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CHAPTER 14
TRANSACTION COSTS, IMPERFECT INFORMATION,
AND BEHAVIORAL ECONOMICS
In this chapter, you will find:
Learning Outcomes
Chapter Outline with PowerPoint Script
Chapter Summary
Teaching Points (as on Prep Card)
Solutions to Problems Appendix
Experiential Assignments
INTRODUCTION
The theories of the firm and market behavior introduced earlier are expanded here to include transaction
costs and imperfect information. The first half of the chapter presents some insights into the reasons for
LEARNING OUTCOMES
14-1 Describe the criteria a firm should apply when deciding whether to produce a component part or
to purchase that part in the market.
Firms arise when production is more efficient using the hierarchy of the firm than using market trans-
actions. Because production requires elaborate coordination of many resources, all this activity can
14-2 Explain the optimal amount of search for information when shopping for a product.
A buyer searches for product information as long as the marginal benefit of search exceeds its
14-3 Define asymmetric information, and explain why it may pose a problem for market operations.
Asymmetric information occurs when one side of the market is better informed about a product than
the other side is. The uninformed side may not know about hidden characteristics or about hidden
actions. Those with more information can take advantage of those with less. Because of adverse
Chapter 14 Transaction Costs, Imperfect Information, and Behavioral Economics 198
14-4 Summarize how labor markets try to cope with the problem of asymmetric information.
Asymmetric information occurs in labor markets when managers cannot attribute specific outputs to
particular workers. If productivity is easy to measure, workers are paid according to their efficiency,
as in piece work. If marginal productivity is harder to quantify, employers pay workers by the hour.
14-5 Identify two types of limitations that can undermine rational decisions.
Standard economics assumes that people are rational in pursuing their self-interest. But psychologists
question the ability of humans to make complex decisions and to follow through on them.
CHAPTER OUTLINE WITH POWERPOINT SCRIPTS
USE POWERPOINT SLIDES 2-6 FOR THE FOLLOWING SECTION
The Firm Reduces Transaction Costs: The firm is more efficient than market exchange because
production requires coordinating many transactions among many resource suppliers. The more
complicated the task, the greater the need for specialization and central control.
The Boundaries of the Firm: Firms minimize the transaction costs and the production costs of economic
activity. The efficient boundaries of the firm or the appropriate degree of vertical integration depend
upon:
• Bounded Rationality of Managers: The notion that the amount of information a manager can
comprehend about the firm’s operations is limited.
USE POWERPOINT SLIDE 7 FOR THE FOLLOWING SECTION
Economies of Scope: Average cost falls as a firm makes a range of different products rather than
specializing in just one product.
USE POWERPOINT SLIDES 8-11 FOR THE FOLLOWING SECTION
Market Behavior with Imperfect Information
Optimal Search with Imperfect Information: The process of gathering consumer information can be
Chapter 14 Transaction Costs, Imperfect Information, and Behavioral Economics 199
Marginal Benefit of Search: The marginal benefit of acquiring additional information is a better quality
for a given price or a lower price for a given quality. As more information is gathered, the marginal
benefit of acquiring additional information declines.
USE POWERPOINT SLIDES 12-18 FOR THE FOLLOWING SECTION
Asymmetric Information in Product Markets: A situation in which one side of the market has
more reliable information than the other side does.
Hidden Characteristics: Adverse Selection: A situation in which those on the informed side of the
market have more information than the other side about important product characteristics. Adverse
selection occurs when those on the informed side of the market self-select in a way that harms the
uninformed side of the market.
USE POWERPOINT SLIDES 19-21 FOR THE FOLLOWING SECTION
Asymmetric Information in Labor Markets
Adverse-Selection Problems in Labor Markets: In order to attract qualified candidates, employers offer
going wages. However, talented individuals find this wage too low, and those who are less talented find
the wage attractive. The result is a pool of less-talented candidates from which the employer can select.
• Efficiency wage theory: Offering above-market wages to attract and retain more productive workers.
Signaling and Screening
CHAPTER SUMMARY
According to Ronald Coase, firms arise when production is more efficient using the hierarchy of the firm
than using market transactions. Because production requires elaborate coordination of many resources, all
this activity can usually be carried out more efficiently under the direction of a firm’s manager than by
having a consumer negotiate detailed performance contracts with many resource suppliers.
The extent to which a firm integrates vertically depends on the transaction costs and the production costs
of economic activity. Other things constant, a firm is likely to buy a component rather than produce it if (a)
Chapter 14 Transaction Costs, Imperfect Information, and Behavioral Economics 200
When the productivity of job applicants cannot be directly observed, an employer may try to screen them
based on some signal such as the level of education or college grades that more-productive workers can
send more easily than can less-productive workers.
Standard economics assumes that people are rational in pursuing their self-interest. But, psychologists
question the ability of humans to make complex decisions and to follow through on them. Behavioral
economics borrows insights from psychology to help explain some economic decisions that otherwise
seem inconsistent with rational self-interest.
TEACHING POINTS
1. Those who are interested in industrial organization will find the first part of this chapter especially
engaging. It concerns the reasons why firms exist. What do they do? What governs their size? What
limits their scope of operation?
