LONG-RUN AGGREGATE MARKET: A macroeconomic model relating the price level and real production under the assumption that ALL prices flexible. This is one of two aggregate market submodels used to analyze business cycles, aggregate production, unemployment, inflation, stabilization policies, and related macroeconomic phenomena. The other is the short-run aggregate market. The long-run aggregate market isolates the interaction between aggregate demand and long-run aggregate supply. The key assumption of this model is that ALL prices, especially resource prices, are flexible. The primary result of this model is that the economy achieves long-run equilibrium at full-employment real production.
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ECONOMICS OF INFORMATION:
The study of the role that information plays in the economy and in the allocation of resources, with special attention paid to efficient information search. Key topics in this area of study and analysis are asymmetric information, moral hazard, adverse selection, signalling, and screening. This study of the economics of information also provides insight into the analysis of risk and uncertainty, which are important to insurance and financial markets. The economics of information is a field of economics (primarily microeconomics) that investigates the importance of information to the allocation of scarce resources. The standard assumption at the basis of most economic theories is one of perfect information, that buyers and sellers, producers and consumers, have perfect (or at least complete) information.
The economics of information, however, indicates that perfect information is just not possible. While information is beneficial to have, it is also costly to acquire. Like the production of any good, the efficient acquisition of information is a matter of balancing benefits against costs. The primary indication is that perfect, complete, or total information is not economically efficient. That is, most people rationally choose to be ignorant (about some things).
Information and Knowledge and TechnologyAn understanding of the role information plays in the economy begins with the concept of information, and a comparison with two related concepts -- knowledge and technology.
One way to compare knowledge, information, and technology is through an analogy with a glass of water. Knowledge is the glass of water itself. Information is then the process of filling the glass with water. And technology is drinking the water to quench your thirst.
- Knowledge: This is the body of facts, data, theories, statistics, etc. that have been acquired over time. Knowledge is the "stock" of what we know.
- Information: This is the transmission of knowledge from one person to another. Information is the "flow" that increases the stock of knowledge.
- Technology: This is the use or application of knowledge for productive purposes. Technology is doing something with the knowledge.
The economic study of information is primarily concerned with the flow of information, with filling the glass of water. It is the transmission of knowledge from one person to another, and like the transmission, transference, or transportation or other goods, this process employs scarce resources with alternative uses. The transmission of information incurs an opportunity cost.
Information SearchThe acquisition of information is comparable to the production and consumption of any good. Acquiring information is beneficial, but doing so incurs a cost. Information is produced. Information is consumed.
The production of information, the transmission of knowledge, is termed information search. The benefits and costs of this productive activity include:
Comparable to other economic decisions, information search entails a balance between the benefit generated by the information and the cost of acquiring the information.
- Benefits: A primary benefit of information is a more efficient allocation of resources. If consumers have information about the location of goods, their prices, and their wants-and-needs satisfying characteristics, then they are better able to purchase goods that generate the greatest satisfaction at the lowest cost. If producers have information about the location of inputs, their prices, and their productive capabilities, then they are better able to purchase the inputs that generate the greatest production at the lowest cost. In both cases efficiency is enhanced. Information also provides benefits in other ways, not the least of which is the direct consumption of information. That is, some people (curious folks) satisfy their "need to know" just by acquiring information.
- Costs: Like the production of other goods, the acquisition of information requires the use of scarce resources. Labor, capital, land, and entrepreneurship are all used to acquire information. The opportunity cost of labor, in particular, is key to most information search. Reading newspapers, magazines, and books; viewing television and movies; listening to radios and MP3s; surfing the Internet; and talking with other people are all means of searching for information and all incur the opportunity cost of human effort. Of course, capital, land, and entrepreneurship are also employed in the production of books, Internet web sites, television programs, audio files, and other "information goods." Use of these resources also incurs opportunity costs.
All About the MarginalsThe efficient information search decision depends on a comparison of the benefit and cost of searching. These two aspects of the decision are capture by marginal benefit of search and marginal cost of search.
- Marginal Benefit of Search: The marginal benefit of search is the additional benefit obtained from information resulting from an incremental change in search effort. As search effort increases the extra benefit obtained decreases. Eventually, with relatively complete information, the incremental benefit of search falls to zero. For example, the first hour spent searching for the best price of Wacky Willy Stuffed Amigos might generate a range of different prices, from a high of $7 to a low of $5, resulting in a beneficial saving of $2. An additional hour of search might reveal a new low price of $4, for a marginal benefit of $1. Further search effort provides incrementally smaller benefits until no lower prices are revealed and the marginal benefit is zero.
