9.1: Overview and Objectives

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In many economic models, it is assumed that information is freely available. For example, in the neoclassical model of the consumer covered in Chapter 5, the consumer knew prices and the amount of satisfaction that would derived from purchased goods. In Lancaster’s model or Becker’s model, the consumer knew even more and could ascertain the amounts of characteristics that were inherent in purchased goods or the time commitments required for household production. Moreover, both the buyer and seller were equally informed about characteristics of the product. In many real world cases, information is not freely available. Information is costly to obtain and a buyer must search for availability of goods and the prices at which they are being offered. Moreover, it is often difficult to judge, pre-purchase, how much of a given characteristic a product will contain.

If information is necessary for economic decision making and is costly, then it might be interesting to subject it to more formal analysis. In fact, economic analysis of information has been one of the most productive areas in the past few decades. The focus in this chapter will be necessarily brief with the overall aims being (1) to shed light on some primary information problems in the functioning of markets and (2) to emphasize the roles that advertising and other activities can play in solving these problems. The specific objectives of this chapter are as follows:

Explain the problems of adverse selection and moral hazard that result from information asymmetries.
Explain the role of advertising to facilitate transactions that involve costly information, asymmetric information, or some combination of the two.
Distinguish between default-independent and default-contingent signals, provide examples of each, and describe situations where each may be effective.
Explain the concept of a separating equilibrium and why it is important to the functioning of economic signals.