1. Twelfth Edition, Global Edition
ECONOMICS
Twelfth Edition, Global Edition
Michael Parkin 1

2. 20 UNCERTAINTY AND INFORMATION
Notes and teaching tips: 22, 33, 52, 64, 65, and 67.
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Applying the principles of economics to interpret and understand the news is a major goal of the principles course. You can encourage your students in this activity by using the two features: Economics in the News and Economics in Action.
(1) Before each class, scan the news and select two or three headlines that are relevant to your session today. There is always something that works. Read the headline and ask for comments, interpretation, discussion. Pose questions arising from it that motivate today’s class. At the end of the class, return to the questions and answer them with the tools you’ve been explaining.
(2) Once or twice a semester, set an assignment, for credit, with the following instructions:
(a) Find a news article about an economic topic that you find interesting.
(b) Make a short bullet-list summary of the article.
(c) Write and illustrate with appropriate graphs an economic analysis of the key points in the article.
Use the Economics in the News features in your textbook as models. 20
UNCERTAINTY AND
INFORMATION 2

3. After studying this chapter, you will be able to:
Explain how people make decisions when they are uncertain about the consequences
Explain how markets enable people to buy and sell risk
Explain how markets cope when buyers and sellers have private information
Explain how uncertainty and incomplete information influence the efficiency of markets 3

4. Decisions in the Face of Uncertainty
Tania, a student, is trying to decide which of two alternative summer jobs to take.
She can work as a house painter and have $2,000 by the end of the summer. There is no uncertainty about the income from this job.
She can work as a telemarketer with a 50 percent chance that she will earn $5,000 and a 50 percent chance that she will earn $1,000.
Which job does she prefer? 4

5. Decisions in the Face of Uncertainty
Expected Wealth
Expected wealth is the money value of what a person expects to own at a given point in time.
An expectation is an average calculated by using a formula that weights each possible outcome with the probability (chance) that it will occur.
What is Tania’s expected wealth from the telemarketing job? 5

6. Decisions in the Face of Uncertainty
The probability that Tania will have $5,000 is 0.5.
The probability that she will have $1,000 is also 0.5.
Expected wealth = ($5,000 × 0.5) + ($1,000 × 0.5)
= $3,000.
Tania can now compare the expected wealth from the two jobs:
$2,000 for the non-risky painting job
$3,000 for the risky telemarketing job 6

7. Decisions in the Face of Uncertainty
Will Tania take the risky job?
It will depend on how much Tania dislikes risk.
Risk Aversion
Risk aversion is the dislike of risk.
We measure a person’s attitude toward risk by using a utility of wealth schedule and curve.
Greater wealth brings greater total utility, but the marginal utility of wealth diminishes as wealth increases. 7

8. Decisions in the Face of Uncertainty
Utility of Wealth
Figure 20.1 shows Tania’s utility of wealth curve.
If Tania’s wealth is $2,000, she gets 70 units of utility. 8

9. 9

10. Decisions in the Face of Uncertainty
Tania’s total utility increases when her wealth increases.
But the marginal utility of wealth diminishes.
Each additional $1,000 of wealth brings successively smaller increments in total utility. 10

11. Decisions in the Face of Uncertainty
Because of diminishing marginal utility,
for a loss of wealth
or a gain of wealth of equal size,
Tania’s pain from the loss exceeds her pleasure from the gain. 11

12. Decisions in the Face of Uncertainty
Expected Utility
When there is uncertainty, people do not know the actual utility they will get from taking a particular action.
But they know the utility they expect to get.
Expected utility is the utility value of what a person expects to own at a given point in time. 12

13. Decisions in the Face of Uncertainty
Figure 20.2 shows how Tania calculates her expected utility.
Tania has a 50 percent chance of having $5,000 of wealth and total utility of 95 units.
Tania has a 50 percent chance of having $1,000 of wealth and a total utility of 45 units. 13

14. 14

15. Decisions in the Face of Uncertainty
Tania’s expected wealth is $3,000 and …
her expected utility is 70 units.
With $3,000 wealth and no uncertainty, utility is 83 units.
For a given expected wealth, the greater the range of uncertainty, the smaller is expected utility. 15

16. Decisions in the Face of Uncertainty
Making a Choice with Uncertainty
Faced with uncertainty, a person chooses the action that maximizes expected utility.
To select the job that gives her the maximum expected utility, Tania must calculate
The expected utility from the risky telemarketing job.
2. The expected utility from the safe painting job.
3. Compare the two expected utilities. 16

