Transaction costs and Information costs
- It is costly to bring buyers and sellers The costs associated with making exchange possible are transaction costs such as travel cost, negotiation cost, and property rights enforcement cost, and the cost of acquiring information.
- Transaction costs are costs of bringing buyers and sellers together.
- In real world markets-even those that are highly competitive- there is considerable uncertainty about current or future prices and even about product If such information were available instantaneously at no cost of time or money, such information typically does have its costs, and information costs have a substantial effect on real- world markets.
- Information costs are cost of acquiring information on prices, product qualities and product performances.
- Information costs include the costs of telephone, shopping, checking credentials, inspecting goods, monitoring the honesty of workers or customers, placing ads, and reading ads and consumer reports in order to acquire more economic information.
- Information is costly because we have limited capacity to acquire, process, store and retrieve facts and figures about prices, qualities and location of products.
- Information is distributed over the populations in bits and The internet has, of course, reduced information costs.
- Transaction costs are affected by information costs. The buyer and seller must first find each other and then agree on the price and other terms of the contract.
- Knowledge of the existence and location of a willing buyer is valuable information to the seller, just as knowledge of a willing seller is valuable information to the Without this information, economic transactions can not take place.
- Information is typically a scare and valuable commodity.
- Because information is costly, each individual accumulates information that is specific to that person’s particular circumstances.
- For example, a farmer has detail knowledge about local growing conditions, and consumers know a great deal about local food This special information can be valuable.
The economy of search
- We know in perfect competition price of products are same but in real market price of the same product differ from store to store.
- In many real-world markets, however, the prices of even homogeneous goods (milk, bread, gasoline, etc.) differ from store to store.
- In these real-world markets, it is more difficult for consumer to know the prices charged for the same items in different stores- even if consumers are aware of price differences, the transaction costs of always going to the cheapest store may outweigh the advantages of the lower price.
- As a consequence, the price for the same good differs from location to Such markets are usually imperfect because different buyers appear to pay different prices for the same product. From an economic viewpoint, however, the same good in a different location is considered a different product.
Information gathering and price dispersion
- The more information you gather (search) the more the price dispersed but you have chances of getting good price.
- A consumer incurs search costs while shopping, reading, or consulting experts in order to acquire pricing or quality Search costs explain why homogeneous products sell for different prices in different locations. A 32-inch Sony TV set may sell for different prices in stores one block apart, the same brand of milk may sell for different prices in adjacent grocery stores, and the same brand of dealerships located in the same part of town.
- If information about the prices charged by different retail outlets were free (assuming that no location is more convenient than other), the same commodity would sell for the same price, as predicted by the theory of perfect competition. But information is not free; real resources must be devoted to gathering Therefore, in the real world, the prices of homogeneous products sold in different locations will be dispersed.
- In gathering costly information, people follow the optimal search rule.
- The optimal search rule estates that people will continue to acquire economic information as long as the marginal benefits of gathering information exceeds the marginal cost of gathering.NOTE:MARGINAL COST:
- represents the incremental costs incurred when producing additional units of goods and services.
- are the maximum amount, a consumer is willing to pay for an additional goods and services.
- When a person decides to buy a new car, the more information that person has on prices and on technical qualities of various automobiles, the better the eventual choice is likely to be.
- But it is costly to gather such information. It is costly to drive all over town to various dealers; it is costly to take time off from work or from leisure activities to compare prices; it may be expensive in terms of time and money to acquire and master technical information contained in the various consumer-guide reports on new automobiles.
- To gather all the available information about new cars would take an inordinate amount of time and money; therefore, the prospective buyer must draw line at the point where the marginal benefit from acquiring more information is equal to the marginal cost of acquiring more information.
OPTIMAL SEARCH RULE
- Figure illustrates the optimal search rule.
- Suppose a consumer has just moved to a new town and is looking for the best place to buy a particular The consumer might visit several stores to collect valid price information. Thus, after some comparison shopping, the consumer will have a sample of the various price charged.
- The vertical axis measures the benefits and costs of search per The horizontal axis measures the lowest known prices (S) that the consumer has collected through search.
- If the lowest known price is very small, the marginal benefit of search for that consumer will be low; if the lowest known price is very high, the marginal benefits of search will be high.
- The upward-sloping curve in Fig shows the marginal benefits of search for different values of the lowest sampled price. Since the marginal cost of search is assumed to be independent of the lowest price sampled, it will remain unchanged over the range of S values. The price at which the marginal benefit of search (at point e) is the consumer’s reservation price.
