Lecture 11 Choice under uncertainty and economic information Flashcards
What is expected value?
The sum of all possible outcomes, weighted by its respective probability of occurrence.
How is expected value calculated?
E(v) = p1 x1 + p2 x2 … + pn xn
P= probability of event to occur
x= outcome of event
Fairgame- A game with an expected value of zero .
What is expected utility?
The 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.
What is diminishing marginal utility?
For a utility function defined on wealth, it is one in which marginal utility declines as wealth rises.
What is the formula for diminishing marginal utility E(u)?
E(u)= p1 u(x1) + p2 u(x2) …. + pn u(xn(
What does the concave utility function graph show?
Risk aversion
It also has diminishing marginal utility, as each additional unit of consumption of wealth provides a smaller increase in utility than the previous one.
What does the convex utility function show?
Risk preference
It also has increasing marginal utility, as each additional unit of consumption of wealth provides a larger increase in utility than the previous one.
What is asymmetric information?
Arises when one side of the market has more information about the product being traded than the other.
Explain the key features/ implications of the principal agent theory.
The agent typically has more information about their actions or efforts than the principal. This imbalance makes it difficult for the principal to ensure that the agent acts in the principals best interest.
Moral hazard- Situations where the agent takes risks because they do not bear the full consequences of their actions. Since the principal cannot observe all actions, the agent may sink responsibility or engage in undesirable activities.
Adverse selection- This arises when the principal cannot perfectly assess the agent’s characteristics before hiring or contracting. As a result, they may hire agents who are less competent or not aligned with their objectives.
What are 2 solutions to the principal agent problem?
Incentive schemes- Aligning the agent’s compensation with the principals goals can reduce conflicts of interest.
Increased monitoring
What are disadvantages or problems that arise due to asymmetric information?
Adverse selection- When one party tends to enter into a transaction in which they can use information unknown to other parties.
Moral hazard- When informed parties take actions that harms the uninformed or less informed party through an unobserved action.
Adverse selection imposes a negative externality on producers and consumers which in-turn gives rise to inefficiencies in competitive markets.
What is signalling?
The process by which one party credibly conveys information to another party to reduce information asymmetry.
This is used when one party has more information about a product, service or characteristic than the other.
To signal high quality credibly, a signal must be a costly fake.
What are some economic applications of signalling?
Education as a signal- In the job market, education can serve as a signal of individual’s ability or productivity.
Warranties and Guarantees- Firms offering warranties signal that their products are of high quality.
What is the full disclosure principal?
Individuals must disclose even unfavourable qualities about themselves, let their science be taken to mean that they have something even worse to hide.
e.g:
Interviews
product warranties
