THE INFORMATIONAL STRUCTURE OF MARKETS, THE INTERNET, TRANSACTION COSTS, AND THE CHANGING STRUCTURE OF THE GLOBAL ECONOMY: THE INFORMATIONAL STRUCTURE OF MARKETS, THE INTERNET, TRANSACTION COSTS, AND THE CHANGING STRUCTURE OF THE GLOBAL ECONOMY A. MICHAEL SPENCE W. EDMUND CLARK LECTURE QUEEN’S UNIVERSITY MARCH 2003


Topics This Afternoon: Topics This Afternoon Informational Structure of Markets The Economic Effects of Network-based Informational Technology Some thoughts on the global economy in the next few years


Informational Gaps/Asymmetries and Their Consequences: Informational Gaps/Asymmetries and Their Consequences The standard assumptions in price theory The informational underpinnings of a market Buyers and sellers can find each other They know the products’ characteristics They know prices Matching in the case of product differentiation In reality there are many markets with informational asymmetries and gaps – and they don’t just go away – at least not always


Examples: Examples Informational asymmetries and the existence of “private” information are common characteristics Labor/job/human resources Insurance Financial Markets Drugs Durable goods of some complexity Used products


How do markets perform with informational gaps?: How do markets perform with informational gaps? Two generic problems Adverse selection Moral hazard Signaling/screening and closing the informational gaps Informational intermediaries and changes in structure Regulation, the legal environment and disclosure laws


Slide6: Quantity Price The Standard Analysis of Market Equilibrium demand supply


Slide7: price quantity Supply curve Family of demand curves Derived demand curve Markets with Adverse Selection


Signaling and Screening: Signaling and Screening There is a clear incentive for the higher quality sellers to try to signal to buyers Equally clear incentive for the lower quality sellers to try to imitate the signal Therefore many potential signals self-destruct in the market place as a result


Signaling (continued): Signaling (continued) The theory concerns what signals survive in a market and why they survive The One Sentence Summary Effective signals (that is signals that survive) are actions that are (I) visible and (ii) less costly for the high-quality sellers Warranties in the case of used cars for example Education in the case of job markets


Signaling Equilibria with Two Groups and an “Unproductive” Signal: Signaling Equilibria with Two Groups and an “Unproductive” Signal Think of this as a job market Two groups Unobserved productivity of 1 and 2 Observable activity called a signal Costs are E and E/2 Fraction of the population in group 1 is “a”


Summary Data: Summary Data


The Main Point: The Main Point The cost of education is less for the higher productivity group Intuitively this is what is required for a signal to survive in the market Otherwise the signal of higher quality can be imitated by the lower productivity group


The Structure of the Model: The Structure of the Model Employers’ beliefs about productivity, given education, formed or revised Wages offered to education levels by employers Costs of Education Choice of Education levels for each level of productivity Empirical relationship of productivity and education in the market – discovered after hiring


Properties: Properties Individual choices are rational And employer expectations are (self) confirmed by incoming data Multiple equilibria Equilibria are Pareto orderable Separating and pooling equilibria


Pooling: Pooling Pooling beats separating if 2-a > 2-.5(1+d) Or if a < 0.5(1+d) That is pooling wins if group 1 is “small enough”


Taxing the Signal to Improve Efficiency: Taxing the Signal to Improve Efficiency To achieve efficiency and separation, set tax rate of t on the signal, and distribute income from the tax equally to all Let E*=(1+d)/(1+t) Let t get large and d small. Result is separating equilibrium with net incomes of 2-a for everyone – the same as the pooling result


The Internet: The Internet Technology Drivers Moore’s Law Metcalfe’s Law Bandwidth in optic fiber Cost reduction in the first 50 years


Transaction Costs and the Internet: Transaction Costs and the Internet Economists refer to all those costs that are associated with creating or altering the informational underpinnings of markets and business processes, as TRANSACTION COSTS Network-based information technology has the potential to reduce (dramatically) transaction costs It does not eliminate private information – but it does alter the characteristics of market equilibria


Areas of Impact: Areas of Impact The effects are pervasive and large Changes the informational structure of markets Also geographic boundaries of markets Because time and distance are collapsed in the information layer Hence liquidity or density increases Buyer knowledge How supply chains respond to shocks


Areas of Impact (continued): Areas of Impact (continued) Creating new markets efficiently Removing time, cost and manual effort from business processes Lowering cost of acquiring product information Expanding the Scope for Outsourcing Changing the informational parameters around market models


