Expected Utility Framework A man does not often change his deepest convictions [utility function]. But it is not unusual for a man to change his calculation of risk [subjective probabilities of possible outcomes]. “Israel’s Unlikely Dove” The Economist, 10/23/04 (An editorial about Sharon’s intention to remove Israeli settlements from Gaza.)

Expected Utility Framework Deriving your utility function: –why weight outcomes 50:50 when searching for certainty equivalents? –after all, some outcomes are much more likely than others But, it’s a lot easier to conceptualize the gamble as a coin toss.

Problem 17.5: Venturesome MBAs Half of MBAs have really good ideas The other half have fair ideas –Why does an investor who buys a small share of each proposition wind up with more fair propositions than really good ones? ASYMMETRIC INFORMATION Insiders know more than outsiders How can purveyors of good ideas signal? How can venture capitalists screen?

Hidden or Asymmetric Information Insiders know more than outsiders Adverse selection … lemons problem –before deal is done Moral hazard –after deal is done

Adverse Selection: the lemons problem Used cars that are worth $ $3000 to potential buyers –Worth somewhat less to sellers If the cars were worth more to them, they’d buy the cars from themselves Reaction Function  Vicious cycle Only a few and the worst cars sold –Market failure

Eliciting Relevant Information: Signaling by Insider Screening by Outsider Demographics Legally mandated disclosure Voluntary disclosure –Ask … and TRUST –Authoritative checks Your mechanic Insurance company’s physician Self-disclosure, e.g. on insurance policies –Deductibles –% Coverage

Warranties: Making the Used Car Market Work Offering a warranty costs seller of a lemon a lot. Offering a warranty doesn’t cost seller of a cream-puff much –And warranty is worth something to buyer besides –Buyer is willing to cover some of the warranty’s cost) Lemons sell at low price and with no warranty Cream-puffs sell at high price with warranty

Auctions: The Winner’s Curse When other informed parties bid less than you do, chances are you’ve bid too much. –Welcome to Ebay world If you’ve bid what the prize is worth to you Be happy … Don’t worry –Oil extraction rights –Foreclosed properties Avoid auctions? Game the auction? –What’s the prize worth to others? –What are their strategies? Figure they’re figuring your strategy