1. Consumer Choice With Uncertainty Part II: Examples Agenda: 1.The Used Car Game 2.Insurance & The Death Spiral 3.The Market for Information 4.The Price of Risk

2. The Used Car Game Buyers: If you buy a car for LESS than what it is worth you get a bonus point! BUT If you buy a care for MORE than what it is worth you LOSE a bonus point. Sellers: If you sell a car for MORE than what it is worth you get a bonus point! BUT If you sell a care for LESS than what it is worth you LOSE a bonus point. Good used cars are worth $10,000 Bad used cars are worth $2,000 The market has both good and bad cars.

3. “The Market for Lemons: Quality Uncertainty and the Market Mechanism” by George A. Akerlof (1970) QJE 84(3) 488 - 500 http://en.wikipedia.org/wiki/The_Market_for_Lemons If a good car is worth $10,000 and a “lemon” car is worth $2,000 how much would you be willing to pay for a car if you think 20% of cars are lemons and your utility = sqrt(M)? Test Yourself: If you owned a “good” car would you be willing to sell it for the “market” price? If you want to buy a car and know this (owners of good cars won’t sell) then how much would you be willing to pay? What units?

4. Market Failure! Is your $10,000 car worth $10,000 if you can’t sell it?

5. Because we are risk averse we are willing to pay MORE than the expected loss to reduce risk! → gains from trade!!

6. Key Formula Expected Utility WITH Risk = Expected Utility WITHOUT (with less) Risk Example: (U = sqrt(M)) Your car is worth $3,000. You have a 10% chance of having it stolen without recovery. How much would you pay for insurance that would pay 100% of your car’s value if stolen? Test yourself: What would you be willing to pay if you were risk neutral (U=M)? What we are willing to pay! MathTrick Square both sides!

7. Math Trick Multiply probabilities on each “branch” of the tree. Insurance – Adverse Selection & “The Insurance Death Spiral” Assume there are two groups in the population: healthy people have a 10% chance of having $360 in expenses and sick people have a 50% chance of having $360 in expenses. If everyone starts with $1000 in wealth and U = sqrt(M), what is the most each group would be willing to pay for insurance? $39.60$190 healthy sick.9.5.1 $1,000 $640.5 If a risk-neutral insurer could not tell who is in which group, what premium would it have to charge to cover expected losses?.5*.1*$360 +.5*.5*360 = $108 What will happen to the market if they charge this?

8. Mark Pauly The Economics of Moral Hazard: Comment The American Economic Review 58(3):1968 D2’: mild illness D3’: serious illness Marginal cost D2 D3’ 50 150 200300 Quantity of Medical Care Price of Medical Care 1 D2 and D3: Elastic demand Lower price, higher quantity Efficiency Loss Efficiency Loss AFP for D2’& D3’: ½ * 0 + ¼*$50 + ¼*$200 = $62.5 AFP for D2 & D3 : ½ *$ 0+ ¼*$150 + ¼*$300 = $112.5 People may be unwilling to pay 112.5. This is not market failure! Forcing people to have insurance does not improve social welfare. D2’ and D3’: Inelastic demand no change in quantity at any price

9. Signaling! Test yourself: Can you come up with a question that determines how much a company would be willing to pay for “brand” identity? How about how much more a consumer would be willing to pay for a branded rather than generic item?

10. The Price of Information You want to get into a top 10 MBA program because you will have an 80% chance of landing a job paying $100,000. In another program your chance of a $100,000 job is just 20%. You figure your odds of admission to a top program are 50-50. Is it worth paying an “admissions coach” $5,000 to improve your chance of admissions to 75%? Consider just one year of salary (not present value of future lifetime income) with a lower salary of $45,000 if you don’t get the $100,000 job. Yes! Utility with the coach = 270.34 > utility without = 264.18 If you’re the coach, could you charge more if you only get paid if your client gets into the top school and lands the $100K job? Assume no time value of money. Yes! You can charge $15,784 Test yourself: If you are the coach, what is your EXPECTED fee?

11. Top school Other School.8.2.75.25 If you’re the coach, could you charge more if you only get paid if your client gets into the top school and lands the $100K job? Again, assume no time value of money.

12. You own a bar, and you face the risk that your bartender will serve free drinks to his friends. You estimate that the probability of this is 50-50, and if he does the lost value to you will be about $10,000 per year. In addition, if he serves an underage friend you can face a $1 million liability. You think the risk of this is only 15% and independent of whether he serves friends generally. You can install a video security system to reduce both probabilities (independently) to 5% for $50,000. You are a risk-neutral business owner. Should you install the system? Expected loss without the system:.5*.85*$10,000 +.5*.15*$1,010,000 = $80,000 Expected loss with the system:.05*.95*$10,000 +.05*.05*$1,010,000 = $3,000 Think about it: What other management considerations might you have? How would you feel as a bartender if you knew you were being watched all the time? How would you feel as a customer? What other things might you be able to do to reduce the risk? Management – Moral Hazard, Incentives and Transaction Costs

13. Conclusion Uncertainty is everywhere! But we can deal with it!! Expected Value Expected Utility Willingness to Pay to reduce risk!