiglitz, for their work on the dynamics of information flows and market development. He conducted this research while at Harvard University...

 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
Joseph E. Stiglitz
Joseph Eugene Stiglitz, ForMemRS, FBA, is an American economist and a professor at Columbia University. He is a recipient of the Nobel Memorial Prize in Economic Sciences and the John Bates Clark Medal . He is also the former Senior Vice President and Chief Economist of the World Bank...

 pioneered the theory of screening
Screening (economics)
Screening in economics refers to a strategy of combating adverse selection, one of the potential decision-making complications in cases of asymmetric information...

. 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 choice depends on the private information of the other party.

Information goods


Buying and selling information is not the same as buying and selling most other 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
Marginal cost
In economics and finance, marginal cost is the change in total cost that arises when the quantity produced changes by one unit. That is, it is the cost of producing one more unit of a good...

. 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
Public good
In economics, a public good is a good that is non-rival and non-excludable. Non-rivalry means that consumption of the good by one individual does not reduce availability of the good for consumption by others; and non-excludability means that no one can be effectively excluded from using the 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 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
George Akerlof
George Arthur Akerlof is an American economist and Koshland Professor of Economics at the University of California, Berkeley. He won the 2001 Nobel Prize in Economics George Arthur Akerlof (born June 17, 1940) is an American economist and Koshland Professor of Economics at the University of...

, Michael Spence
Michael Spence
Andrew Michael Spence is an American economist and recipient of the 2001 Nobel Memorial Prize in Economic Sciences, along with George A. Akerlof and Joseph E. Stiglitz, for their work on the dynamics of information flows and market development. He conducted this research while at Harvard University...

, and Joseph E. Stiglitz
Joseph E. Stiglitz
Joseph Eugene Stiglitz, ForMemRS, FBA, is an American economist and a professor at Columbia University. He is a recipient of the Nobel Memorial Prize in Economic Sciences and the John Bates Clark Medal . He is also the former Senior Vice President and Chief Economist of the World Bank...

 "for their analyses of markets with asymmetric information."

See also


  • Contract theory
    Contract theory
    In economics, contract theory studies how economic actors can and do construct contractual arrangements, generally in the presence of asymmetric information. Because of its connections with both agency and incentives, contract theory is often categorized within a field known as Law and economics...

  • Adverse selection
    Adverse selection
    Adverse selection, anti-selection, or negative selection is a term used in economics, insurance, statistics, and risk management. It refers to a market process in which "bad" results occur when buyers and sellers have asymmetric information : the "bad" products or services are more likely to be...

  • Moral hazard
    Moral hazard
    In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...


  • Signaling
  • Screening
    Screening (economics)
    Screening in economics refers to a strategy of combating adverse selection, one of the potential decision-making complications in cases of asymmetric information...

  • Information economy
    Information economy
    Information economy is a term that characterizes an economy with an increased emphasis on informational activities and information industry.The vagueness of the term has three major sources...


  • Single crossing condition
    Single crossing condition
    In economics, the single-crossing condition or single-crossing property refers to how the probability distribution of outcomes changes as a function of an input and a parameter....

  • Product bundling
    Product bundling
    Product bundling is a marketing strategy that involves offering several products for sale as one combined product. This strategy is very common in the software business , in the cable television industry Product bundling is a marketing strategy that involves offering several products for sale as...

  • Game theory
    Game theory
    Game theory is a mathematical method for analyzing calculated circumstances, such as in games, where a person’s success is based upon the choices of others...