- Marginal Cost of Search: The marginal cost of search is the additional cost incurred for an incremental change in search effort. Comparable to the cost of producing any good, as search effort increases the extra cost incurred also increases. Additional search effort requires additional scarce resources with alternative uses and increasing opportunity cost. For example, the first hour of searching for the lowest price of Wacky Willy Stuffed Amigos might entail an inexpensive walk to a nearby drug store. The next hour might then require a more distant and expensive drive to a discount super center. Further searching requires additional increasingly cost resources.
Efficient information search, that is, the production of information, can be illustrated with a standard "demand and supply" type diagram. The exhibit to the right presents the framework for this analysis. The vertical axis measures the cost and benefit of undertaking search effort. The horizontal axis then measures the amount of information search effort, in this case measured in hours.
Efficiency is achieved with a balance between benefit and cost, or more specifically, the marginal benefit of search and the marginal cost of search. Each is represented by its own curve.
The intersection of the MBS curve and the MCS curve indicates the efficiently level of information search. Click the [Efficient] button to highlight this intersection. In this exhibit, the MBS and MCS curves intersect at a search level of 5 hours. That is, 5 hours of search balances the additional benefit obtained from extra search effort and the additional cost of the extra effort.
- Marginal Benefit of Search Curve: The marginal benefit of search is represented by the negatively-sloped marginal benefit curve. Click the [MBS] button to reveal this curve. The MBS curve is negatively-sloped like a standard market demand curve.
- Marginal Cost of Search Curve: The marginal cost of search is represented by the positively-sloped marginal cost curve. Click the [MCS] button to reveal this curve. The MCS curve is positively-sloped like a standard market supply curve.
Searching more than 5 hours means the cost of extra search exceeds the benefit. Extra search is not worthwhile. Searching less than 5 hours means the benefit of extra search exceeds the cost. Extra search is worthwhile.
Key to this analysis is that as long as search is costly, search effort will not increase to the level that forces the marginal benefit of search to zero, to the level in which no further benefit can be obtained. In other words people decided to stop short of complete information. They voluntarily choose to remain (somewhat) ignorant
This result gives rise to what is termed the sixth rule of ignorance, which states that obtaining information is a costly activity that requires resources with alternative uses and thus no one knows everything and everyone is ignorant about something.
Rational ChoicesThe decision to undertake a level of search that stops short of complete knowledge is a perfectly rational one. It is no different than the decision to eat four slices of pizza rather than five. It also gives rise to two related concepts -- rational ignorance and rational abstention.
Rational ignorance and rational abstention are both important concepts in the study of public choice and voting behavior. The rational decisions to remain ignorant and to refrain from participating are key sources of voter apathy and government inefficiency. That is, seemingly apathetic people often decide NOT to participate in the political process because it's not worth the effort.
- Rational Ignorance: This is the decision NOT to become informed about a topic (such as what a political candidate wants to do) because the cost of acquiring the information is more than the expected benefit. The rational decision to remain ignorant about a subject is a straightforward application of utility maximization.
- Rational Abstention: This is the decision NOT to do something (such as vote in an election) because the cost of taking the action is more than the expected benefit. The rational decision to refrain from an endeavor is also a straightforward application of utility maximization.
Information IssuesThe economic study of information and the efficient search for information provides useful analysis for a number of important issues.
- Asymmetric Information: First up is the observation that information is not equally available to everyone, asymmetric information. Some people are bound to rationally choose to know more than others. In particular, information is likely to be unbalanced or asymmetrically available to buyers and sellers in a market. Sellers, who have possession of a good, often have more information than buyers.
- Adverse Selection: An important consequence of asymmetric information is adverse selection, which arises when the lack of information limits the quality of goods exchanged. Because buyers have less accurate information about the quality of goods, they are likely to offer a lower price, which discourages sellers from offering higher quality goods.
- Moral Hazard: Asymmetric information also leads to moral hazard, which arises when one person makes a decision that adversely affects another. The best example is found with insurance in which an insured person undertakes risky behavior knowing the insurance provider incurs the cost. The problem is that the insurance provider is unaware of the risky actions of the insured person.
- Signalling: Because people lack complete information, they necessarily make decisions based on the few key bits that are available. That is, people seek out indicators or signals that reflect the "bigger picture." For example, an employer uses grade point average as a signal of the quality of a prospective employee. A consumer uses brand name as a signal of the quality of product.
Uncertainty and RiskThe economic analysis of information is also important to the study of uncertainty and risk, which are critical to financial markets and the insurance industry. While closely related concepts that are occasionally (and erroneously) used interchangeably, uncertainty and risk have important differences.
