Choice under Uncertainty Flashcards
What impact does the existence of uncertainty have on economic decision-making?
It means that there are risks involved because the payoff/benefit is not always clear
What is the definition of uncertainty?
Where we don’t know the probability distribution
What is the definition of risk?
Where we do know the probability distribution
What does expected value capture?
It captures the long-term average benefit of playing a game so that the player can determine whether they want to play or not
How is EV calculated?
By adding up the probability of all of the outcomes of the game
What is an actuarially fair game?
A game where the expected outcome of a game = the input required to play the game
What risks come from playing an actuarially fair game?
There is the potential that you can exceed your expected value but also a risk that you may get a payout lower than that expected value
What will make the risks of an actuarially fair game increase?
If the stakes of the game increase, the risk increases because you lose more if you fail
Diagram of husband and wife expected value example
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What does the probability chord of an expected value diagram capture?
Shows the payoffs and utility possible from taking part in the game
What is the relation of utility on the chord to on the curve on a utility diagram for an actuarially fair game?
The utility achieved on the chord will be lower for certain payoffs than the utility for when that payoff is guaranteed because of the risk involved in taking part in the game
What shape is the utility curve for a risk averse person?
It will be convex, they have diminishing marginal utility of income -> as income increases the extra utility achieved will continue to decrease as income increases
What shape is the utility curve for a risk seeker?
It will be concave, where their utility of income increases as income increases -> this is very rare
What is expected utility?
It is the long term average utility achieved from taking part in a game
How is EU calculated?
Same was as EV -> sum of probabilities of achieving each outcome
Why may the answers for EU and EV differ?
The attitudes to risk are not factored into the EV calculations
What are the different attitudes to risk?
Averse, neutral and seeker
What attitude does a risk averse player have to an actuarially fair game?
They will not take part -> the level of utility of expected wealth > expected utility of wealth
What attitude does a risk neutral player have to an actuarially fair game?
They are indifferent about whether they play or not -> the level of utility of expected wealth = expected utility of wealth
What attitudes does a risk seeker have to an actuarially fair game?
They will take part -> the level of utility of expected wealth < expected utility of wealth
What attitude to risk is most common and why?
Risk averse is most common because economic agents prefer certainty to uncertainty
What will impact the level of risk aversion?
As the stakes/input increases, the level of aversion will increase because the risks increase
How does insurance impact risk?
It reduces the risks that the player faces as it is passed on to a different agent
How does insurance impact the outcomes of playing a game?
It makes the bad outcome better by giving up some of the payoff of the better outcome in the form of a premium
How do we know that insurance is actuarially fair?
It will be actuarially fair if the expected utility of the EV is increased when insurance is purchased
For a diagrammatical representation:
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When is insurance actuarially unfavourable?
When the premium paid by the household > expected loss
Why does actuarially unfavourable insurance exist?
Insurance will only be supplied if the providers can make a profit off of it
How does unfavourable insurance affect household wealth?
Household wealth with insurance < expected wealth
How will households react to unfavourable insurance?
Depending on how unfavourable the insurance is, it will mean that some households will not buy it
When may households still buy unfavourable insurance?
When the expected loss of having insurance is below the maximum that a household is willing to pay for the insurance
What is asymmetric information?
This is a scenario when there is hidden information, where one party has more information than the other
What 2 key problems can arise from asymmetric information?
Adverse selection: when there is hidden information
Moral hazard: when there is hidden action
For grade insurance example:
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What is the summary of the grade insurance example?
When insurance is optional, the stronger in the market will drop out as their risk is very low
How will the fact that some drop out of the insurance market impact those that remain in the market?
It will increase the payoff for those that remain in the market as the market has shrunk and the insurance provider has to spread their cost across fewer people
What may happen to the insurance market if people continue to leave it?
Could see the market shrink or even completely disappear
When does adverse selection occur?
When the customer has more info about their ability than the insurer
What does adverse selection allow the consumer to do?
It means they have some control over the cost of the insurance
How will adverse selection impact the larger insurance market?
It means that no competitive equilibrium will be reached
What is moral hazard and how is it represented in consumer behaviour?
When there is action hidden -> consumers may change their behaviour when they are insured because they have the safety of that insurance
How may the insurance provider react to moral hazard?
If every party in the market reacts this way then the provider can adjust the premium to balance out the market again
Why is the market reaction by providers to moral hazard not necessarily realistic?
It assumes that all parties will act the same way, but the extent to which consumers change their behaviour will most likely differ, so different premiums will be needed for different people
How will moral hazard affect the larger market equilibrium?
It means that no competitive equilibrium can be reached as the provider will not know who is exhibiting more moral hazard
What are the 5 solutions to these insurance issues?
1) gather more info -> helps predict the risk of the player
2) use incentive schemes -> create bonuses that incentivise effort e.g. principal agent problem
3) Excesses -> how much voluntary excess are you willing to pay? - pay a small amount to contribute to insurance payouts
4) No claims bonus -> premium goes down if you don’t claim
5) Signals -> make it clear to the provider that you are a good risk
Why is signalling hard?
You can’t simply say that you are a good risk because everyone will do that
What example was used in the lectures to show why signalling is hard?
Used car market -> peaches and lemons
What must a strong signal have for sellers of high quality goods?
It must have a low cost
Example of a strong signal?
Warranties -> longer the warranty the stronger the signal of quality as the provider is confident that their product will not be faulty
How may this example of a strong signal potentially put the provider at risk?
Exposes them to moral hazard -> consumers may behave differently if they know they are under warranty
For diagrams about signalling:
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What is screening?
When you gather info about the market to better inform you about the risk or cost of a consumer
Why is screening an issue for providers?
It is an extra cost that they need to pay
How can providers deal with the cost of screening?
They can pass the cost on to consumers
Who does the use of screening impact most heavily?
The low cost clients because they will incur the majority of the cost
Why do low cost clients incur the majority of the screening costs?
If the cost of the screening is put on high cost clients they will just go to a provider that does not screen
For diagram about screening:
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