Week 11 - Choice under risk and uncertainty, Asymmetric information, International trade

Question 1

What is risk?

Answer 1

know the probability of the outcome

Question 2

What is uncertainty?

Answer 2

refers to situations where the
probability of certain occurrences is not known

Question 3

What tool do we use to study individuals behaviour around risk and uncertainty?

Answer 3

a lottery/ gamble

Question 4

How to calculate the expected value of this lottery?

Answer 4

calculate the probability weighted average of the value from each possible outcome

EV = probability x outcome + probability x outcome

Question 5

What does it mean if the expected value of a lottery is zero?

Answer 5

the lottery is fair, neither gaining or losing something

Question 6

Suppose that a consumer has an initial income of £5. He can invest his initial income in a stock asset today
(Assume that the stock today costs exactly £5). Next month, the value of the stock can either increase or
decrease. If it increases, then the consumer increases his income to £7.5, but if it decreases, then consumer
decreases his income to £2.5.
The consumer believes that there is a 50 per cent chance that the stock will increase its value and 50 per cent
change that it will decrease its value.
The expected value from buying the stock asset is:

Answer 6

costs you £5

50% £7.5
50% £2.5

EV = 0.5 x 7.5 + 0.5 x 2.5 = 5

although expected value is £5, the lottery is fair because EV-Cost = 0

Question 7

You play a lottery for free
30% +£100
70% -£30
What is the expected value of this lottery?

Answer 7

EV = 0.3 x 100 + 0.7 x (-30) = 30-21 = 9 (average earning) this lottery is unfair

Question 8

How do economists classify people in terms of risk?

Answer 8

risk-averse, risk-neutral and risk-loving

Question 9

What is a key issue in individual attitudes to risk?

Answer 9

a key issue is whether or not a person would accept a fair gamble

Question 10

What is risk neutral?

Answer 10

a person who is only interested in whether the odds yield a profit on average

only about expected value and not about the risk involved.

They will always take a bet or investment if it has a positive EV, regardless of how risky it is.

Question 11

What is risk averse?

Answer 11

a person who will refuse a fair gamble

prefers certainty over risk, even if the risk has a positive expected value.

They require a risk premium (extra compensation) to take on risk.

Even if a risky investment has a positive EV, they might avoid it unless the potential return is significantly higher than a safer alternative.

Question 12

What is risk loving?

Answer 12

a person who bets even when the odds are unfavourable

enjoys taking risks and may even accept a negative EV gamble if there is a chance of a big win.

They actively seek risks with high rewards, even if the odds are against them.

Question 13

Which individual risk would go for a negative expected value

Answer 13

risk-loving since there is a small chance of still winning

Question 14

What is asymmetric information?

Answer 14

a situation in which one side of an economic relationship has better information than the other

This can influence how individuals with different risk preferences approach decisions involving positive expected value (EV) risks

Question 15

What are the 2 different types of asymmetric information than an economic decision maker might lack but desire?

Answer 15

1. Hidden characteristics
2. Hidden actions

Question 16

What are hidden characteristics?

Answer 16

things that one side of a transaction knows about itself that the other side would like to know but doesn’t know

1) sellers are better informed
2) buyers are better informed

Question 17

What are hidden actions?

Answer 17

Actions taken by one side of an economic relationship that the other side of the relationship cannot observe
1) firms vs employees
2) insurance companies vs their customers

Question 18

Example of price discrimination in an imperfectly competitive market with asymmetric information:
Consider the following situation:
A flight company flies a direct route from London to Rome to deliver air freight.
The marginal cost of adding passengers to the flight is £120 per passenger.
Two passengers: A businessman and a holidaymaker
Businessman is willing to pay £500 for the flight, but wants to stay for one day only.
If he has to stay for more than one day, he is willing to pay £250.
Holidaymaker is willing to pay at most £200 for a flight, and he does not much care about the trip’s length.

Answer 18

Asymmetric Information – The airline does not know whether a customer is a businessman (high willingness to pay) or a holidaymaker (low willingness to pay).
Price Discrimination – The airline wants to charge different prices to different customers to maximize profits.
Self-Selection (Screening Mechanism) – The airline must design ticket pricing so that each type of customer reveals themselves based on their choices.

Situation 1: Symmetric Information + No Price Discrimination
The airline must charge one uniform price to all customers.

