(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 199

174 PART 2 • Producers, Consumers, and Competitive Markets
Because the title insurance company is a specialist in such insurance and can collect the relevant information relatively easily, the cost of title
insurance is often less than the expected value of
the loss involved. A fee of $1500 for title insurance is not unusual, even though the expected
loss can be much higher. It is also in the interest of sellers to provide title insurance, because

all but the most risk-loving buyers will pay much
more for a house when it is insured than when it is
not. In fact, most states require sellers to provide
title insurance before a sale can be completed.
In addition, because mortgage lenders are all
concerned about such risks, they usually require
new buyers to have title insurance before issuing
a mortgage.

The Value of Information
• value of complete
information Difference
between the expected value of
a choice when there is complete
information and the expected
value when information is
incomplete.

People often make decisions based on limited information. If more information
were available, one could make better predictions and reduce risk. Because information is a valuable commodity, people will pay for it. The value of complete
information is the difference between the expected value of a choice when there
is complete information and the expected value when information is incomplete.
To see how information can be valuable, suppose you manage a clothing store
and must decide how many suits to order for the fall season. If you order 100 suits,
your cost is $180 per suit. If you order only 50 suits, your cost increases to $200.

You know that you will be selling suits for $300 each, but you are not sure how
many you can sell. All suits not sold can be returned, but for only half of what you
paid for them. Without additional information, you will act on your belief that
there is a .5 probability that you will sell 100 suits and a .5 probability that you will
sell 50. Table 5.7 gives the profit that you would earn in each of these two cases.
Without additional information, you would choose to buy 100 suits if you
were risk neutral, taking the chance that your profit might be either $12,000 or
$1500. But if you were risk averse, you might buy 50 suits: In that case, you
would know for sure that your profit would be $5000.
With complete information, you can place the correct order regardless of
future sales. If sales were going to be 50 and you ordered 50 suits, your profits would be $5000. If, on the other hand, sales were going to be 100 and you
ordered 100 suits, your profits would be $12,000. Because both outcomes are
equally likely, your expected profit with complete information would be $8500.
The value of information is computed as
Expected value with complete information:
Less: Expected value with uncertainty (buy 100 suits):
Equals: Value of complete information

$8500
- 6750
$1750

Thus it is worth paying up to $1750 to obtain an accurate prediction of sales.
Even though forecasting is inevitably imperfect, it may be worth investing in a
marketing study that provides a reasonable forecast of next year’s sales.

TABLE 5.7

PROFITS FROM SALES OF SUITS ($)
SALES OF 50

SALES OF 100

EXPECTED PROFIT

Buy 50 suits

5000

5000

5000

Buy 100 suits

1500

12,000

6750