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July 26, 2004

The Value of Information and Consumer Values

One research theme I've been pursuing is the implication of a consumer not knowing his own value for a good he might buy. This has well-known implications when the problem is of product quality, a dimension going from bad to good that is the same for everybody and that is known to the seller, if not the buyer. What I have looked at is the situation when what the buyer doesn't know is a value *unique to himself*, or to the particular transaction. Here are summaries of the papers:

"Explaining Incomplete Contracts as the Result of Contract-Reading Costs," in the BE Press journal, Advances in Economic Analysis and Policy. Vol. 1: No. 1, Article 2 (2001). http://www.bepress.com/bejeap/advances/vol1/iss1/art2. Much real-world contracting involves adding finding new clauses to add to a basic agreement, clauses which may or may not increase the welfare of both parties. The parties must decide which complications to propose, how closely to examine the other side's proposals, and whether to accept them. This suggests a reason why contracts are incomplete in the sense of lacking Pareto-improving clauses: contract-reading costs matter as much as contract- writing costs. Fine print that is cheap to write can be expensive to read carefully enough to understand the value to the reader, and especially to verify the absence of clauses artfully written to benefit the writer at the reader's expense. As a result, complicated clauses may be rejected outright even if they really do benefit both parties, and this will deter proposing such clauses in the first place. (http: //Pacioli.bus.indiana.edu/erasmuse/published/Rasmusen_01.negot.pdf).

"Getting Carried Away in Auctions as Imperfect Value Discovery" Bidders have to decide whether and when to incur the cost of estimating their own values in auctions. This can explain why people seem to get carried away, bidding higher than they had planned before the auction and then finding they had paid more than the object was worth to them. Even when such behavior is rational, ex ante, it may be perceived as irrational if one ignores other situations in which people revise their bid ceilings upwards and are happy when that enables them to win the auction. (http://www.rasmusen.org/papers/carried-rasmusen.pdf).

"Strategic Implications of Uncertainty Over One's Own Private Value in Auctions." Bidders have to decide whether and when to incur the cost of estimating their own values in auctions. This can explain sniping-- flurries of bids late in auctions with deadlines-- as the result of bidders trying to avoid stimulating other bidders into examining their bid ceiling more carefully. (http://www.rasmusen.org/papers/auction.pdf).

A new thought I just had is that this relates to the classic decision theory problem of The Value of Information, which I used to teach to 1st-year MBA students at UCLA (I've not been teaching first-years for five years or so, even at Indiana-- I wouldn't be surprised if this topic has now been dropped as too technical and upsetting to the students). The question is how much a decisionmaker should pay for information. The most valuable insight is that often he shouldn't pay anything.

I'll use consumer valuation as an example. Suppose I am thinking of buying a new car. How much time should I spend thinking about how much I like the BMW 300 series? Let us assume first that I don't enjoy thinking about cars, so this is a cost rather than recreation. Also, to make it precise, let us focus on the particular information of whether I really like the way the rear bumper looks. What is the greatest number of minutes of thinking time I should be willing to spend to find the answer?

One profound point is that I cannot answer that question unless I know (a) The value of buying the car if it turns out the bumper is ugly, (b) The value of buying the car if it turns out the bumper is pretty, and (c) The value of not buying the car at all.

Suppose that on reflection I decide I would buy the car even if the bumper is ugly. Then the information is worthless to me, and I shouldn't spend any time whatsoever thinking about it.

Or, suppose I decide I wouldn't buy the car even if the bumper were pretty. Again, the information is worthless to me. BIG LESSON: Information that won't affect the choice is useless.

Only in the case where the beauty of the bumper would swing the value of buying the car from negative to positive should I spend any time at all thinking about that feature. And we could then calculate the maximum number of minutes I should be willing to spend acquiring that information.

I find this idea coming up constantly in daily life, chiefly in the context of shopping. I will be shopping with someone, and we will decide that item X is really not suitable. I can then use this idea to say, "OK-- let's stop thinking about it, and go on to item Y. We really don't need to decide whether X is very bad, or merely bad." Or, if we decide to buy Z: "OK- let's buy it. We don't need to agonize over whether it has feature W or not, because we know we'd buy it even if it turned out to lack W."

Option theory enters into this too. I wonder if the Decision Theory texts look at it using option theory from Finance?

Posted by erasmuse at July 26, 2004 12:10 PM

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