17. Decisions in the Face of Uncertainty
Figure 20.3 shows the choice under uncertainty.
In a telemarketing job, there is a 50 percent chance that Tania will make $5,000 and a 50 percent chance that she will make $1,000.
Her expected wealth is $3,000 and her expected utility is 70 units. 17

18. 18

19. Decisions in the Face of Uncertainty
Tania would have the same 70 units utility with wealth of $2,000 and no risk, so …
Tania’s cost of bearing this risk is $1,000. 19

20. Decisions in the Face of Uncertainty
Tania is indifferent between …
the job that pays $2,000 with no risk and
the job that offers an equal chance of $5,000 and $1,000. 20

21. Buying and Selling Risk
Just as buyers and sellers gain from trading goods and services, they can also gain from trading risk.
Risk is a bad, not a good, so the good that is traded is risk avoidance.
A buyer of risk avoidance can gain because the value of avoiding risk is greater than the price that must be paid to get someone else to bear that risk.
The seller of risk avoidance faces a lower cost of risk than the price that people are willing to pay to avoid that risk. 21

22. Buying and Selling Risk
Insurance Markets
Insurance plays a huge role in our lives.
How Insurance Reduces Risk
Insurance reduces the risk that people face by sharing or pooling risks.
When people buy insurance against the risk of an unwanted event, they pay an insurance company a premium.
And if the unwanted event does occur, the insurance company pays out the amount of the insured loss.
Classroom activity
Check out Economics in Action: Insurance in the United States 22

23. Buying and Selling Risk
Why People Buy Insurance
Dan owns a car worth $10,000, and that is his only wealth.
There is a 10 percent chance that Dan will have a serious accident that makes his car worth nothing.
Would Dan buy insurance? 23

24. Buying and Selling Risk
A Graphical Analysis of Insurance
Risk-Taking Without Insurance
Figure 20.4 illustrates. Dan’s wealth (the value of his car) is $10,000 and his utility is 100 units.
With no insurance, if Dan has a crash, he has no wealth and no utility. 24

25. 25

26. Buying and Selling Risk
With a 10 percent chance of a crash,
Dan’s expected wealth is $9,000. ($10,000 × 0.1)
With no insurance his expected utility is 90 units. 26

27. Buying and Selling Risk
Value and Cost of Insurance
Figure 20.5 shows that if Dan had $7,000 of wealth with no risk, …
he would have the same utility as he has with $10,000 of wealth and 10 percent risk of loss. 27

28. 28

29. Buying and Selling Risk
If Dan pays $3,000 for insurance, his wealth is $7,000 and …
his utility is 90 units.
So $3,000 is the value of insurance for Dan. 29

30. Buying and Selling Risk
If there are lots of people like Dan, each with a $10,000 car and a 10 percent chance of having an accident, …
an insurance company would pay claims of $1,000 per person on average.
The insurance company can provide coverage for people like Dan for $1,000 (10% of $10,000). 30

31. Buying and Selling Risk
Gains from Trade
If Dan pays $1,000 for insurance,
his expected wealth is $9,000 and his expected utility is 98 units.
Dan gains from insurance. 31

32. Buying and Selling Risk
Dan is willing to pay up to $3,000 for insurance that costs the insurance company $1,000, …
so there is a gain from trading risk of $2,000 per person. 32

33. Private Information
In the markets so far, the buyer and the seller are well informed about the features and value of the item traded.
But in some markets, either buyers or sellers are better informed.
These buyers or sellers have private information.
For example, you know about the quality of your driving, your work effort, and whether you intend to repay a loan, but others don’t.
Why are men (especially young men) charged more for auto insurance? Have the students consider the difficulty of providing insurance with affordable premiums to consumers, yet be profitable enough to encourage producers to accept the risks involved. For example, car insurance companies charge higher premiums to unmarried young men than they charge unmarried young women, even if two such individuals have the same driving records. This difference is based on statistical probabilities calculated by the insurance company keeping record of large samples of loss claims. Ask the students if this difference is “fair?” Then ask how a drivers’ risk-taking behavior might change once he or she is insured. This last question is a good introduction to the following material on private information and moral hazard. 33

34. Private Information
Private information is information possessed by a buyer or seller about the value of the item being traded that is not available to the person on the other side of a transaction.
When either buyers or sellers have private information, the market has asymmetric information. 34

35. Private Information Asymmetric Information: Examples and Problems
Asymmetric information creates two problems:
Adverse selection
Moral hazard 35

36. Private Information Adverse Selection
Adverse selection is the tendency for people to enter into agreements in which they can use their private information to their own advantage and to the disadvantage of the less informed party.
For example, if Jackie advertises jobs for salespeople at a fixed wage, she will attract lazy salespeople.
Hardworking salespeople will prefer to work for someone who pays by results, rather than a fixed wage.
The fixed-wage contract adversely selects those with private information about their work effort. 36

