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EC204 Micro Notes > Choice under Uncertainty > Flashcards

Choice under Uncertainty Flashcards

1
Q

What impact does the existence of uncertainty have on economic decision-making?

A

It means that there are risks involved because the payoff/benefit is not always clear

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2
Q

What is the definition of uncertainty?

A

Where we don’t know the probability distribution

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3
Q

What is the definition of risk?

A

Where we do know the probability distribution

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4
Q

What does expected value capture?

A

It captures the long-term average benefit of playing a game so that the player can determine whether they want to play or not

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5
Q

How is EV calculated?

A

By adding up the probability of all of the outcomes of the game

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6
Q

What is an actuarially fair game?

A

A game where the expected outcome of a game = the input required to play the game

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7
Q

What risks come from playing an actuarially fair game?

A

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

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8
Q

What will make the risks of an actuarially fair game increase?

A

If the stakes of the game increase, the risk increases because you lose more if you fail

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9
Q

Diagram of husband and wife expected value example

A

Check notes

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10
Q

What does the probability chord of an expected value diagram capture?

A

Shows the payoffs and utility possible from taking part in the game

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11
Q

What is the relation of utility on the chord to on the curve on a utility diagram for an actuarially fair game?

A

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

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12
Q

What shape is the utility curve for a risk averse person?

A

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

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13
Q

What shape is the utility curve for a risk seeker?

A

It will be concave, where their utility of income increases as income increases -> this is very rare

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14
Q

What is expected utility?

A

It is the long term average utility achieved from taking part in a game

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15
Q

How is EU calculated?

A

Same was as EV -> sum of probabilities of achieving each outcome

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16
Q

Why may the answers for EU and EV differ?

A

The attitudes to risk are not factored into the EV calculations

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17
Q

What are the different attitudes to risk?

A

Averse, neutral and seeker

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18
Q

What attitude does a risk averse player have to an actuarially fair game?

A

They will not take part -> the level of utility of expected wealth > expected utility of wealth

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19
Q

What attitude does a risk neutral player have to an actuarially fair game?

A

They are indifferent about whether they play or not -> the level of utility of expected wealth = expected utility of wealth

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20
Q

What attitudes does a risk seeker have to an actuarially fair game?

A

They will take part -> the level of utility of expected wealth < expected utility of wealth

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21
Q

What attitude to risk is most common and why?

A

Risk averse is most common because economic agents prefer certainty to uncertainty

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22
Q

What will impact the level of risk aversion?

A

As the stakes/input increases, the level of aversion will increase because the risks increase

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23
Q

How does insurance impact risk?

A

It reduces the risks that the player faces as it is passed on to a different agent

24
Q

How does insurance impact the outcomes of playing a game?

A

It makes the bad outcome better by giving up some of the payoff of the better outcome in the form of a premium

25
Q

How do we know that insurance is actuarially fair?

A

It will be actuarially fair if the expected utility of the EV is increased when insurance is purchased

26
Q

For a diagrammatical representation:

A

Check notes

27
Q

When is insurance actuarially unfavourable?

A

When the premium paid by the household > expected loss

28
Q

Why does actuarially unfavourable insurance exist?

A

Insurance will only be supplied if the providers can make a profit off of it

29
Q

How does unfavourable insurance affect household wealth?

A

Household wealth with insurance < expected wealth

30
Q

How will households react to unfavourable insurance?

A

Depending on how unfavourable the insurance is, it will mean that some households will not buy it

31
Q

When may households still buy unfavourable insurance?

A

When the expected loss of having insurance is below the maximum that a household is willing to pay for the insurance

32
Q

What is asymmetric information?

A

This is a scenario when there is hidden information, where one party has more information than the other

33
Q

What 2 key problems can arise from asymmetric information?

A

Adverse selection: when there is hidden information

Moral hazard: when there is hidden action

34
Q

For grade insurance example:

A

Check notes

35
Q

What is the summary of the grade insurance example?

A

When insurance is optional, the stronger in the market will drop out as their risk is very low

36
Q

How will the fact that some drop out of the insurance market impact those that remain in the market?

A

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

37
Q

What may happen to the insurance market if people continue to leave it?

A

Could see the market shrink or even completely disappear

38
Q

When does adverse selection occur?

A

When the customer has more info about their ability than the insurer

39
Q

What does adverse selection allow the consumer to do?

A

It means they have some control over the cost of the insurance

40
Q

How will adverse selection impact the larger insurance market?

A

It means that no competitive equilibrium will be reached

41
Q

What is moral hazard and how is it represented in consumer behaviour?

A

When there is action hidden -> consumers may change their behaviour when they are insured because they have the safety of that insurance

42
Q

How may the insurance provider react to moral hazard?

A

If every party in the market reacts this way then the provider can adjust the premium to balance out the market again

43
Q

Why is the market reaction by providers to moral hazard not necessarily realistic?

A

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

44
Q

How will moral hazard affect the larger market equilibrium?

A

It means that no competitive equilibrium can be reached as the provider will not know who is exhibiting more moral hazard

45
Q

What are the 5 solutions to these insurance issues?

A

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

46
Q

Why is signalling hard?

A

You can’t simply say that you are a good risk because everyone will do that

47
Q

What example was used in the lectures to show why signalling is hard?

A

Used car market -> peaches and lemons

48
Q

What must a strong signal have for sellers of high quality goods?

A

It must have a low cost

49
Q

Example of a strong signal?

A

Warranties -> longer the warranty the stronger the signal of quality as the provider is confident that their product will not be faulty

50
Q

How may this example of a strong signal potentially put the provider at risk?

A

Exposes them to moral hazard -> consumers may behave differently if they know they are under warranty

51
Q

For diagrams about signalling:

A

Check slides

52
Q

What is screening?

A

When you gather info about the market to better inform you about the risk or cost of a consumer

53
Q

Why is screening an issue for providers?

A

It is an extra cost that they need to pay

54
Q

How can providers deal with the cost of screening?

A

They can pass the cost on to consumers

55
Q

Who does the use of screening impact most heavily?

A

The low cost clients because they will incur the majority of the cost

56
Q

Why do low cost clients incur the majority of the screening costs?

A

If the cost of the screening is put on high cost clients they will just go to a provider that does not screen

57
Q

For diagram about screening:

A

Check notes

EC204 Micro Notes (5 decks)

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