- The reservation price is the highest price at which the consumer will buy a good.
- Although the consumer will buy any good with a price lower than the reservation price, he or she will continue to search for a lower price only if the lowest price found exceeds the reservation price.
- The reservation price in Fig is $5. If the lowest price sampled is $6, the consumer should still search because the marginal benefit of search exceeds the marginal cost of search. If the lowest price is below $5, say $4, the consumer will purchase the good because the marginal cost of search exceeds the marginal benefit of search. If the lowest price sampled is $5, the consumer is indifferent regarding continued search, because $5 is the highest price the consumer will pay for the product.
- Reservation price occurs at a sampled price at which the marginal benefit of search equals the marginal cost of search.
We can apply the theory that consumers use a search rule where marginal benefits equal marginal costs to predict the extent of price dispersion on different products. Clearly, anything that raises the marginal benefits of search relative to the marginal costs of search will increase the amount of searching. The more resources devoted to searching, the closer will be the prices of homogenous products sold at different stores (high priced-stores will lose business to low-priced stores). The marginal benefits of search should be greater for expensive items; therefore, theory, the theory of search suggests that prices of more expensive items will be less widely dispersed than those of less expensive items.
Information costs can be minimized for consumers by organizations such as the Consumers Unions, which tests products and sells the results in a monthly magazine. Government can also reduce information costs by establishing minimum standards and carrying out inspections to ensure that these standards are being observed. Without these governmental regulation and inspections, the costs of personal inspection and information gathering would be excessive.
- Economics dealings between individuals are governed by When a good is purchased, the seller explicitly or implicitly guarantees that the good will work according to an expected performance standard.
- An insurance contract stipulates that for a certain premium, the insurance company will pay out a certain amount of insurance if one or more specified events (a fire, a theft, or an automobile accident) occur.
- When information is costly, however, it can become difficult for one in a contract to monitor the other party’s to monitor the other party’s performance, and it can be difficult to check the claims made by economic agents trying to secure favorable contracts.
THE MORAL HAZARD PROBLEM
- It is not possible to buy insurance against poverty. No insurance company will sell you a policy that will pay you in the event of bankruptcy or Such insurance does not exist because it could provide an incentive for a person to quit working or seek bankruptcy.
- A moral-hazard problem exists when one of the parties to a contract has an incentive to alter his or her behavior after the contract is made at the expenses of the second party. It arises because it is too costly for the second party to obtain information about the first party’s post contractual behavior.
- Moral hazard is the reason why every fire insurance policy contains a provision that fires deliberately set by a policy owner (or agent of the owner) are not covered. Indeed, insurance companies spend millions to investigate fires to determine if there was any foul play.
- The basic consequence of the moral-hazard problem is that firms can offer only those contracts that will not be deliberately abused by their The kinds of contracts offered must be limited to those that will minimize the moral hazard problem.
- “Any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go ”
- Moral hazard is a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost.
- For example, assume a homeowner does not have homeowner’s insurance or flood insurance but lives in a flood zone. The homeowner is very careful and subscribes to a home security system that helps prevent When there are storms, he prepares for floods by clearing the drains and moving furniture to prevent damage.
- However, the homeowner is tired of always having to worry about potential burglaries and preparing for floods, so he purchases home and flood insurance. After his house is insured, his behavior He cancels his home security system subscription and he does less to prepare for potential flooding. The insurance company is now at a greater risk of having a claim filed against them as the result of damage from flooding or loss of property.
- A second example is provided by smoking. We have known for decades that smoking cigarettes is harmful to the Some people want to make cigarette manufacturers liable for the health damage caused by smoking. However, if manufacturers are made liable for the health risks of smoking, the unintended consequence would be that the incentive to smoke would be much greater. The higher health costs would be passed from the individual to the company. This is a highly inefficient method of social engineering. If the cigarette companies had to pay some of the health costs of their customers, they would have to charge a higher price for cigarettes, whether or not they smoked one cigarette a day or 100. When it is known that smoking exposes person to an additional health risk, it makes sense for society to place the cost on the individual doing the smoking.
ADVERSE SELECTION PROBLEM
- The moral-hazard occurs when one party to contract engages in opportunistic behavior after the contract is The adverse-selection problem arises prior to the making of the contract.
- Adverse selection problem occurs when a buyer or seller enters a disadvantageous contract on the basis of incomplete or inaccurate information because the cost of obtaining the relevant information makes it difficult to determine whether the deal is a good one or a bad one.
