Information Economics

by

Jeffrey Reuer, Sandip Bisui

• LAST REVIEWED: 12 January 2022
• LAST MODIFIED: 12 January 2022
• DOI: 10.1093/obo/9780199846740-0209

Introduction

Information economics can be best described as a shift in the traditional neoclassical assumption of perfect information. Neoclassical economics assumes that all actors have access to perfect information and are rational in their behavior. Over the years, as scholars have realized that the assumptions of neoclassical economics are not an accurate reflection of the real world, other research streams have developed that relax these assumptions. Information economics is one such stream, arguing that actors or parties have differential access to information, which raises the concern of adverse selection and moral hazard when the actors or parties participate in a transaction. Adverse selection occurs when one party has more information about the product or service than the other party and it leads to a less profitable or riskier transaction for the uninformed party. Alternatively, moral hazard occurs after the transaction, where one party has an incentive to engage in risky behavior when the other party bears the cost of failure. Information economics offers insights to both these concerns and offers solutions in the form of signaling and protection mechanisms. Signaling theory, a component of information economics, addresses how one party can credibly convey information to its potential exchange partners to facilitate transactions. The concepts of information asymmetry and signaling have been widely used in economics and business research to understand concepts ranging from game theoretic models of investments to principal–agent relationships to adverse selection problems in transactions. Information economics offers strong foundations for research within management as it helps understand several phenomena related to organizational transactions. For instance, corporate strategy scholars have utilized the predictions stemming from information economics in acquisition research to study target search, selection, signaling behavior, acquisition contracting, premiums, and governance. Information economics also has broad potential to affect firms’ organizational governance and entry mode choices. The following paragraphs will discuss how this theory has been developed and provide a few applications of information economics in strategy and management research.

Key Terminologies in Information Economics

In this section is a list of key terminologies that are prominent in this scholarly field. Notable scholarly works such as Arrow 1963, Akerlof 1970, Spence 1973, Stigler 1961, and Stiglitz 2000 use these terminologies extensively to understand important managerial consequences that can be studied using information economics. These terminologies are quite relevant to understand the dilemmas firms face while transacting in the presence of information asymmetry. For example, a review article, Bergh, et al. 2019, shows that the term information asymmetry has been used in over two hundred articles published in leading management journals. Bergh, et al. 2014 and Connelly, et al. 2011 give comprehensive overviews of all the studies that used signaling theory in management research. Terms include information asymmetry: Information asymmetry is a state in which parties involved in transactions have differential access to information, and typically the seller has more information regarding the quality of the goods than potential buyers; adverse selection: Adverse selection occurs when one party involved in a trade (typically the buyer) has less access to information and overpays, or acquires a good or asset of inferior quality or value relative to its price; moral hazard: Occurs when one party performs risky actions because the other party bears the cost of failure; screening: Screening represents costly information search or actions by less informed parties to mitigate adverse selection—for example, insurance companies design policies so that customers of different risks choose appropriate policies; signals: Signals are actions that sellers can take to reduce adverse selection, or the risks associated with information asymmetry—actions are signals when they are positively related to unobserved quality and are also more costly for parties with inferior goods or assets to undertake; hidden action: A party involved in a transaction is unaware of the behavior of its counterpart; and hidden information: A party does not know the counterpart’s “type” (e.g., high versus low quality) prior to a transaction.

• Akerlof, G. “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism.” The Quarterly Journal of Economics 84.3 (1970): 488–500.

  DOI: 10.2307/1879431

  Akerlof is one of the first scholars to provide insights on how asymmetric information between buyer and seller leads to inefficiencies.

• Arrow, K. J. “Uncertainty and the Welfare Economics of Medical Care.” American Economic Review 53.5 (1963): 941–973.

  Arrow introduced the notion of information asymmetry between a buyer (in this case, a patient) and a seller (the doctor).

• Bergh, D. D., B. L. Connelly, D. J. Ketchen Jr., and L. M. Shannon. “Signalling Theory and Equilibrium in Strategic Management Research: An Assessment and a Research Agenda.” Journal of Management Studies 51.8 (2014): 1334–1360.

  DOI: 10.1111/joms.12097

  This article shows the importance of signaling theory in strategic management and gives a comprehensive overview of all the studies that used this theory.

• Bergh, D. D., D. J. Ketchen Jr., I. Orlandi, P. P. Heugens, and B. K. Boyd. “Information Asymmetry in Management Research: Past Accomplishments and Future Opportunities.” Journal of Management 45.1 (2019): 122–158.

  DOI: 10.1177/0149206318798026

  This article examines the growing use of the concepts related to information asymmetry in management research.

• Connelly, B. L., S. T. Certo, R. D. Ireland, and C. R. Reutzel. “Signaling Theory: A Review and Assessment.” Journal of Management 37.1 (2011): 39–67.

  DOI: 10.1177/0149206310388419

  This article shows the growing use of signaling theory and gives a comprehensive overview of the studies that used this concept.

• Spence, M. “Job Market Signaling.” The Quarterly Journal of Economics 87.3 (1973): 355–374.

  DOI: 10.2307/1882010

  Spence was one of the first scholars to discuss how signals can potentially mitigate exchange hazards such as adverse selection in a transaction with asymmetric information.

• Stigler, G. J. “The Economics of Information.” Journal of Political Economy 69.3 (1961): 213–225.

  DOI: 10.1086/258464

  Stigler is one of the first scholars to emphasize the economics of information. In this article, Stigler examines the important effect of information on market prices.

• Stiglitz, J. E. “The Contributions of the Economics of Information to Twentieth Century Economics.” Quarterly Journal of Economics 115.4 (2000): 1441–1478.

  DOI: 10.1162/003355300555015

  In this review article, Stiglitz discusses the key concepts of information economics and their impact on the actions of firms and individuals.