Two possible pricing strategies:

Charge £500 per ticket

The businessman buys a ticket (£500), but the holidaymaker does not.
Revenue: £500
Cost: £120
Profit: £500 - £120 = £380
Charge £200 per ticket

Both the businessman and the holidaymaker buy tickets.
Revenue: 2 × £200 = £400
Cost: 2 × £120 = £240
Profit: £400 - £240 = £160
Since £380 is greater than £160, the airline will choose to charge £500 per ticket, even if it loses the holidaymaker’s business.

Situation 2: Symmetric Information + Price Discrimination
If the airline knows who is a businessman and who is a holidaymaker, it can engage in first-degree price discrimination:

Charge £500 to the businessman (who is willing to pay £500).
Charge £200 to the holidaymaker (who is willing to pay £200).
Revenue Calculation:

Businessman: £500
Holidaymaker: £200
Total revenue: £700
Total cost: 2 × £120 = £240
Profit: £700 - £240 = £460
Conclusion: With perfect knowledge about each customer, price discrimination increases profits from £380 (without discrimination) to £460.

Situation 3: Asymmetric Information + Second-Degree Price Discrimination
In reality, the airline does not know who is a businessman and who is a holidaymaker.

To solve this problem, it uses a self-selection mechanism:

Offer two ticket types:
A £500 flexible ticket (no restrictions) for the businessman.
A £200 ticket with a Saturday night stay requirement for the holidaymaker.
Why does this work?

The businessman values a short trip and does not want to stay over the weekend.
The holidaymaker is indifferent to trip length, so he will choose the cheaper ticket.
This forces customers to reveal their type through their choice of ticket.
Revenue Calculation:

Businessman buys a £500 ticket.
Holidaymaker buys a £200 ticket.
Total revenue: £700
Total cost: 2 × £120 = £240
Profit: £460
Conclusion: Even with asymmetric information, the airline can achieve the same £460 profit by structuring ticket restrictions to force self-selection.

Question 19

What will a self-selection device do for an airline?

Answer 19

the airline can use a self-selection mechanism to address asymmetric information by offering a set of choices (tickets) that vary in terms of price and restrictions. The idea is that these choices will reveal the hidden characteristics of the consumers, allowing the company to maximise profits by tailoring its pricing strategy to different customer segments.

Question 20

Example of self selection

Answer 20

For example:
(1) A £449 ticket that has no restrictions on when it can be used.
(2) A special £200 “holiday ticket” that can be used only if the traveller goes on a trip of at least two weeks.

Businessman is willing to pay £500 for the flight, but wants to stay for one day only. If he has to stay for more
than one day, he is willing to pay £250.
If he buys (1), his surplus is £500 - £449 = £51
If he buys (2), his surplus is £250 – £200 = £50
So the businessman will pay £449
The holidaymaker will pay £200
The firm will earn (£449-£120) + (£200-£120) = £409
Note: £380 < £409 < £460

Question 21

Real-world examples of price discrimination and self-selection mechanisms in flight companies

Answer 21

Flight Companies (Price Discrimination Based on Flexibility)
Flexible Fare Pricing:
Airlines use price discrimination based on flexibility and timing. For example:
Short-term flight tickets (e.g., for business travelers who need to fly back the next day) are more expensive due to the higher willingness to pay for flexibility.
Longer-term flight tickets (e.g., for holidaymakers who are willing to stay for a month or more) are cheaper because the airline knows that leisure travelers are more price-sensitive and less concerned with timing restrictions.
This pricing strategy ensures that the airline captures as much consumer surplus as possible by offering different prices based on the consumer’s demand elasticity and willingness to pay.

Question 22

Real-world examples of price discrimination and self-selection mechanisms 1850 french national railway

Answer 22

3rd Class Railway Coaches:
In the 1850s, the French national railway offered three classes of travel. While the 3rd class had very poor conditions (crowded, uncomfortable, and lacking amenities), the prices were very low compared to 1st and 2nd class.

This is an example of price discrimination based on quality of service:

The 3rd class ticket was intended for lower-income individuals who were more price-sensitive and willing to endure poor conditions for the lower fare.
The 1st and 2nd class tickets were much more expensive, with better conditions, targeting wealthier passengers who valued comfort and convenience.
The railway company was using vertical price discrimination to maximize profits from different customer segments (those willing to pay for comfort vs. those looking for the cheapest option).

3. Auctions (Different Types of Auctions and Their Price Discrimination Mechanisms)
   In the world of auctions, price discrimination and self-selection are inherent in the auction types themselves. Let’s look at three types of common auctions:

a. English (Ascending) Auction
Description: In an English auction, participants start with a low price, and the price rises as bidders compete to outbid each other until no one is willing to bid higher. The auction ends when the highest bid is reached.