- When a contracting party does not know the real intentions of the other party, the party with the superior information may be able to lure the other party into accepting an unfavorable A contract is unfavorable if one of the contracting parties would not have entered into it if he or she had the same information as the other party.
- Example: Insurance companies face a different world; Smith and Jones are exactly alike except that Smith is a good driver who has never had an accident and Jones is a terrible driver who has been lucky never to have had an accident. Smith knows she is a good driver; Jones knows she is an accident waiting to happen. What about the insurance company? Unless insurance agents were to follow Smith and Jones around town and interview friends and neighbors, the insurance company cannot differentiate between Smith and Jones at the same rate as Smith. If the insurance company knew more about Smith and Jones, Jones would have to pay higher insurance rates to compensate for the higher probability of an accident.
- In another example, business firm wish to hire high- quality workers, but it is very costly to find out in advance the true characteristics of workers. Harry and Michael are alike except that Harry is diligent and hardworking while Michael is lazy and without There is no reason for Michael to inform a potential employer of his laziness, and Harry’s claims of diligence are likely to be dismissed as boasting. Because Harry and Michael appear alike to the firm, they are hired at the same wage rate. Michael, aware of his bad work skills, jumps at the chance. Armed with better information, the firm would not have entered in this contract.
THE ROLE OF INTERMEDIARIES
- Exchange opportunities between Buyers and Sellers.
- Variety and qualities of different products.
- Channels of marketing distribution for produced goods.
- Intermediaries buy in order to sell again or simply bring together a buyer and seller.
- Real state brokers, grocery stores, department stores, used-car dealers, auctioneers, stockbrokers, insurance agents, and travel agents are all intermediaries.
SPECULATION AND RISK BEARING
- Although product information is important to consumers, information about changes in the market conditions for any number of goods and services is important to speculators.
- Speculators are those who buy or sell in the hope of profiting from market fluctuations.
- Profit from misfortunes of others.
- The person who stocks up on peanut butter after hearing of a shortage of peanuts, the frozen-orange- juice distributor who buys oranges in response to a late frost in Florida, and the young couple that buys a house now because they fear home prices will rise beyond reach if they wait another year are all speculator, however, is more maligned than any other economic agent.
- Most people associate the term speculator with the person who buys up agricultural land and holds it for future shopping-centre development or the person who buys and sells foreign currencies or gold in the hopes of buying low and selling high. Such speculators buy or sell commodities in huge quantities in huge quantities hoping to profit from a frost, war, scare, bad news, or good news.
THE ECONOMIC ROLE OF THE SPECULATOR
- Speculators do, indeed, often profit from the misfortunes of others. They by from the hard-pressed farmer when prices are low and they sell later at much higher prices. Has the farm family been robbed by the speculator? Not really.
- The farmer is not in the business of risk-bearing. Upon hearing of a frost in Florida, speculators buy oranges in large quantities, thereby driving up the prices of orange juice for the consumer. At the first sign of international trouble, speculators may buy gold and sell American dollars, thereby weakening the American dollar.
- The popular view of speculators is that they do only harm; however, speculators are performing a useful economic function- that is, engaging in arbitrage through time.
- Arbitrage is buying in a market where a commodity is cheap and reselling in a market where a commodity is more expensive.
- The arbitrageur buys wheat in Chicago at $5 per bushel and resells it for $5.10 the next minute in Kansas City. Thus, arbitrageurs serve to keep the prices of wheat in Chicago and Kansas City approximately equal.
- Simple arbitrage of this type is not very risky because information about prices in Chicago and Kansas City can be obtained instantly from commodity brokers.
- Unlike the arbitrageur, who buys in one location and sells in another, the speculator buys goods at one time and resells at another time. Speculation is a risky business because tomorrows„ prices cannot be known with certainty.
- The speculator is bearing risks that others do not wish to carry.
- The speculator is performing the economic function of sharing in the risky activities of producers and consumers.
- Profitable Speculation
- Unprofitable Speculation
- The objective of the speculator is to make a profit by buying low and selling When the speculator is making profit- and when there are enough speculators- low price will be driven up and the high prices will be driven down.
- When speculators buy at low prices, they add to the demand and drive prices up. When speculators sell when prices are high, they drive prices down by adding to the supply.
- Profitable Speculation (is that speculation that succeeds in buying low and selling high) stabilizes prices and consumption over time by reducing fluctuations in prices and consumption over time.
