13. the economics of information and uncertainty risk aversion asymmetric information (pages...
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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