Price Discrimination Mechanism:
This type of auction allows the seller to discover the highest willingness to pay through a competitive process. Each bidder reveals their true value of the item by submitting progressively higher bids.
The seller captures consumer surplus (the difference between what a bidder is willing to pay and the actual price they pay) by allowing the price to increase based on demand.
b. Dutch (Descending) Auction
Description: In a Dutch auction, the price starts high and decreases until a bidder accepts the current price. The first bidder to accept the price wins the item at that price.

Price Discrimination Mechanism:
In this auction type, faster decision-makers or those willing to accept a lower price will be the first to bid. This allows the auctioneer to capture higher consumer surplus by forcing buyers to reveal their reservation price.
This auction allows for quick price discovery in markets where time is crucial, and buyers are willing to make decisions on the fly based on how low the price drops.
c. Sealed-Bid Auction
Description: In a sealed-bid auction, all participants submit their bids in secret, and the highest bidder wins the item. There’s no visibility of other bids during the auction.

Price Discrimination Mechanism:
Participants are competing based on their private information about the value they place on the item, and the seller will receive the highest bid.
This type of auction encourages bidders to reveal their true maximum willingness to pay. However, since participants are unaware of others’ bids, they might offer a bid based on their perceived value, leading to potential inefficiency (especially if bidders overestimate or underestimate the value).

Question 23

Real-world examples of price discrimination and self-selection mechanisms auctions

Answer 23

English Auctions: Common in art sales (e.g., Sotheby’s or Christie’s). The price of a painting or artifact increases as bidders compete to outbid one another.
Dutch Auctions: Used by flower markets in the Netherlands, where the price of flowers starts high and gradually decreases until a buyer accepts the price. Also used in government bond auctions.
Sealed-Bid Auctions: Common in government contracting, where companies submit their best price for a contract, and the one with the highest (or most appropriate) bid wins.

Conclusion
These examples demonstrate how asymmetric information and price discrimination are central to many industries, from airlines to railways to auctions:

In airlines, price discrimination is often based on timing and flexibility of travel.
In the French railway, price discrimination was based on the quality of travel and the class of the passenger.
Auctions use various formats to allow participants to reveal their true willingness to pay, and the auctioneer can capture the highest value through these mechanisms.
Each of these examples relies on some form of self-selection, where consumers or bidders reveal their preferences through their actions, and the seller or auctioneer can use that information to maximize profits.

Question 24

When information is symmetric in terms of low ability and high ability workers

Answer 24

When information is symmetric (i.e., the employer knows the ability of each worker), the following happens:

Low Ability Workers:
Marginal Revenue Product (MRP): £200 per week.
Wages: Since their MRP is £200, they will be paid £200 per week because, in a competitive market, workers are paid according to their marginal contribution to the employer’s revenue.

High Ability Workers:
Marginal Revenue Product (MRP): £400 per week.
Wages: Since their MRP is £400, they will be paid £400 per week.
With symmetric information, wages align with the marginal revenue product of each worker, and the labor market functions efficiently.

Question 25

When information is asymmetric in terms of low ability and high ability workers

Answer 25

In reality, asymmetric information is often present in the labor market. The employer does not know the worker’s ability in advance, so they must make decisions based on the information available. Here’s how the situation might unfold:

The Employer’s Dilemma:
The employer cannot directly observe whether a worker is of low ability or high ability.
This creates uncertainty about the value the worker will bring to the company.
As a result, the employer may face the challenge of offering a wage that is attractive enough for both high and low ability workers, but also fairly compensates the worker’s productivity.

The Adverse Selection Problem:
If the employer offers a wage that is somewhere between £200 and £400, workers with higher ability (who have a higher MRP) may be reluctant to accept the wage if it is too low for their skills, while low ability workers might be willing to accept that wage.
High ability workers, knowing their higher value to the company, might expect to be paid more than £200, but they may not reveal their ability up front, and so they might not be interested in a wage offer of £200.
In turn, low ability workers might accept a wage that is close to the £200 level, because they have lower productivity and thus a lower expectation of wages.
This problem is known as adverse selection: the employer may end up hiring more low ability workers than high ability ones if they cannot differentiate between them.

Potential Solutions to Asymmetric Information:
Screening: Employers may use techniques such as interviews, testing, or probation periods to better understand the worker’s skills and abilities.
Signaling: Workers may provide signals of their ability through education, experience, or other credentials to differentiate themselves from lower ability workers.
Wage Differentiation: The employer could offer higher wages to incentivize higher ability workers to self-select themselves for the position, though this could also attract low ability workers if the wage is too attractive.

