Information Flashcards
What is the mean of a random variable?
The sum of the probabilities that different outcomes will occur multiplied by the resulting payoff.
What is a key limitation of just considering the mean of a random variable?
It doesn’t tell us about the risk involved with certain outcomes!
What is the variance of a random variable?
The sum of the probabilities that different outcomes will occur, multiplied by the deviation from the mean of the resulting payoffs.
How can firms try and persuade a risk averse customer to try a new product?
- Reduce the price of the new product, to mitigate the risk. For example, it could provide a free sample.
- Comparative advertising: Try and persuade the consumer that the new product is significantly better than the other product.
How can we determine whether or not a consumer should search for a cheaper product?
For a search to be worthwhile, the cost of the search should not exceed the expected benefit of another search. Note: EB = the sum of (the probabilities of each price * the price).
What’s a reservation price?
A price in which a consumer is indifferent as to whether to buy the good or continue searching for a lower price. (i.e.. any lower price he will accept; any higher price he will reject).
What happens when the cost of searching increases?
The consumer finds more prices acceptable (i.e the price acceptance region is higher), and thus he is less willing to search.
What is diversification?
Where manager take on a number of projects to reduce the risk of losing vast amounts of money.
How can a risk-neutral manager maximise his profits?
By ensuring the expected revenue is equal to marginal cost: E(R) = MC.
What is the problem with asymmetric information?
Uncertainty can impact the market’s ability to allocate resources efficiently. For example, if one party has significantly more info than another, the party with less info may choose not to participate in the market.
What are two possible negative outcomes that can occur in markets with asymmetric information?
- Adverse selection
- Moral Hazard
What is adverse selection?
Where individuals have hidden characteristics, and thus a selection process ends up producing a pool of individuals with undesirable characteristics. E.g In a recruitment process, worker knows his true abilities, but potential employer doesn’t.
What is moral hazard?
Where one party undertakes a hidden action, that benefits him/her, at the expense of another party. e.g a manager cannot always effectively monitor a worker’s effort.
How can adverse selection be overcome in “the market for lemons”?
- Employ an independent car expert to value used cars
- Certify the good cars.
How can moral hazard be overcome?
Create incentives for agents to not undertake hidden actions. i.e make pay conditional on company profits, or make car renters pay a refundable charge in case they damage the rented car.
