An Economic Theory of Information

Abstract: We develop a formal model that expands, and in the process radically alters the basic Walrasian model, by incorporating costly information into it. In the Walrasian model, where information is costless, actors in the market are consumers and producers and prices are all they react to. Moreover, property rights are well-defined and there is no dissipation. In our model information is costly and this changed assumption does not merely add a third axis to the traditional two. Rather, costly information affects the contents of the two variables. For instance, changes in information cost affect the supply function via the decision to switch from producing for the market to producing within the firm. Regarding consumption, consumers require information to learn about the existence of commodities, their quality and their prices, thus affecting the consumption function. The costliness of information implies that transaction costs are positive and property rights are not well-defined. As an additional result of the costliness of information, besides buyers and sellers, also emerging are intermediaries. In our model, beside buying and selling, the parties engage in activities that include measuring, deception, waiting in line, erecting fences, establishing reputation and guaranteeing, all of which are absent from the Walrasian model. Whereas property rights are not well defined, the parties act so as to minimize the dissipation. Our model enables us to make predictions regarding such phenomena as the change in the make-up of hamburgers as we move from buying them in supermarkets to buying them for take-outs to buying them in restaurants where land rent is cheap and in ones where land rent is expensive. It also makes predictions regarding intermediation and horizontal and vertical integration. The usefulness of our model is demonstrated by recognizing that the Walrasian model is incapable of making many of the predictions we are able to derive from our model.