- Profitable speculation is illustrated in Fig Panel (a) shows that the supply of wheat in the first period (say, 2000) is S1, or 4 million bushels.
- Panel (b) shows that the supply of wheat in the second (say, 2001) is S2, or 2 million bushels.
- If there were no speculation, the price of wheat would be $3 in period 1 and $5 in period 2 (we assume that demand does not change between the two periods).
- Thus, without speculation, prices and consumption would vary dramatically between the two periods.
- If speculators correctly anticipate that next years’ wheat crop will be small, they could make handsome profits by buying at $3 and selling next year at $5.
- But what happens as speculators begin to this year’s wheat? When speculators buy wheat, they withdraw it from the market and place it in As a result, the supply of wheat offered on the market is reduced. This trend will continue until the profits of the marginal speculator are driven to zero.
- When speculators buy 1 million bushels in the first period, the effective supply shifts (left) to 3 million bushels, and the price rise to $4. When speculators resell this wheat in the second period, the effective supply also shifts (right) to 3 million bushels in year 2.
- When speculative profits are zero, the price will remain stable at $4 and the quantity of wheat sold on the market will remain stable at 3 million bushels-despite substantial differences in the wheat harvest in the two periods.
- In this example, we assume that storage costs are Had storage costs been positive, the price of wheat in the second period would have been higher by the cost of storage.
- Profitable speculation shifts supplies from periods when supplies are relatively abundant and prices potentially low at periods when supplies are relatively scarce and prices potentially In this sense, profitable speculation provides the valuable economic service of stabilizing prices and consumption over time.
- The $4 price of wheat reflects all the available information about the In this sense, the market is efficient. No one can then make a profit buying wheat and reselling it because the price is the same in both periods.
- Profits can be made only when information available to some people is not reflected in the current market Those individuals can make a profit by exploiting their information advantage.
- Speculation is Speculators cannot always guess correctly. They may buy when they think prices are low only to find that prices sink even lower.
- They may sell when they think prices are at their peak only to watch the prices rise even further.
- In such cases, speculation destabilizes prices and consumption over When prices would otherwise be high, such speculators are buying and driving prices even higher; when prices would otherwise be low, such speculators are selling and driving prices even lower.
- Without speculations, the price and consumption would have been the same in both periods (point e). With unprofitable speculation, consumption is 3 million bushels in preiod1 and 7 million bushels in period 2. Period 1 one’s price is $6 and period two’s price is $2. Unprofitable speculation is inefficiently for the economy as a whole.
- Unprofitable speculation is destabilizing because it creates artificial scarcity in some periods and artificial abundance in other periods. In this sense, speculation can be costly to society.
The Future Market
Speculation is so highly specialized that markets have developed that separate the business of storing the commodity being bought and sold from their actual business of speculation. The grains speculator does not have to worry about what the purchase grain looks like, where it is stored, and how much to take out of storage. Those who wish only to speculate can buy and sell in a futures market.
A futures market is an organized market in which a buyers and sellers agree now on the price of a commodity to be delivered at some specified date in the future.
The type of market most people know best is one in which there is an actual outlay of cash (or the arrangement of credits) for the immediate delivery of goods. The market in which a good is purchased today for immediate delivery is called a spot (or cash) market.
In a spot (cash) market, arrangement between buyers and sellers are made now for payment and delivery of the product now.
Most of the goods consumers buy and sell are transacted in spot markets. In the grocery store, consumers pay now for goods that are delivered now. Stocks, foreign exchange, gold, and commodities such as wheat, copper are traded in organized spot markets. Unlike the grocery store, however, such commodities are also traded on future markets.
Future contracts are brought and sold in futures markets. In a futures contracts, the terms (the price and the quantity) of a futures transaction are set today. The buyer of the futures contracts enters a contract today to purchase specified quantities of a good at a specified price at some specified date in the future. Both delivery and payment are to be made in the future. The seller is obliged to deliver the specified quantity of the good at the specified price at the specified future date. The seller of the future contracts need not even own the commodity at the time of the sale (but will, in many instances).
The seller of the future contracts is in a short position because something is being sold that is not owned. The buyer of the future contracts is in a long position because a claim on a good is being acquired.
When the seller agrees to sell and buyers agrees to buy at a specified price at a specified date in the future, what guarantees that both parties will fulfill their part of the bargain? The buyer and seller must each put-up cash -called a margin requirement- equal to a small percentage of the value of the contracts.