11 - Choice Under Uncertainty And Economics Of Information

Question 1

What is expected value, E(v)

Answer 1

The sum of all possible outcomes, weighted by its respective probability of occurrence

• E.g. toss a coin with a win of £1 and a loss of £1, has an expected value of:
  E(v) = 0.5 (1) + 0.5 (-1) = 0

This is fair game

Question 2

What is fair game

Answer 2

A game with an expected value of 0

Question 3

When it comes to decision making, what do we base our decisions off

Answer 3

Expected utility, not expected value

Question 4

What is expected utility, E(u)

Answer 4

Expected utility of a gamble is the expected value of utility over all possible outcomes

• People choose the alternative that has the highest expected utility

Question 5

Diminishing marginal utility

Answer 5

Marginal utility decreases as wealth rises

• E (u) = pu (x1) + p2 u (x2) +…+ pu (xn)

Question 6

Types of preferences towards risk

Answer 6

• Risk neutral = Indifferent about taking a fair game (Constant marginal utility)
• Risk averse = Unwilling to take a fair game (Hates risk, diminishing marginal utility)
• Risk lover = Willing to take a fair game (Loves risk, increasing marginal utility)

Question 7

What does risk averse graph look like

Answer 7

• A concave utility function
• Curve start off steep from origin, then flattens out (diminishing marginal utility)
• The line goes underneath the curve, which you find expected marginal utility
• If initial income (utility) is higher than expected utility, don’t play game
• E.g. marginal utility = If thirsty, 1st glass of water will have highest utility compared to the 2nd, 3rd, 4th glass of water

Question 8

What does Risk lover graph look like

Answer 8

• Convex utility function
• Curve starts off flat then curves up (increasing marginal utility)
• The line goes above the curve
• Expected utility is higher than initial utility of income, therefore would take the game

Question 9

What does Risk neutral graph look like

Answer 9

• Linear utility function
• Straight diagonal line upwards from the origin
• Expected utility is same as initial utility of income
• Make decision off of expected value as they have linear utility function

Question 10

What’s symmetric and asymmetric information

Answer 10

• Symmetric information = Both sides of the market know what product is being traded - have the same information about the product
• Asymmetric information = One side of the market has more information about the product being traded than the other
• Causes market failure, as imbalance of power

Question 11

All applications of asymmetric information are examples of what

Answer 11

Principal agent problem

Question 12

What is principal agent problem, and principal and agent

Answer 12

• Principal agent problem = A principal ‘employs’ an agent to do a job for him
• Principal = Player is offering the contract in a principal agent model
• Agent = Player who performs under the terms of the contract in the principal agent model
• Agent has private information about their action

Question 13

2 types of problems due to asymmetric information

Answer 13

• Adverse selection
• Moral hazard

Question 14

What is adverse selection

Answer 14

• When one party tends to enter a transaction where they can use information unknown to other parties
• They use this information for their own advantage and as a disadvantage of the less informed party - Before or during the transaction

Question 15

What is moral hazard

Answer 15

When the informed party takes action that harms the less informed party through an unobserved action - After the transaction

• Change In behaviour by someone who enters a contract due to having entered the contract

Question 16

Examples of adverse selection and moral hazard

Answer 16

Insurance market:
- Adverse selection arises as people who create greater risks are more likely to buy insurance
- Insurance companies are incentivised to find ways around moral hazard and adverse selection
- Moral hazard is when people are less cautious drivers when they get their insurance
- Doing so, they offer lower premiums for low-risk people and raise premiums for high-risk people

• Other examples = 2nd Hans car market, recruiting labour

Question 17

What is signalling

Answer 17

Communication that conveys information

Question 18

The 2 properties of signalling

Answer 18

1) Signals must be costly to fake
2) If individuals use signals to convey favourable information about themselves, others will be forced to reveal information even when it is considerably less favourable

Question 19

1) Costly to fake principle

Answer 19

• To signal high quality credibly, a signal must be costly to fake

Economic applications:
- Product quality assurance
- Choosing a trustworthy employee
- Choosing a hard working, smart employee

Question 20

2) The full disclosure principle

Answer 20

• Individuals must disclose even unfavourable qualities about themselves, otherwise their silence will be taken to mean they have something even worse to hide

Economic applications:
- Product warranties
- Interviews