# 13. The Economics of Information and Uncertainty Risk aversion Asymmetric information (pages 333-342) Risk aversion Asymmetric information (pages 333-342)

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13. The Economics of Information and Uncertainty Risk aversion Asymmetric information (pages 333-342) Risk aversion Asymmetric information (pages 333-342)

The role of information assumption: free flow of information reality:  information is costly time and money  decisions under uncertainty lack of complete information some parties have more information assumption: free flow of information reality:  information is costly time and money  decisions under uncertainty lack of complete information some parties have more information

Uncertainty & Risk Uncertainty  which event will occur? With uncertainty, comes risk Risk = possibility of a bad outcome financial or property loss illness death Uncertainty  which event will occur? With uncertainty, comes risk Risk = possibility of a bad outcome financial or property loss illness death

concept: expected value (EV) need  probability of outcome  value of outcome EV = sum of (probability)(value) for each outcome EV is like the “average outcome”  actually center of distribution of outcomes need  probability of outcome  value of outcome EV = sum of (probability)(value) for each outcome EV is like the “average outcome”  actually center of distribution of outcomes

example 1: flip a coin 2 outcomes:  50% chance of heads  50% chance of tails game: flip a coin  if heads, you get \$0  if tails, I pay you \$20 2 outcomes:  50% chance of heads  50% chance of tails game: flip a coin  if heads, you get \$0  if tails, I pay you \$20

expect value of the game EV = (.5)0 + (.5)(20) = \$10 Note: \$10 is not a possible outcome But, played over and over, expect to average \$10/game expect value of the game EV = (.5)0 + (.5)(20) = \$10 Note: \$10 is not a possible outcome But, played over and over, expect to average \$10/game

example 2: Lottery \$2 scatch off game \$0 80% \$2 12% \$5 7.9% \$500.1% EV =.8(0) +.12(2) +.079(5) +.001(500) = 1.135 \$2 scatch off game \$0 80% \$2 12% \$5 7.9% \$500.1% EV =.8(0) +.12(2) +.079(5) +.001(500) = 1.135

back to example 1, coin toss What if I gave you a choice…. (1) take \$10 and walk away (2) take the gamble What if I gave you a choice…. (1) take \$10 and walk away (2) take the gamble

If you take the \$10  risk averse prefer the risk free \$10 to the game with EV of \$10 If you take the gamble  risk preference/risk loving If you don’t care  risk neutral If you take the \$10  risk averse prefer the risk free \$10 to the game with EV of \$10 If you take the gamble  risk preference/risk loving If you don’t care  risk neutral

What if I gave you a choice…. (1) take \$5 and walk away (2) take the gamble What if I gave you a choice…. (1) take \$5 and walk away (2) take the gamble

if you take the \$5  still risk averse  “paying” to avoid the gamble if you take the \$5  still risk averse  “paying” to avoid the gamble

risk aversion all else equal, we do not like risk basic assumption in finance explains  insurance market  risk/return tradeoff in financial assets all else equal, we do not like risk basic assumption in finance explains  insurance market  risk/return tradeoff in financial assets

then why does a lottery exist? risk aversion depends on what is at stake  lottery is a leisure activity  different attitudes with retirement, college savings, etc. risk aversion depends on what is at stake  lottery is a leisure activity  different attitudes with retirement, college savings, etc.

Risk Pooling & Insurance risk is inevitable what to do?  spread out risk among many  loss for any one event is small  = risk pooling risk is inevitable what to do?  spread out risk among many  loss for any one event is small  = risk pooling

exampleexample \$10,000 in stock market (1) all of it in Google (2) spread out among 500 stocks, including Google What if Google loses 20% of value? option 2 takes less of a hit  offset by gains in other stocks \$10,000 in stock market (1) all of it in Google (2) spread out among 500 stocks, including Google What if Google loses 20% of value? option 2 takes less of a hit  offset by gains in other stocks

Insurance market based on  customers paying to avoid risk risk averse  firm pooling the risks of many customers my home burning down is catastrophic for me, a small set back for State Farm based on  customers paying to avoid risk risk averse  firm pooling the risks of many customers my home burning down is catastrophic for me, a small set back for State Farm

Asymmetric Information 2 parties in a transaction one has better info than the other  could exploit this for advantage if not controlled, this leads to markets breaking down 2 parties in a transaction one has better info than the other  could exploit this for advantage if not controlled, this leads to markets breaking down

Asym. info affects  buy/sell goods eBay, used cars  insurance market  lending market Asym. info affects  buy/sell goods eBay, used cars  insurance market  lending market

2 problems: adverse selection  occurs before the transaction moral hazard  occurs after the transaction adverse selection  occurs before the transaction moral hazard  occurs after the transaction

Adverse selection people most who are most risky are more likely to  seek insurance  borrow money  sell their crappy stuff the adverse are more likely to be selected people most who are most risky are more likely to  seek insurance  borrow money  sell their crappy stuff the adverse are more likely to be selected

why a problem?  uninformed party may leave market  beneficial transactions do not occur solution?  screening  certifications why a problem?  uninformed party may leave market  beneficial transactions do not occur solution?  screening  certifications

example 1: life insurance adverse selection:  sick/dying people more likely to want life insurance solution  health history, blood work, etc.  or group membership adverse selection:  sick/dying people more likely to want life insurance solution  health history, blood work, etc.  or group membership

example 2: bank loan adverse selection:  riskier people more likely to need money solution  credit history, references…. adverse selection:  riskier people more likely to need money solution  credit history, references….

example 3: used cars adverse selection:  used cars for sale because owner wanted to dump it solution:  VIN checks, certified, warranty adverse selection:  used cars for sale because owner wanted to dump it solution:  VIN checks, certified, warranty

example 4: ebay adverse selection  site attracts scam artists since buyer must pay first solution  screening: feedback system  backround check (not done) adverse selection  site attracts scam artists since buyer must pay first solution  screening: feedback system  backround check (not done)

Moral Hazard after transaction, people likely to engage in risky behavior or not “do the right thing.” hazard of lack of moral conduct after transaction, people likely to engage in risky behavior or not “do the right thing.” hazard of lack of moral conduct

why a problem?  uninformed party may leave market  beneficial transactions do not occur solution?  monitoring  restrictions on allowed behavior why a problem?  uninformed party may leave market  beneficial transactions do not occur solution?  monitoring  restrictions on allowed behavior

example 1: auto insurance moral hazard  given coverage, drive less carefully or do not lock up solution  monitor for tickets  discount for anti-theft device moral hazard  given coverage, drive less carefully or do not lock up solution  monitor for tickets  discount for anti-theft device

example 2: bank loan moral hazard  get the loan and “blow the money” so cannot pay it back solution  collateral  insurance to protect collateral  consequences on credit report moral hazard  get the loan and “blow the money” so cannot pay it back solution  collateral  insurance to protect collateral  consequences on credit report

example 3: ebay moral hazard  buyer pays for item, never gets it or defective seller disappears solution  feedback consequences  PayPal & credit card protection moral hazard  buyer pays for item, never gets it or defective seller disappears solution  feedback consequences  PayPal & credit card protection

SummarySummary risk is central to most transactions information is costly and not perfect  (a big benefit of the internet is how it lowered the cost of information) all else equal, we do not like risk or uncertainty  risk pooling, screening, & monitoring all manage this risk is central to most transactions information is costly and not perfect  (a big benefit of the internet is how it lowered the cost of information) all else equal, we do not like risk or uncertainty  risk pooling, screening, & monitoring all manage this

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