While anything is possible (which is the essence of uncertainty) everything is not equally probably (which is the essence of risk). Many who participate in the financial markets and in the insurance industry spend a great deal of time and effort trying to transform uncertainty into risk. This can be accomplished with simple historical extrapolation. If, for example, every winter 5 people out of 100 contract the flu, then the projected risk of this outcome is 5%. However, more sophisticated analysis is frequently used. That is, the risk of flu contraction might be evaluated based on lifestyle, weather conditions, medical treatment, and other factors.
- Uncertainty: This quite simply is the observation that the future is not known. You don't know what might happen tomorrow. You might step in a puddle of mud on the way to class. Or you might anger an intelligent extraterrestrial life form that retaliates by destroying all life on the planet. You just never know.
- Risk: This is assigning quantitative probabilities to alternative future outcomes. While it is possible that you could either step in a mud puddle or your could cause total destruction of the planet, both are not equally likely outcomes. Risk is the process of assigning probabilities to these alternatives (for example, 99.999999999% chance of mud puddle stepping versus 0.000000001% chance of total planet destruction).
Risk PreferencesDifferent people have different views, perspectives, and preferences about risk. Some people enjoy a risky situation and others do not. This gives rise to three alternative risk preferences -- risk aversion, risk neutrality, and risk loving. As the names suggest, some people prefer to avoid risk (risk aversion), others enjoy engaging in risk (risk loving), and still others are indifferent (risk neutrality).
These three alternatives can be more precisely defined based on the marginal utility of income. Marginal utility is the change in utility resulting from a given change in the consumption of a good. Marginal utility of income is then the change in utility resulting from a given change in income. The standard presumption is that marginal utility declines as more of a good is consumed, that is, decreasing marginal utility. As a general rule the marginal utility of income also declines with an increase in income. However, it can also increase or remain constant.
Suppose, for example, that you have $100 of income and are confronted with a $50 wager on the flip of a coin. If the coin comes up heads, then you win $50 and thus have a total of $150. If the coin comes up tails, then you lose $50 and thus have a total of only $50. Risk preferences determine your willingness to decline the wager and keep the $100 of income that you have (certain income) or agree to the wager not knowing whether you will win or lose (risky income).
It is important to note that the income expected from the wager (so called expected income) is actually equal to certain income ($100). That is, because the coin has an equal chance of coming up heads or tails, if you undertake this wager 100 times, you can expect to win 50 times and lose 50 times. The loses exactly equal the wins and the income you can expect to end up with is $100.
These three alternatives give rise to risk aversion, risk loving, and risk neutrality.
Most people tend to be risk averse, preferring certain income to an equal amount of risky income. Not only do they prefer certainty over risk, they are willing to pay. This is the essence of insurance. People pay a relatively small insurance premium to avoid the prospect of incurring a much bigger loss. They are thus guaranteed a certain income, net of the insurance premium, and eliminate the risk, albeit a small risk, of a loss of income.
- Risk Aversion: This exists when a person has decreasing marginal utility of income. In this case you prefer the certain income to the risky income. With decreasing marginal utility of income you obtain less utility from the income won than the income lost. Even though the expected income is equal to the certain income, the utility obtained from the certain income exceeds the utility obtained from the expected income. The utility from winning is exceeded by the utility from losing. You are better off not wagering.
- Risk Loving: This exists when a person has increasing marginal utility of income. With increasing marginal utility of income you obtain more utility from the income won than the income lost. Even though the expected income is equal to the certain income, the utility obtained from the expected income exceeds the utility obtained from the certain income. The utility from losing is exceeded by the utility from winning. You are better off wagering.
- Risk Neutrality: This exists when a person has constant marginal utility of income. With constant marginal utility of income you obtain the same utility from the income won as the income lost. Not only is the expected income is equal to the certain income, the utility obtained from the expected income is equal to the utility obtained from the certain income. The utility from losing is matches by the utility from winning. You are equally well off wagering or not wagering.
Financial MarketsInformation is a key factor in financial markets. Financial markets exchange financial instruments or legal claims, such as stocks, bonds, and futures contracts. The most common financial market is the stock market that exchanges corporate stock, which are legal claims representing ownership of corporations.
Those who buy and sell legal claims do so based on information they have about current and expected values. For example, you might be willing to buy a few shares of OmniConglomerate, Inc. based on expectations that the company will be more profitable in the near future.
But why might you have those expectations? Perhaps because you heard that the company is on the verge of obtaining a lucrative government contract. Or perhaps you read that the economy will be prospering and with it the demand for company production will increase. Of course others might have different information and different expectations about the company and thus would be willing to sell shares of the stock.
The accuracy of the information plays a big part in who "wins" and "loses" in the financial markets. If your information is better and the price does increase, then you win. If the seller has better information and the price decreases, then you lose.
ECONOMICS OF INFORMATION, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2020. [Accessed: September 29, 2020].
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