Question 26

What is adverse selection?

Answer 26

refers to a situation in a market where one party (usually the seller or employer) has less information than the other party (usually the buyer or employee), leading to the selection of undesirable outcomes. This typically happens when the party with more information makes decisions that result in a market inefficiency.

In simple terms, adverse selection occurs when individuals with higher risks or lower quality (for example, less skilled workers or riskier insurance buyers) are more likely to participate in a transaction because the other party cannot distinguish them from others who might be of better quality.

Question 27

Adverse selection in terms of low ability and high ability workers

Answer 27

Let’s assume that the employer offers a wage of £300 per week in an attempt to balance between the two types of workers:

Low Ability Worker’s Response:
The low ability worker, who has a marginal revenue product of £200 per week, is likely to accept the £300 wage because it’s more than their MRP and represents an improvement in their compensation.

High Ability Worker’s Response:
The high ability worker, who has a marginal revenue product of £400 per week, may not accept the £300 wage because it is below their MRP, and they could likely find a better-paying opportunity elsewhere.
Therefore, the employer may end up attracting more low ability workers than high ability workers, resulting in inefficient labor allocation (the company might hire workers who are underpaid relative to their ability, while underutilising high ability workers).

Question 28

What is the market for lemons model?

Answer 28

The Market for Lemons model, developed by George Akerlof in 1970, demonstrates how asymmetric information can lead to market failure. It describes a situation where buyers and sellers have unequal information about the quality of goods, leading to a reduction in the overall quality of goods available in the market.

Question 29

What are the ‘lemons’ in the market for lemons model?

Answer 29

Lemons refer to low-quality goods that are more likely to be sold by sellers who are trying to unload them at a price.

The term “lemons” was used by Akerlof to describe the bad cars that sellers were more eager to sell, often due to hidden defects or lower value.

Question 30

What is the asymmetric information in the market for lemons model?

Answer 30

In a used car market, the sellers have more information about the condition of the car than the buyers.
Buyers cannot distinguish between good cars (high-quality) and bad cars (lemons, low-quality).

Question 31

What is the buyers perception in the market for lemons model?

Answer 31

Buyers are aware of the risk that they might purchase a lemon, so they lower their reservation price (the maximum price they are willing to pay).

Skepticism leads to price reduction because the buyers cannot tell whether a car is a lemon or a good one, so they adjust their expectations.

Question 32

What is the sellers behaviour in the market for lemons model?

Answer 32

Sellers of high-quality cars (those with “good cars”) know that they cannot get the price they want because of the lower average price in the market caused by the presence of lemons.
Good car owners may decide to keep their cars instead of selling them for a lower price, reducing the number of good cars available on the market.

Question 33

How could there be market failure in the market for lemons model?

Answer 33

As more and more lemons (bad cars) are sold, the overall quality of the goods in the market declines.
Buyers’ confidence drops, and they continue to offer even lower prices for used cars.

Eventually, this reduces the supply of high-quality cars (as people with good cars withdraw from the market), which can lead to a collapse of the market for used cars—leading to a market failure.

Question 34

Whats the cycle that leads to adverse selection and market failure in Akerlof’s model?

Answer 34

1. sellers know more (know how used their car is)
2. buyers lower their price (uncertain about quality)
3. good car sellers leave the market (if the price buyers are willing to pay is too low)
4. more lemons on the market (buyers adjust their prices even further downward)
5. market collapses (the average quality of cars on the market continues to decline, and the market may fail altogether)

Question 35

Adverse selection example: How much will a naive buyer pay for a used car?

Answer 35

Assume there are only good cars and lemons, 10% of all cars are lemons.
Good used cars worth £10,000, lemons £6,000
The used car market is 90% good cars and 10% lemons

Calculating expected value
0.9 x £10,000 + 0.1 x £6000 = £9600
This is the reservation price for a risk neutral buyer

Question 36

What is moral hazard?

Answer 36

People take fewer precautions when they know they are insured

Question 37

Examples of moral hazard

Answer 37

1. A driver in possession of a car insurance policy may exercise less care while operating their vehicle than an individual with no car insurance.
2. Governments promising to bail out loss-making banks can encourage banks to take greater risks.
3. When a business owner pays a salesperson a set salary–not based on their performance or sales numbers– that salesperson may have an incentive to put forth less effort.

Question 38

ADD MODELS

Question 39

What is opportunity cost?

Answer 39

refers to the value of the next best alternative that must be forgone in order to pursue a particular action

Question 40

Person A makes £200 an hour as an attorney and is considering paying someone £500 to paint his house. If
he decides to do it himself, it will take four hours. What is the opportunity cost?