Creating New Markets – eBay: Creating New Markets – eBay Cost of buyers and sellers finding each other The marketplace Localization and liquidity Several million new markets a day Liquidity Effect and “natural” monopoly


Outsourcing and The Supply-Demand Chain: Outsourcing and The Supply-Demand Chain Well known subject in economics and business Ronald Coase The outsourcer gets to focus on what it is good at The outsourcee adds value by contributing expertise, economies of scale and scope, best practice The countervailing force is transaction costs All those costs or communicating coordinating and aligning incentives among multiple organizations


What does this have to do with information technology: What does this have to do with information technology At one level these are separate but related subjects The economics of vertical, horizontal, geographical and functional integration (or disintegration) have been around for a long time Absence transaction costs, there would be no excuse for performing any function that another entity can perform at lower costs Many types of transaction costs are lowered by the internet and hence shift the balance significantly in the direction of outsourcing


Transactions/Communication Costs: Transactions/Communication Costs Historically a rising function of time and distance Because time and distance are collapsed in the information layer The absolute and percentage reductions are a rising function of time and distance Hence the biggest long run effect is likely to be a step-up in the degree of efficiency and integration in the global economy


Trapped Intangible Assets and Human Resources: Trapped Intangible Assets and Human Resources Lowering transaction costs makes intangible assets that were isolated more valuable Human resources Knowledge Geographic and organizational dimensions Value can be created for all parties Employees, employers and suppliers of the connecting technology


Another Perspective: The Global Company as Vertical Architect of the Value Added Chain: Another Perspective: The Global Company as Vertical Architect of the Value Added Chain The input-output paradigm in economics Vertical integration versus vertical architect The traditional constraints Information technology as the critical tool In some ways outsourcing is the story of the development of the global economy


Productivity Data: Productivity Data The puzzle in the early years of information technology Large productivity growth in the last decade In most industries Related to IT investment The importance of the network Lowering the costs of coordinating economic activity The elimination of time and distance related costs in the information layer The good news is that this has barely started


The Internet Bubble: The Internet Bubble Hype? Will it all go away Excess valuations Historical experience The case of the electric motor What we have just observed and lived through is quite common The mistake that gets repeated


NASDAQ: NASDAQ


The Short Run: The Short Run Excess capacity and excess debt Terrorism and war Corporate misbehavior Skepticism about financial markets, corporate information, valuations and public and private companies Absence of exit strategies for venture-funded companies A higher degree of uncertainty and complexity than in a “normal” recession Digging out of this is not going to be easy


The Longer Run: The Longer Run Network based information technology infrastructure will get built out globally making the idea of the global economy real This is efficient outsourcing on a very large scale The growth potential is staggering if your time horizon is 10 to 20 years In the infrastructure And in the outsourcing It will occur over several decades at an accelerating pace


Number of Years to Reach 30% Penetration of U.S. Householdsfor Various Information Technologies: Number of Years to Reach 30% Penetration of U.S. Households for Various Information Technologies


Growth Rates in Economic Development: Various Industrial Revolutions – Paul Romer: Growth Rates in Economic Development: Various Industrial Revolutions – Paul Romer England 1% 69 Continental Europe and the USA 2% 35 Japan 7-8% 10 South Korea 10+% 6.6 It is accelerating probably because of Developed economy demand Technology transfer Efficiency of integration of global markets


The Economic Development Process and Globalization: The Economic Development Process and Globalization 20th Century experience – no known substitute for market system for efficient allocation of resources to highest and best use But the market system is being oversold It is a necessary but not sufficient condition for economic development and growth


Growth, Productivity and Assets: Growth, Productivity and Assets Per capita GDP grows with Productivity Increases Productivity is function of a vector of assets that are accumulated over time Human capital Infrastructure Legal and regulatory structure Technology and know how Tangible Private Capital Political Stability and Peace Labor Mobility These are accumulated over decades


Anti-globalization forces: Anti-globalization forces Complex coalition Environmental issues The wage issue Protectionism Volatility Governance


Creating Versus Capturing Value: Creating Versus Capturing Value It is easy to see the potential social value creation The issue is whether suppliers capture enough of the value to justify the investment Capturing value The revenue model Closely related question What is the right mix of public and private sector investment


Surpluses and Sources of Value Creation: Surpluses and Sources of Value Creation Price/ willingness to pay Quantity Demand curve Supply curve


Education in the Developing World: Education in the Developing World The production function Teachers A facility Health Enough wealth that not needed at home to work Stability at home and in environment Information resources