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The Economics of Information and Uncertainty

Risk aversion Asymmetric information

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The 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

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Uncertainty & Risk

Uncertainty which event will occur?

With uncertainty, comes risk Risk

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

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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

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example 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

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expect value of the gameEV = (.5)0 + (.5)(20)

= $10

Note: $10 is not a possible outcome

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

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example 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

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back to example 1, coin toss

What if I gave you a choice….(1) take $10 and walk away

(2) take the gamble

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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

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What if I gave you a choice….(1) take $5 and walk away

(2) take the gamble

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

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risk aversion

all else equal, we do not like risk basic assumption in finance explains

insurance market risk/return tradeoff in financial assets

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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.

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Risk Pooling & Insurance

risk is inevitable what to do?

spread out risk among many loss for any one event is small = risk pooling

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example

$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

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Insurance 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

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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

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Asym. info affects buy/sell goods

eBay, used cars

insurance market lending market

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2 problems:

adverse selection occurs before the transaction

moral hazard occurs after the transaction

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Adverse 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

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why a problem? uninformed party may leave market beneficial transactions do not occur

solution? screening certifications

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example 1: life insurance

adverse selection: sick/dying people more likely to want life

insurance

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

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example 2: bank loan

adverse selection: riskier people more likely to need money

solution credit history, references….

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example 3: used cars

adverse selection: used cars for sale because owner wanted to dump

it

solution: VIN checks, certified, warranty

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example 4: ebay

adverse selection site attracts scam artists since buyer must pay first

solution screening: feedback system backround check (not done)

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Moral Hazard

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

hazard of lack of moral conduct

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why a problem? uninformed party may leave market beneficial transactions do not occur

solution? monitoring restrictions on allowed behavior

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example 1: auto insurance

moral hazard given coverage, drive less carefully or do not lock

up

solution monitor for tickets discount for anti-theft device

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example 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

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example 3: ebay

moral hazard buyer pays for item,

never gets it or defective seller disappears

solution feedback consequences PayPal & credit card protection

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Summary

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