2. The firm arises as a response to transaction costs. In a perfectly frictionless world of perfect infor-
3. The middle part of this chapter makes microeconomics more real by looking at the causes and con-
sequences of imperfect information problems. Students should be able to relate to many examples
including buying a used car, buying car insurance, and interviewing for a job. None of the material is
technical, and the students can get deeply involved in these issues if you let them.
SOLUTIONS TO PROBLEMS APPENDIX
1. (Make or Buy) List the criteria a firm applies in deciding whether to produce a component
part or purchase it in the market.
Chapter 14 Transaction Costs, Imperfect Information, and Behavioral Economics 201
Other things constant, the firm is more likely to buy a component rather than produce it if (a)
2. (Boundaries of the Firm) Ashland Oil buys its crude oil in the market. Larger oil refiners, such
as Texaco, drill for their own crude oil. Why do some oil companies drill for their own crude oil
and others buy crude oil in the market?
This question is asking about the appropriate level of vertical integration. Ashland may decide
not to provide its own crude oil for various reasons. As a small refiner, it may believe that its
3. (Economies of Scope) Distinguish between economies of scale and economies of scope. Why do
some firms produce multiple product lines, while others produce only one?
Economies of scale refers to a decrease in average cost per unit as the size of production
increases, whereas economies of scope refers to a decrease in average cost as a single firm
4. (Search with Imperfect Information) The following questions concern the accompanying graph.
a. Identify the two curves shown on the graph, and explain their upward or downward slopes.
b. Why does curve A intersect the horizontal axis?
c. What is the significance of quantity d?
d. What does e represent?
e. How would the optimal quantity of information change if the marginal benefit of
information increased—that is, if the marginal benefit curve shifted upward?
Chapter 14 Transaction Costs, Imperfect Information, and Behavioral Economics 202
a. Curve A represents the marginal cost of searching for additional information; curve B
represents the marginal benefit of additional information. The marginal cost curve slopes
upward because, as more and more information is gathered, gathering additional
5. (Search with Imperfect Information) Determine the effect of each of the following on the
optimal level of search.
a. The consumer’s wage increases.
b. One seller guarantees to offer the lowest price on the market.
c. The technology of gathering and transmitting market information improves.
a. As the consumer’s income increases, the opportunity cost of his or her time also increases.
Therefore, the marginal cost of additional information rises. The marginal cost curve shifts
Chapter 14 Transaction Costs, Imperfect Information, and Behavioral Economics 203
6. (Asymmetric Information) Define asymmetric information. Distinguish between hidden
characteristics and hidden actions. Which type of asymmetric information contributes to the
principal-agent problem?
Asymmetric information refers to a situation in which one side has more reliable information
about a good or service than the other side has. If one side of the transaction has more
7. (The Principal-Agent Problem) Discuss the nature of the principal-agent problem. Determine
which is the principal and which is the agent in each of the following relationships:
a. A firm that produces export goods and the export management company that helps market
its goods overseas
b. The management of a firm and its stockholders
c. A homeowner and the plumber hired to make repairs
d. A dentist and a patient
e. An employee-pension management firm and the company using its services
An agent is a person hired to act on behalf of the principal. The principal-agent problem occurs
when (1) the goals of the agent are incompatible with the goals of the principal and (2) the
e. Principal = company hiring the service; agent = pension management firm
8. (Adverse Selection and Moral Hazard) Describe the problems faced by health insurance
companies as a result of adverse selection and moral hazard. How do insurance companies try to
reduce these problems?
With adverse selection, people who are the most likely to make claims on their insurance (those
with the poorest health characteristics or lifestyles) are those who are the most likely to buy
9. (Signaling and Screening) Describe the functions of signaling and of screening in labor mar-
kets.
Chapter 14 Transaction Costs, Imperfect Information, and Behavioral Economics 204
Signaling is the attempt by the informed side of the market to communicate information that
the other side would find valuable. In the job market some jobs require abilities that are un-
10. (Signaling) Give an example of signaling in each of the following situations.
a. Choosing a doctor
b. Applying to graduate school
c. Filling out a form for a dating service
a. The doctor you choose is often recommended by another patient who presumably is a
“satisfied customer.” A doctor also displays his or her diploma and certification.
11. (Behavioral Economics) A management consultant advised a small business owner to fully
analyze all transaction costs, delineate the boundaries of the business, and develop an equation
to calculate exactly economies of scope. The owner replied that there were not enough hours in
the day to gather all this information and so the owner would just keep running the business in
the same way as usual. What assumption from traditional economics is in dispute here?
The traditional economic assumption illustrated in the question is unbounded rationality, the
12. (Limitations of Rationality) Describe two limitations that make rational economic decisions
more challenging.
Standard economics assumes that people are rational in pursuing their self-interest. But psy-
Chapter 14 Transaction Costs, Imperfect Information, and Behavioral Economics 205
Experiential Exercises
1. Nobel laureate Kenneth Arrow has contributed many important ideas to the economics of
2. Once students learn about the economics of asymmetric information, they can begin to see exam-
ples all around them. To demonstrate this point, have them check today’s Wall Street Journal for a
3. Many firms utilize both the concepts of outsourcing and economies of scope. Ask students to find
an example of a firm using one of these concepts in the Wall Street Journal (the lead stories,
