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Chapter 14
Transaction Costs, Imperfect
Information, and Market
Behavior
© 2006 Thomson/South-Western
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Rationale for the Firm
Ronald Coase
 Firms
are superior to markets when
production is complicated
The more complicated the task, the greater the
ability to economize on transaction costs
through specialization and centralized control
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Bounds of the Firm
Vertical integration: expansion of the firm into
stages of production earlier or later than those
in which it has specialized
Backward integration: steel company mines
its own iron ore
Forward integration: forms raw steel into
various components
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Bounds of the Firm
How does the firm determine which activities to
undertake and which to purchase from other
firms?
Answer depends on a comparison of the
benefits and costs of internal production versus
market purchases – which method is more
efficient
As firms take on more and more activities,
managers lose track of things and quality of
managerial decisions suffers
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Bounded Rationality of the Manager
Manager’s bounded rationality: limits
the amount of information a manager can
comprehend about the firm’s operation
The more tasks, the more likely the firm
is to experience diseconomies similar to
those when expanding output beyond the
efficient scale of production
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Minimum Efficient Scale
The minimum efficient scale: the
minimum level of output at which
economies of scale have been fully
exploited
Other things constant, a firm should buy
an input if the market price is below what
it would cost the firm to make
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Exhibit 1: Minimum Efficient Scale and Vertical Integration
Cost per unit
(a) Computer Manufacturer
LRAC
0
1,000,000
Computers per year
If a PC producer only requires
1,000,000 chips per year but the
per unit cost of the chips is not
minimized unless 5,000,000 are
produced, the firm is better off
purchasing the inputs than
making them internally.
Cost per unit
(b) Chip Manufacturer
LRAC
0
1,000,000
Computer chips per year
5,000,000
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Number of Suppliers
When there are many interchangeable
suppliers of a particular input, a firm is more
likely to purchase that input in the market than
produce it internally, other things constant
Competition also keeps the price down
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Economies of Scope
Economies of scope: average costs decline as a
firm makes different products rather than just
one
Exist when it is cheaper to combine two or
more product lines in one firm than to produce
them in separate firms
Tend to occur because the cost of some fixed
resources, such as specialized knowledge, can
be spread across product lines
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Market Behavior with Imperfect
Information
Reliable information is often costly
for both consumers and producers.
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Marginal Cost of Search
Marginal Cost of Search
Individuals gather the easy and obvious
information first
as the search widens, the marginal cost of
acquiring additional information increases
because
Individuals may have to travel greater distances
to check prices and services
opportunity cost of time increases as more time
is spent acquiring information
Marginal cost curve for additional information
slopes upward
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Marginal Benefit of Search
The marginal benefit from acquiring additional
information is
 better quality
at a given price or a lower price for a
given quality
 relatively large at first, but as more information is
gathered and people grow more acquainted with the
market, additional information yields less and less
additional benefits
The marginal benefit curve for additional
information slopes downward
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Information costs and benefits (dollars)
Exhibit 2: Optimal Search with Imperfect Information
Marginal cost
of information
Marginal benefit
of information
0
If
I*
Ip
Market participants will
continue to gather information
as long as the marginal benefit
of additional information
exceeds its marginal cost
Optimal search occurs when
the marginal benefit equals
the marginal cost at point I*
As search levels exceed I*,
the marginal benefit of
additional information is still
positive, but exceeds the cost
At some point the value of
additional information reaches
zero, Ip - this is referred to as
perfect information
Quantity of information
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Implications
Search costs result in price dispersion, or
different prices, for the same product
Search costs lead to quality differences across
sellers, even for identically priced products,
because consumers find it too costly to shop for
the highest quality product
The more expensive the commodity, the greater
the price dispersion in dollar terms , thus the
greater the incentive to shop around
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Implications
As the consumer’s wage increases, so does the
opportunity cost of time  the marginal cost of
additional information increases  less
searching and more price dispersion
Any change in technology that lowers the
marginal cost of information will reduce the
marginal cost of additional information 
more information and less dispersion 
internet
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Winner’s Curse
The Winner’s Curse: plight of the winning
bidder who overestimates an asset’s true
value
Winners of such bids are said to
experience the winner’s curse because
they often lose money after winning the
bid, because they were overly optimistic
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Asymmetric Information in Product Markets
Two types of information that a market
participant may want but lacks
One side of the market may know more about
characteristics of the product for sale than the other
side knows: asymmetric information involves hidden
characteristics
One side of a transaction can pursue an action that
affects the other side but that cannot be observed by the
other side: asymmetric information involves hidden
actions
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Hidden Characteristics: Adverse Selection
Seller knows more about the quality of
the product than do buyers
Buyers have less information
When those on the informed side of the
market self-select in a way that harms the
uninformed side this is called adverse
selection
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Hidden Actions: Principal-Agent Problem
Describes a situation in which one party, the
principal, contracts with another party, the agent,
in the expectation that the agent will act on behalf
of the principal
The problem arises when the goals of the agent
are incompatible with those of the principal and
when the agent can pursue hidden actions
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Asymmetric Information in Insurance Markets
In the insurance market, it is the buyers, not
the sellers, who have more information about
the characteristics and actions that predict
their likely need for insurance in the future
If the insurance company has no way of
distinguishing among applicants it must charge
those who are good health risks the same as
those who are poor health risks
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Asymmetric Information in Insurance Markets
This price is attractive to poor health risks, but will
seem too high to good health risks, some of whom
will choose not to buy insurance
As the number of healthy people who don’t buy
insurance increases, the insured group becomes less
healthy on average  rates must rise  insurance
is even less attractive to healthy people  adverse
selection tends to make insurance buyers less
healthy than the population as a whole
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Asymmetric Information in Insurance Markets
Once people buy insurance, their behavior
may change in a way that increases the
probability that a claim will be made
This incentive problem is referred to as
moral hazard  occurs when an
individual’s behavior changes in a way
that increases the likelihood of an
unfavorable outcome
Moral hazard is a principal-agent problem
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Coping with Asymmetric Information
An incentive structure or an informationrevealing system can be developed to reduce the
problem associated with the lopsided
availability of information
Lemon laws that offer compensation to buyers of
new or used cars that turn out to be lemons
Health insurance companies use a variety of
tools
Physical exams and filling out questionnaires
Deductibles
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Asymmetric Information in Labor Markets
Differences in the ability of labor present no
particular problem as long as these differences
can be readily observed by the employer
That is, if the productivity of each particular
worker is easily quantified that measure can be
used and serves as a basis for pay
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Asymmetric Information in Labor Markets
 Because production often takes place through the
coordinated efforts of several workers, the employer
may not be able to attribute specific outputs to each
particular worker
 An adverse-selection problem arises in the labor
market when labor suppliers have better information
about their own productivities than do employers,
because a worker’s ability is not observed prior to
employment  hidden characteristics
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Asymmetric Information in Labor Markets
In a labor market with hidden characteristics,
employers might be better off offering a higher
wage  makes the job more attractive to morequalified workers
Paying a higher wage gets at the problem of
hidden actions by workers
Paying a higher wage to attract and retain moreproductive workers is called paying efficiency
wages
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Signaling and Screening
Signaling: the attempt by the informed side
of the market to communicate information
that the other side would find valuable
Screening: the attempt by the uninformed
side of the market to uncover the relevant
but hidden characteristics of the informed
party
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