1. Chapter 14
Transaction Costs, Imperfect
Information, and Market Behavior

2. The Firm Reduces Transaction Costs
• Why do firms exist?
• Why do people organize in the hierarchical
structure of the firm and coordinate their
decisions through a manager rather than
simply rely on market exchange?
– Organizing activities through the hierarchy of the
firm is usually more efficient than market
exchange because production requires the
coordination of many transactions among many
resources suppliers.

3. Competitive Firm and Information
• In a competitive firm, all participants in the
market know everything they need to about
the price and availability of all inputs, outputs,
and production process.
• But what about the other firms?
– Is this true for monopolistic competition,
oligopolies, and a monopoly.

4. The Firm Reduces Transaction Costs
• Firms are superior to markets when production is
complicated!
• Using resource markets directly involves:
– The cost of determining what inputs are needed and
how they should be combined
– The cost of reaching an agreement with each resource
supplier over and above the inputs
• The more complicated the task, the greater the
ability to economize on transaction costs through
specialization and centralized control.

5. The Boundaries of the Firm
• Vertical integration is the expansion of a firm
into stages of production earlier or later than
those in which it specializes.
• Should a manufacturer own its input
providers’ companies?
– It depends on the benefits and costs of internal
production versus market purchases.
– Remember specialization and comparative
advantage

6. Bounded Rationality of the Manager
• The notion that there is a limit to the
information that a firm’s manager can
comprehend and act on.
– As the firms takes on more and more functions,
coordination and communication become more
difficult.
– Diseconomies of scale can develop

7. Minimum Efficient Scale
• The minimum rate of output at which
economies of scale are fully exploited.
– The firm should buy an input if the market price is
below what it would cost the firm to make.

8. Easily Observable Quality
• If an input is well defined and its quality is
easily determined at the time of purchase,
that input is more likely to be purchased in
the market than produced internally.
• However, sometimes the quality of a certain
input can be determined only during
production.

9. Many Suppliers
• If there are many suppliers of the input, the
company is more likely to buy the input than
make it.
– Dependable supply of resources

10. The Trend Toward Outsourcing
• Outsourcing is when a firm buys inputs from
outside suppliers.
– Comparative advantage of the good or service
• Core competency is the area of specialty
– What the company does best!

11. Economies of Scope
• Some firms branch into product lines that do
not have a vertical relationship
– Sara Lee
• Economies of scope exit when it’s cheaper to
produce two or more different items in one
firm than to produce them in separate firms.
– Product and Gamble
– Average cost per unit falls as the firm supplies
more types of products (the scope of the firm
increases)

12. Market Behavior with Imperfect
Information
• Information is COSTLY for both the consumer
and the producer.
• What is the cost to the Consumer?
• What is the cost to the Producer?

13. Marginal Cost and Marginal Benefit of
the Search
• As you increase your search, the cost
increases
– Common knowledge= MC=0
• The marginal benefit from the additional
information is a better quality product at a
given price or a lower price for a given quality
level (it may be less quality).

14. LO2 Exhibit 2
Optimal Search with Imperfect Information
Information costs and benefits (dollars)
Marginal cost When information is not free,
of information additional information is
acquired as long as its
marginal benefit exceeds its
marginal cost.
Equilibrium, or optimal search,
occurs where marginal benefit
equals marginal cost.
Marginal benefit I* is the optimal quantity of
of information information.
Quantity of
0 If I* Ip
information

15. Optimal Search
• As long as the MB> MC of additional
information the individual will continue the
search.
• The search will continue until MB=MC.
– Example

16. The Winner’s Curse
• Why do so many “winners” end up losers?
– The plight of the winning bidder who
overestimates an asset’s true value.
– Paying the price of being overly optimistic.
– Applies to all cases where the true value is not
known.

17. Asymmetric Information
• One side of the market has better information
about the product than does the other side.
– Health and car insurance
• Two types of information that a market
participant may want but lack
– Lack information on the product’s characteristics
– Lack information on the information about actions
taken by the other party of the transaction

18. Hidden Characteristics: Adverse
Selection
• The “Lemon” Problem
– The proportion of good cars on the market will fall
and the proportion of lemons will rise.
– When sellers have better information about a
product’s quality than buyers do, lower-quality
products dominate the market.
• Adverse Selection
– The informed side will self-select, meaning they
decide whether or not to offer the item, i.e.
increasing the chances of a lemon.

19. Hidden Actions: The Principal-Agent
Problem
• Hidden Actions
– One side of the transaction can not observe the
action of the other side.
• The Principal-Agent Problem
– Principal: the party that contracts with another
party known as The Agent in the expectation that
the agent will act on behalf of the principal.
– Problem: Sometimes the goals of the agent are
incompatible with those of the principal and the
agent will pursue hidden actions.

20. Asymmetric Information in Insurance
Markets
• As a health insurance company, who do you
want as a consumer?
– The runner or
– The TV watcher
• Moral hazard occurs when an individual’s
behavior changes in a way that increase the
likelihood of an unfavorable outcome.
– Bank Bailout

21. Coping with Asymmetric Information
• Incentive structure
– Warranties
• Information-revealing system
– Physical exams

22. Adverse Selection in Labor Markets
• The higher the wage, the more attractive the
job is to more-qualified workers.
• Efficiency wages
– Paying above-market wages to attract and retain
more productive workers

23. Signaling and Screening
• Signaling is the attempt by the informed side
of the market to communicate information
that the other side would find valuable
– Years of education
• Screening is the attempt by the uninformed
side of the market to uncover the relevant but
hidden characteristics of the informed party.
– Spelling errors in resumes