37. Private Information Moral Hazard
Moral hazard is the tendency for people with private information, after entering into an agreement, to use that information for their own benefit and at the cost of the less- informed party.
For example, Jackie hires Mitch as a salesperson and pays him a fixed wage regardless of how much he sells.
Mitch faces a moral hazard.
He has an incentive to put in the least possible effort, benefiting himself and lowering Jackie’s profits. 37

38. Private Information
A variety of devices have evolved that enable markets to function in the face of adverse selection and moral hazard.
We’re going to look at how three markets cope with adverse selection and moral hazard. They are
The market for used cars
The market for loans
The market for insurance 38

39. Private Information
The Market for Used Cars
A used car might be a lemon—a car that is worth less than a car with no defects.
But only the seller knows whether a car is a lemon.
The lemons problem is the problem that in a market in which it is not possible to distinguish reliable products from lemons, too many lemons and too few reliable products are traded.
How does a market work when it has a lemons problem? 39

40. Private Information The Lemons Problem in a Used Car Market
The market has two types of cars:
Lemons worth $5,000 each.
Cars without defects worth $25,000 each.
Whether the car is a lemon or not is private information of the current owner.
A buyer discovers a lemon only after buying it. 40

41. Private Information
Because buyers can’t tell the difference between a lemon and a good car, the price they are willing to pay reflects the fact that the car might be a lemon.
The highest price that a buyer will pay must be less than $25,000 because the car might be a lemon.
Some people with low incomes and time to fix a car are willing to buy lemons as long as they know what they are buying and paying for.
What is the price of a used car? 41

42. Private Information
So the most that the buyer knows is the probability of buying a lemon.
If half of the used cars sold turn out to be lemons, the buyer knows that he has a 50 percent chance of getting a good car and a 50 percent chance of getting a lemon.
The price that a buyer is willing to pay for a car of unknown quality is more than the value of a lemon because the car might be a good one.
But the price is less than the value of a good car because it might turn out to be a lemon. 42

43. Private Information
Sellers of used cars know the quality of their cars.
Someone who owns a good car is going to be offered a price that is less than the value of that car to the buyer.
Many owners will be reluctant to sell for such a low price.
So the quantity of good used cars supplied will not be as large as it would be if buyers paid the price they are worth. 43

44. Private Information
But someone who owns a lemon is going to be offered more than the value of that car to the buyer.
Owners of lemons will be eager to sell at such a high price.
So the quantity of lemons supplied will be greater than it would be if buyers paid the price that a lemon is worth. 44

45. Private Information In the used car market:
Adverse selection exists because there is a greater incentive to offer a lemon for sale.
Moral hazard exists because the owner of a lemon has little incentive to take good care of the car, so it is likely to become even worse.
The market for used cars is not working well.
Too many lemons and too few good cars are traded. 45

46. Private Information
Figure 20.6 illustrates the used car market. Part (a) shows the used car market.
Equilibrium price is $10,000 a car and 400 cars are traded. 46

47. 47

48. Private Information Part (b) shows the demand and supply of good cars.
At $10,000 a car, 200 good cars are traded. 48

49. Private Information Buyers are willing to pay $25,000 for a good car.
Too few good cars are traded.
A deadweight loss is created. 49

50. Private Information Part (c) shows the demand and supply of lemons.
At $10,000 a car, 200 lemons are traded. 50

51. Private Information Buyers are willing to pay $5,000 for a lemon.
Too many lemons are traded.
A deadweight loss is created. 51

52. Private Information A Used Car Market with Dealers’ Warranties
Buyers can’t tell a lemon from a good car, but car dealers sometimes can.
To convince a buyer to pay $10,000 for what might be a lemon, the dealer offers a warranty.
The dealer signals which cars are good ones and which are lemons.
Signaling occurs when an informed person takes actions that send information to uninformed persons.
Warranties enable the market to trade good used cars.
Classroom activity
Check out Economics in the News: Grades as Signals 52

53. Private Information
Figure 20.7 shows how warranties solve the lemons problem.
Part (a) shows the market for good cars.
With warranties, the price of a good car is $20,000 and 400 good cars are traded.
The market for good cars is efficient. 53

54. 54

55. Private Information Part (b) shows the market for lemons.
Because buyers can now spot a lemon (a car without a warranty) …
the price of a lemon is $6,667 and 150 lemons are traded.
The market for lemons is efficient. 55

