Chapter 12: The Economics of Information
Mean (expected value) – The sum of the probabilities that different outcomes will occur
multiplied by the resulting payoffs.
, where
Variance – The sum of the probabilities that different outcomes will occur multiplied by the
squared deviations from the mean of the random variable.
Standard deviation – The square root of the variance.
Uncertainty and Consumer behavior.
Uncertainty affects economic decisions of both consumers and managers.
Risk Averse – Preferring a sure amount of $M to a risky prospect with an expected value of $M.
Risk Loving – Preferring a risky prospect with an expected value of $M to a sure amount of $M.
Risk Neutral – Indifferent between a risky prospect with an expected value of $M and a sure
amount of $M.
Managerial decisions with Risk-averse Consumers
For gambles with nontrivial outcomes, most individuals are risk averse.
Product Quality
Two tactics to induce risk-averse consumers to try a new product:
Lower price. Example: giving out free samples.
, Make it look like the quality of the new product is better (comparative advertising).
Chain Stores
The key thing to notice is that even if local stores offer a better product than the national chain,
the national chain can remain in business if the number of out-of-town customers is large
enough.
Insurance
The fact that consumers are risk averse implies that they are willing to pay to avoid risk.
Consumer Search
The analysis of consumers is different if the consumers do not know the prices charged by
different firms for the same product.
Free recall – The consumer is free to return to the store at any time to purchase a certain good
for a certain price. The consumer should search for a lower price as long as the expected benefits
are greater than the cost of an additional search.
Replacement – the distribution of prices charged by other firms does not change just because the
consumer has learned that one store charges certain price for a certain product.
Reservation price – The price at which a consumer is indifferent between purchasing at that
price and searching for a lower price. If is the expected benefit of searching for a price lower
than p, and c represents the cost per search, the reservation price satisfies the condition:
The Consumer’s Search Rule
The optimal search rule is such that the consumer rejects prices above the reservation price (R)
and accepts prices below the reservation price. Stated differently, the optimal search strategy is
to search for a better price when the price charged by a firm is above the reservation price and
stop searching when a price below the reservation price is found.
Mean (expected value) – The sum of the probabilities that different outcomes will occur
multiplied by the resulting payoffs.
, where
Variance – The sum of the probabilities that different outcomes will occur multiplied by the
squared deviations from the mean of the random variable.
Standard deviation – The square root of the variance.
Uncertainty and Consumer behavior.
Uncertainty affects economic decisions of both consumers and managers.
Risk Averse – Preferring a sure amount of $M to a risky prospect with an expected value of $M.
Risk Loving – Preferring a risky prospect with an expected value of $M to a sure amount of $M.
Risk Neutral – Indifferent between a risky prospect with an expected value of $M and a sure
amount of $M.
Managerial decisions with Risk-averse Consumers
For gambles with nontrivial outcomes, most individuals are risk averse.
Product Quality
Two tactics to induce risk-averse consumers to try a new product:
Lower price. Example: giving out free samples.
, Make it look like the quality of the new product is better (comparative advertising).
Chain Stores
The key thing to notice is that even if local stores offer a better product than the national chain,
the national chain can remain in business if the number of out-of-town customers is large
enough.
Insurance
The fact that consumers are risk averse implies that they are willing to pay to avoid risk.
Consumer Search
The analysis of consumers is different if the consumers do not know the prices charged by
different firms for the same product.
Free recall – The consumer is free to return to the store at any time to purchase a certain good
for a certain price. The consumer should search for a lower price as long as the expected benefits
are greater than the cost of an additional search.
Replacement – the distribution of prices charged by other firms does not change just because the
consumer has learned that one store charges certain price for a certain product.
Reservation price – The price at which a consumer is indifferent between purchasing at that
price and searching for a lower price. If is the expected benefit of searching for a price lower
than p, and c represents the cost per search, the reservation price satisfies the condition:
The Consumer’s Search Rule
The optimal search rule is such that the consumer rejects prices above the reservation price (R)
and accepts prices below the reservation price. Stated differently, the optimal search strategy is
to search for a better price when the price charged by a firm is above the reservation price and
stop searching when a price below the reservation price is found.
