13. The Economics of 13. The Economics of Information and UncertaintyInformation and Uncertainty13. The Economics of 13. The Economics of Information and UncertaintyInformation and Uncertainty

• Risk aversion

• Asymmetric information

• (pages 333-342)

• Risk aversion

• Asymmetric information

• (pages 333-342)

The role of informationThe role of informationThe role of informationThe role of information

• assumption: free flow of information

• reality: information is costly • time and money

decisions under uncertainty• lack of complete information• some parties have more information

• assumption: free flow of information

• reality: information is costly • time and money

decisions under uncertainty• lack of complete information• some parties have more information

Uncertainty & RiskUncertainty & RiskUncertainty & RiskUncertainty & Risk

• Uncertainty which event will occur?

With uncertainty, comes risk

• Risk= possibility of a bad outcome• financial or property loss• illness• death

• Uncertainty which event will occur?

With uncertainty, comes risk

• Risk= possibility of a bad outcome• financial or property loss• illness• death

concept: expected value (EV)concept: expected value (EV)concept: expected value (EV)concept: expected value (EV)

• need probability of outcome value of outcome

• EV = sum of (probability)(value) for each outcome

• EV is like the “average outcome” actually center of distribution of

outcomes

• need probability of outcome value of outcome

• EV = sum of (probability)(value) for each outcome

• EV is like the “average outcome” actually center of distribution of

outcomes

example 1: flip a coinexample 1: flip a coinexample 1: flip a coinexample 1: flip a coin

• 2 outcomes: 50% chance of heads 50% chance of tails

• game: flip a coin if heads, you get $0 if tails, I pay you $20

• 2 outcomes: 50% chance of heads 50% chance of tails

• game: flip a coin if heads, you get $0 if tails, I pay you $20

• expect value of the game

EV = (.5)0 + (.5)(20)

= $10

Note: $10 is not a possible outcome

But, played over and over, expect to average $10/game

• expect value of the game

EV = (.5)0 + (.5)(20)

= $10

Note: $10 is not a possible outcome

But, played over and over, expect to average $10/game

example 2: Lotteryexample 2: Lotteryexample 2: Lotteryexample 2: Lottery

• $2 scatch off game$0 80%

$2 12%

$5 7.9%

$500 .1%

EV = .8(0) + .12(2) + .079(5)

+ .001(500) = 1.135

• $2 scatch off game$0 80%

$2 12%

$5 7.9%

$500 .1%

EV = .8(0) + .12(2) + .079(5)

+ .001(500) = 1.135

back to example 1, coin tossback to example 1, coin tossback to example 1, coin tossback to example 1, coin toss

• What if I gave you a choice….

(1) take $10 and walk away

(2) take the gamble

• What if I gave you a choice….

(1) take $10 and walk away

(2) take the gamble

• If you take the $10 risk averse

prefer the risk free $10 to the game with EV of $10

• If you take the gamble risk preference/risk loving

• If you don’t care risk neutral

• If you take the $10 risk averse

prefer the risk free $10 to the game with EV of $10

• If you take the gamble risk preference/risk loving

• If you don’t care risk neutral

• What if I gave you a choice….

(1) take $5 and walk away

(2) take the gamble

• What if I gave you a choice….

(1) take $5 and walk away

(2) take the gamble

• if you take the $5 still risk averse “paying” to avoid the gamble

• if you take the $5 still risk averse “paying” to avoid the gamble

risk aversionrisk aversionrisk aversionrisk aversion

• all else equal, we do not like risk

• basic assumption in finance

• explains insurance market risk/return tradeoff in financial

assets

• all else equal, we do not like risk

• basic assumption in finance

• explains insurance market risk/return tradeoff in financial

assets

then why does a lottery exist?then why does a lottery exist?then why does a lottery exist?then why does a lottery exist?

• risk aversion depends on what is at stake lottery is a leisure activity different attitudes with retirement,

college savings, etc.

• risk aversion depends on what is at stake lottery is a leisure activity different attitudes with retirement,

college savings, etc.

Risk Pooling & InsuranceRisk Pooling & InsuranceRisk Pooling & InsuranceRisk Pooling & Insurance

• risk is inevitable

• what to do? spread out risk among many loss for any one event is small = risk pooling

• risk is inevitable

• what to do? spread out risk among many loss for any one event is small = risk pooling

exampleexampleexampleexample

• $10,000 in stock market

(1) all of it in Google

(2) spread out among 500 stocks, including Google

What if Google loses 20% of value?

• option 2 takes less of a hit offset by gains in other stocks

• $10,000 in stock market

(1) all of it in Google

(2) spread out among 500 stocks, including Google

What if Google loses 20% of value?