56. 56

57. Private Information Pooling Equilibrium and Separating Equilibrium
Without warranties, only one message is visible to the buyer: All cars look the same.
The market equilibrium when only one message is available and an uninformed person cannot determine the quality is called a pooling equilibrium. 57

58. Private Information
In a market with warranties, there are two messages:
Cars with warranties are good cars and cars without warranties are lemons.
The market equilibrium when signaling provides full information to a previously uninformed person is called a separating equilibrium. 58

59. Private Information The Market for Loans Borrowers demand loans.
The lower the interest rate, the greater is the quantity of loans demanded.
Banks and other lenders supply loans.
For a given credit risk, the higher the interest rate, the greater is the quantity of loans supplied. 59

60. Private Information
The risk that a borrower, also called a creditor, might not repay a loan is called credit risk or default risk.
The credit risk depends on the quality of the borrower.
Low-risk borrowers always repay.
High-risk borrowers frequently default on their loans.
The market for loans determines the interest rate and the price of credit risk. 60

61. Private Information Inefficient Pooling Equilibrium
Suppose that banks cannot tell whether they are lending to a low-risk or a high-risk customer.
In this situation, all borrowers pay the same interest rate and the market is a pooling equilibrium.
The market for loans has the same problems as the used car market without warranties. 61

62. Private Information
If all borrowers pay the same interest rate, low-risk customers borrow less than they would if they were offered the low interest rate appropriate for their low credit risk.
High-risk customers borrow more than they would if they faced the high interest rate appropriate for their high credit risk.
So banks face an adverse selection problem.
Too many borrowers are high risk and too few are low risk. 62

63. Private Information Signaling and Screening in the Market for Loans
Lenders don’t know how likely a given loan will be repaid, but the borrower does know.
Low-risk borrowers have an incentive to signal their risk by providing lenders with relevant information.
Signals might include information about a person’s employment, home ownership, marital status, and age. 63

64. Private Information
High-risk borrowers might be identified simply as those who have failed to signal low risk.
These borrowers have an incentive to mislead lenders; and lenders have an incentive to induce high-risk borrowers to reveal their risk level.
Inducing an informed party to reveal private information is called screening.
Classroom activity
Check out Economics in Action: The Sub-Prime Credit Crisis 64

65. Private Information The Market for Insurance
People who buy insurance face moral hazard because they have less incentive than an uninsured person to avoid risk.
Insurance companies face adverse selection because people who create greater risk are more likely to buy insurance.
Moral hazard in game shows. The television show, “Who Wants to Be a Millionaire?” was insured by an insurance company that reimbursed the producers of the show when a contestant answered all the questions correctly and won a big dollar pay-out. This insurer had some serious disagreements with show’s producers after the show ran on national television for the first year, claiming concerns over moral hazard. In particular, the insurer claimed that the producer eased the questions asked the contestants in order to guarantee that some contestants won and thereby boosted the show’s excitement and ratings. The insurer wanted greater control over the difficulty of the questions being asked of the contestants. 65

66. Private Information
Insurance companies can do profitable business with everyone by offering coverage with a deductible (or a no claim bonus).
The larger the deductible, the lower is the premium.
High-risk people choose policies with the low deductible and high premium.
Low-risk people choose policies with a large deductible and low premium. 66

67. Uncertainty, Information, and the Invisible Hand
Information as a Good
More information is generally useful, and less uncertainty about the future is generally useful.
Along the production possibilities frontier, we face a tradeoff between information and other goods and services.
Information, like other goods and services, can be produced at an increasing opportunity cost.
Decreasing marginal benefit also applies to information.
Does the reduction of uncertainty necessarily reduce inefficiency? Point out to the students that even in our imperfect world of less-than-perfect information, there is no reason to expect that a government program designed to stamp out uncertainty can increase society’s net benefits. Because the marginal cost of information gathering and dissemination increases as more information is gathered and disseminated, attempts to eliminate uncertainty would surely require using productive resources that would have more benefit to society if they were used to provide other goods and services. 67

68. Uncertainty, Information, and the Invisible Hand
Because the marginal cost of information is increasing and the marginal benefit from information is decreasing, there is an efficient amount of information.
It is inefficient to have too much information.
Competitive markets in information might deliver the efficient amount. 68

69. Uncertainty, Information, and the Invisible Hand
Monopoly in Markets that Cope with Uncertainty
There are probably large economies of scale in providing services that cope with uncertainty.
Where monopoly elements exist, exactly the same inefficiency issues arise as occur in markets where uncertainty and incomplete information are not big issues.
So it is likely there is underproduction arising from the attempt to maximize monopoly profit. 69