12 - Information Flashcards
Mean or Expected Value
Sum of the resulting probabilities times the resulting payoffs.
Does not communicate degree of risk.
Variance
Quantifies the degree of risk associated with random outcomes.
The variance of a random variable is the sum of the probabilities that different outcomes will occur times the squared deviations from the mean of the random variable.
Standard Deviation
The square root of the variance.
The outcomes for any random variable will fall within 2 standard deviations from the mean at least 75% of the time.
St. Petersburg Paradox
The diminishing marginal utility of income.
The difference between the expected value and the amount an individual is willing to pay.
The measure of risk has more to do with a person’s assessment of perceived value. Satisfied people do not want as much and are more risk averse. Winning first million is far more satisfying than winning the 100th million.
Risk Aversion
Ceteris Paribus a customer will choose the more familiar option.
Product quality uncertainty increases aversion
Send free samples
Comparative benefits advertising
Chain stores lower aversion because there is a predictable experience compared to local diner
Insurance in the form of money back guarantees and extended warranty plans reduce uncertainties.
Cost of Search vs Reservation Price
The reservation price is that which the customer is indifferent to buying or searching.
Where search cost crosses the expected benefit curve equates to the reservation price.
EB(R) = c
P > reservation means reject
P< reservation means accept
As search costs increase, more higher prices are acceptable.
Asymmetric Information
When some market participants have more information. Those with less information routinely choose not to participate in transactions.
Adverse Selection
The unintended outcome of attracting undesirable inputs with hidden characteristics.
Offering more sick time attracts the unhealthy.
Charging higher premiums attracts poor drivers. Better for firm to charge low premiums and reject all with poor records - poor drivers and unlucky good drives.
Moral Hazard
When one party insulates another party from economic loss but the protected party takes hidden action to harm its protector.
Principal-Agent Problem. On strait salary the manager is insulated by the contract and shirking is likely.
Deductibles are how insurers reduce moral hazard. The insured have some skin in the game.
Signaling
Must be observable and difficult to mimic.
The unworthy are generally unwilling to expend the cost of effort to mimic the signal - like earning an MBA.
Screening
Methods uniformed parties use to sort inputs according to characteristics.
With people, providing options allows them to self-select without Manager knowing their hidden characteristics.
English Auction
Ascending bidding
Sequential bidding
Known competitive bids
Winner pays highest full amount bid that exceeds second highest bid. The winner does not necessarily pay their full value estimate of the item.
Key difference is knowledge
First Price -
Sealed-bid Auction
Simultaneous bidding
Unknown competitive bids
Winner pays highest full amount bid which is their full value estimate.
With respect to knowledge and amount paid, the Dutch Auction and First-Price Sealed-Bid Auction are strategically identical.
Second Price -
Sealed-bid Auction
Simultaneous bidding
Unknown competitive bids
Highest bidder wins but pays second highest bid amount which is less than their value estimate of the item.
Key difference is amount paid by winner.
Dutch Auction
Descending values
Unknown competitive bids
First bid wins and pays
Only one bid per auction
With respect to knowledge and amount paid, the Dutch Auction and First-Price Sealed-Bid Auction are strategically identical.
