1 Extra Topics

2 Economics of Information Thus far we have assumed all economic entities have perfect information when making decisions - this is obviously a gross simplification We generally worry more about information flows between adversaries (those with conflicting goals) than those with common goals b/c there is goals in common - there’s an incentives problem Signaling: the conveying of credible information - signals work better when: –They are costly to fake (costly to fake principle) –Disclosure of favorable qualities creates an incentive for individuals to disclose unfavorable ones (full disclosure principle)

3 Information Problem: Adverse Selection & Moral Hazard If individuals have different attributes(i.e. they are heterogeneous), they will have different incentives to engage in economic trades (e.g. the purchase of insurance) –Adverse selection is the process whereby the less desirable potential trading partners are the ones who volunteer for trades We often see the problem of adverse selection arise with insurance when insurers cannot accurately distinguish between the good and bad insurance risks –A consequence of adverse selection is differential prices charged to individuals with different characteristics(statistical discrimination) based on attributes other than the attribute (e.g. careful driving) we care about most - related to arguments over national health care Insurance against losses may lead to an altering (inefficient type) of behavior referred to as moral hazard

4 Inefficiency Associated with Imperfect Information Assume that teenage boys make up 10% of drivers and that they cause an average of $1000/year in auto accidents where all other drivers cause an average of $100/year. Imagine that a law is passed that prohibits insurance companies from charging different rates based on personal characteristics. If all drivers are required by law to have insurance, what is the minimum premium insurance companies would charge for all drivers? If drivers are not required to have insurance, who would opt to buy insurance (assume they are risk neutral)? In the above case, what is the premium the insurance would end up charging?

5 Choice Under Uncertainty In the real world we make choices (economic transactions) based on uncertain payoffs –Thus, we calculate the expected value of alternative transactions in order to make decisions Expected value is the weighted average of all possible outcomes associated with a choice Von Neumann-Morgenstern expected utility model is the formal model whereby individuals are assumed to choose the alternative that brings the highest expected utility –Expected utility of a gamble (virtually everything is a gamble at one level or another) is the expected value of utility over all possible outcomes

6 Concavity of Utility Function and Risk Aversion Suppose a person gets utility only from the level of their wealth (W). These specifications have very different implications for the expected change in utility for a risky endeavor. Risk Neutral: Utility= aW Risk Aversion: Utility= W 1/2 Risk Loving: Utility = W 2

7 Expected Utility Problem Suppose U=W 1/2 You currently have wealth of $900 but have a 50% chance of losing $800 of it What is the maximum you would be willing to pay for an insurance policy that protects you from this risk?

8 Graphical Depiction of Expected Utility Problem Income Utility