• option 2 takes less of a hit offset by gains in other stocks

Insurance marketInsurance marketInsurance marketInsurance market

• based on customers paying to avoid risk• risk averse

firm pooling the risks of many customers

• my home burning down is catastrophic for me, a small set back for State Farm

• based on customers paying to avoid risk• risk averse

firm pooling the risks of many customers

• my home burning down is catastrophic for me, a small set back for State Farm

Asymmetric Information Asymmetric Information Asymmetric Information Asymmetric Information

• 2 parties in a transaction

• one has better info than the other could exploit this for advantage

• if not controlled, this leads to markets breaking down

• 2 parties in a transaction

• one has better info than the other could exploit this for advantage

• if not controlled, this leads to markets breaking down

• Asym. info affects buy/sell goods• eBay, used cars

insurance market lending market

• Asym. info affects buy/sell goods• eBay, used cars

insurance market lending market

2 problems:2 problems:2 problems:2 problems:

• adverse selection occurs before the transaction

• moral hazard occurs after the transaction

• adverse selection occurs before the transaction

• moral hazard occurs after the transaction

Adverse selectionAdverse selectionAdverse selectionAdverse selection

• people most who are most risky are more likely to seek insurance borrow money sell their crappy stuff

• the adverse are more likely to be selected

• people most who are most risky are more likely to seek insurance borrow money sell their crappy stuff

• the adverse are more likely to be selected

• why a problem? uninformed party may leave

market beneficial transactions do not

occur

• solution? screening certifications

• why a problem? uninformed party may leave

market beneficial transactions do not

occur

• solution? screening certifications

example 1: life insuranceexample 1: life insuranceexample 1: life insuranceexample 1: life insurance

• adverse selection: sick/dying people more likely to

want life insurance

• solution health history, blood work, etc. or group membership

• adverse selection: sick/dying people more likely to

want life insurance

• solution health history, blood work, etc. or group membership

example 2: bank loanexample 2: bank loanexample 2: bank loanexample 2: bank loan

• adverse selection: riskier people more likely to need

money

• solution credit history, references….

• adverse selection: riskier people more likely to need

money

• solution credit history, references….

example 3: used carsexample 3: used carsexample 3: used carsexample 3: used cars

• adverse selection: used cars for sale because owner

wanted to dump it

• solution: VIN checks, certified, warranty

• adverse selection: used cars for sale because owner

wanted to dump it

• solution: VIN checks, certified, warranty

example 4: ebayexample 4: ebayexample 4: ebayexample 4: ebay

• adverse selection site attracts scam artists since

buyer must pay first

• solution screening: feedback system backround check (not done)

• adverse selection site attracts scam artists since

buyer must pay first

• solution screening: feedback system backround check (not done)

Moral HazardMoral HazardMoral HazardMoral Hazard

• after transaction, people likely to engage in risky behavior or not “do the right thing.”

• hazard of lack of moral conduct

• after transaction, people likely to engage in risky behavior or not “do the right thing.”

• hazard of lack of moral conduct

• why a problem? uninformed party may leave

market beneficial transactions do not

occur

• solution? monitoring restrictions on allowed behavior

• why a problem? uninformed party may leave

market beneficial transactions do not

occur

• solution? monitoring restrictions on allowed behavior

example 1: auto insuranceexample 1: auto insuranceexample 1: auto insuranceexample 1: auto insurance

• moral hazard given coverage, drive less

carefully or do not lock up

• solution monitor for tickets discount for anti-theft device

• moral hazard given coverage, drive less

carefully or do not lock up

• solution monitor for tickets discount for anti-theft device

example 2: bank loanexample 2: bank loanexample 2: bank loanexample 2: bank loan

• moral hazard get the loan and “blow the money”

so cannot pay it back

• solution collateral insurance to protect collateral consequences on credit report

• moral hazard get the loan and “blow the money”

so cannot pay it back

• solution collateral insurance to protect collateral consequences on credit report

example 3: ebay example 3: ebay example 3: ebay example 3: ebay

• moral hazard buyer pays for item,• never gets it or defective• seller disappears

• solution feedback consequences PayPal & credit card protection

• moral hazard buyer pays for item,• never gets it or defective• seller disappears

• solution feedback consequences PayPal & credit card protection

SummarySummarySummarySummary

• risk is central to most transactions

• information is costly and not perfect (a big benefit of the internet is how

it lowered the cost of information)

• all else equal, we do not like risk or uncertainty risk pooling, screening, &

monitoring all manage this

• risk is central to most transactions

• information is costly and not perfect (a big benefit of the internet is how

it lowered the cost of information)

• all else equal, we do not like risk or uncertainty risk pooling, screening, &

monitoring all manage this