Economics by David Begg, Gianluigi Vernasca, Stanley Fischer & Rudiger Dornbusch TENTH EDITION ©McGraw-Hill Companies, 2010 Chapter 12 Risk and information

Individual attitudes towards risk A risk neutral person –is only interested in whether the odds will yield a profit on average. A risk-averse person –will refuse a fair gamble –i.e. one which on average will make exactly zero monetary profit. A risk-lover –will bet even when a strict mathematical calculation reveals that the odds are unfavourable. ©McGraw-Hill Companies, 2010

Risk and insurance Risk-pooling –works by aggregating independent risks to make the aggregate more certain. Risk-sharing –works by reducing the stake. By pooling and sharing risks, insurance allows individuals to deal with many risks at affordable premiums. ©McGraw-Hill Companies, 2010

Moral hazard ©McGraw-Hill Companies, 2010 Moral hazard (or hidden action): in this case the uninformed agent cannot observe a particular action of the informed individual. For example, a worker may put little effort in performing his job if it is difficult for the employer to monitor her. The problem of moral hazard is also known as the principal-agent problem, where the principal is the name we give to the uninformed individual while the agent is the informed one.

Moral hazard and adverse selection Adverse selection (or hidden information) is the case where the uninformed individual does not know about an unobservable characteristic of the informed individual. Example of adverse selection: A person with a fatal disease signs up for life insurance. Example of moral hazard: Reassured by the fact that he took out life assurance to protect his dependants, a person who has unexpectedly become depressed decides to commit suicide. ©McGraw-Hill Companies, 2010

Education and signalling The theory assumes that people are born with different innate ability. The problem for firms is to tell which applicants are the ones with high productivity. There is a problem of asymmetric information. Signalling theory says that, in going on in education, people who know that they are clever send a signal to firms that they are the high- productivity workers of the future. ©McGraw-Hill Companies, 2010

Education and signalling (2) To be effective, the screening process must separate the high-ability workers from the others. Lower-ability workers do not go to university because they could not be confident of passing. ©McGraw-Hill Companies, 2010

d Decreasing returns to scale Total utility of income Utility Income £2,50£5.00£7.50 The utility of having £5 with certainty (point a) is higher than the expected utility from buying the asset (point d). The consumer is risk averse. Point d lies on the chord connecting points b and c. This is because expected utility is given by: E(U)=0.5U(£2.5)+0.5U(7.5) Point b is associated with U(£2.50) while point c is associated with U(£7.50). a b c ©McGraw-Hill Companies, 2010

Portfolio selection The risk-averse consumer prefers a higher average return on a portfolio of assets –but dislikes risk. ©McGraw-Hill Companies, 2010 Diversification –is a strategy of reducing risk by risk-pooling across several assets whose individual returns behave differently from one another. Beta –is a measurement of the extent to which a particular share's return moves with the return on the whole stock market.

Beta A share with beta = 1 moves the same way as the whole market. A high beta share does even better when the market is up, even worse when the market is down. A low beta share moves in the same general direction as the market but more sluggishly than the market. Negative beta shares move against the market. ©McGraw-Hill Companies, 2010

Beta for selected sectors Retailing 0.96Media1.2 Cosmetics0.66Defence1.14 Banks 1.27Paper0.99 Chemicals0.81Mining1.19 Energy0.82Textiles0.27 Brewing0.66Personal Products0.63 Tobacco0.59Clothing0.71 Source: Risk Management Services, A share with a low (or even negative) beta will be in high demand. Risk-averse purchasers are anxious to buy these as they reduce the total portfolio risk. ©McGraw-Hill Companies, 2010

More on risk A spot market –deals in contracts for immediate delivery and payment. A forward market –deals in contracts made today for delivery of goods at a specified future date at a price agreed today. Hedging –the use of forward markets to shift risk onto somebody else. A speculator –temporarily holds an asset in the hope of making a capital gain. ©McGraw-Hill Companies, 2010

Hedging Suppose today you can sell 1 tonne of copper for delivery in 12 months’ time at a price of £860 agreed today. You have hedged against the risky future spot price. You have sold your copper for only £860, even though you expect copper then to sell for £880 on the spot market. You regard this as an insurance premium to get out of the risk associated with the future spot price. ©McGraw-Hill Companies, 2010

Hedging: The speculator You sell the copper to a trader whom we can call a speculator. The speculator has no interest in the copper per se. Having promised you £860 for copper to be delivered in one year’s time, she currently expects to resell that copper immediately it is delivered. She expects to get £880 for that copper in the spot market next year, thus making £20 as compensation for bearing your risk. The speculator pays no money now. But If spot copper prices turn out to be less than £860 next year the speculator will lose money. ©McGraw-Hill Companies, 2010

Efficient asset markets The theory of efficient markets –says that the stock market is a sensitive processor of information, –quickly responding to new information to adjust share prices correctly. An efficient asset market already incorporates existing information properly in asset prices. ©McGraw-Hill Companies, 2010

Behavioural Finance Empirical evidence in support of efficient markets is mixed. Behavioural finance links finance, economics and psychology. Bounded rationality leads people to make decisions using heuristics. ©McGraw-Hill Companies, 2010

E-products: 4 key characteristics Experience explains why sellers allow sampling and browsing. Sellers also invest in a good reputation to reduce the need for buyers to sample. Information is an experience product. The first time we try something we find out how useful it is to us. Potential information overload explains why specialist agents develop to pre-screen material. Switching costs make future opportunities depend on current choices. ©McGraw-Hill Companies, 2010

Network externalities Network externalities are the final attribute. These arise when the value of a network depends on how densely it is populated. There is no point having a phone if nobody else has one. A network externality arises when an additional network member conveys benefits to those already on the network. ©McGraw-Hill Companies, 2010

P2P2 D1D1 D1D1 D2D2 q1q1 P1P1 q2q2 Each short run demand curve reflects the number of people already using the network. Reducing the price from P 1 to P 2 nor only causes a move from A to B, it also induces a shift in the demand curve since the network is more valuable. The long run demand curve joining points such as A and C is more elastic A demand curve with network externalities D2D2 D D A BC ©McGraw-Hill Companies, 2010