Answer 40

His opportunity cost for doing it himself is the lost wages
for four hours, £800

Question 41

What is absolute advantage?

Answer 41

refers to the ability of an individual, firm, or country to produce a good or service more efficiently than others.

Specifically, it means that the entity can produce the same quantity of a good with fewer resources or produce more of a good using the same amount of resources than its competitors

Question 42

What is a production possibility curve?

Answer 42

a graph that describes the maximum amount of one good that can be produced for every possible level of production of the other good

illustrates the trade-offs between the two goods, meaning that producing more of one good typically requires producing less of the other good, due to scarcity of resources

Question 43

What does the slope represent on the PPC?

Answer 43

The slope of the PPC represents the opportunity cost of producing one good in terms of the other. As you move along the curve, to produce more of one good, you have to give up some amount of the other good

The PPC shows the trade-off between two goods or services. If an economy is producing at a certain point on the curve, to produce more of one good, it must sacrifice some amount of the other

Question 44

Why must we make a choice on how to allocate resources (PPC)?

Answer 44

The PPC highlights the scarcity of resources (land, labor, capital, and entrepreneurship). Since resources are limited, we cannot produce unlimited quantities of every good or service, and we must make choices about how to allocate resources

Question 45

What do different points on the PPC graph represent?

Answer 45

Points on the curve represent efficient production, where all resources are used fully and efficiently.

Points inside the curve represent inefficiency (i.e., not using resources fully or efficiently).

Points outside the curve are unattainable with the current resources and technology

Two attainable points are the inefficient and efficient points

Question 46

What is comparative advantage?

Answer 46

describing how two parties (individuals, firms, or countries) can benefit from specialising in the production of goods for which they have the lowest opportunity cost and then trading with one another

Question 47

How do we calculate opportunity cost?

Answer 47

Opportunity cost of good X = Amount of good Y given up/ amount of good x produced

Question 48

Example of calculating comparative advantage

Answer 48

Zoe:
8 Bread = 6 Beer
1 Bread = 6/8 Beer
1 Bread = 0.75 Beer

6 Beer = 8 Bread
1 Beer = 8/6 Bread
1 Beer = 1.33 Bread

Ian:
5 Bread = 4 Beer
1 Bread = 4/5 Beer
1 Bread = 0.8 Beer

4 Beer = 5 Bread
1 Beer = 5/4 Bread
1 Beer = 1.25 Bread

Zoe has a comparative advantage over Ian in the production of Bread.
Ian has a comparative advantage over Zoe in the production of Beer

Question 49

How does comparative advantage benefit international trade?

Answer 49

Countries can specialise in producing goods and services for which they have a comparative advantage (i.e., the lowest opportunity cost). This specialisation leads to more efficient production processes, as each country focuses on what it does best.

Resources are used more efficiently, as countries allocate labor and capital toward industries where they have a productivity edge, leading to higher output and lower costs (resource allocation)

Question 50

How to trade with comparative advantage? ->
Zoe:
1 Bread = 0.75 Beer
1 Beer = 1.33 Bread
Ian:
1 Bread = 0.8 Beer
1 Beer = 1.25 Bread

Zoe has a comparative advantage over Ian in the production of Bread.
Ian has a comparative advantage over Zoe in the production of Beer.

Zoe chooses to produce bread, she can produce 8 units of bread.
Ian chooses to produce beer, he can produce 4 units of beer.
Zoe and Ian can trade.

Answer 50

To benefit both people, the price of bread needs to be between 0.75 Beer and 0.8 Beer
0.75 beer ≤ 1 bread ≤ 0.8 beer
1.25 bread ≤ 1 beer ≤ 1.33 bread

Suppose a trade price (of bread) is determined so that 1 bread = 0.78 beer (1 beer = 1.282 bread)

If trade:
Before trade: Zoe has 8 units of bread.
If Zoe sells 3.9 units of bread to Ian
then Zoe will get 0.78 * 3.9 = 3.042 units of beer
After trade: Zoe has 4.1 bread + 3.042 beer

If trade:
Before trade: Ian has 4 units of beer.
If Ian sells 1.99 units of beer to Zoe
then Ian will get 1.282 * 1.99 = 2.55 units of bread
After trade: Ian has 2.55 bread + 2.01 beer

Both better off, international trade on the basis of comparative advantage improves global output.

If no trade:
Zoe has 4 bread + 3 beer
(spend 30 minutes on producing each good)

If no trade:
Ian has 2.5 bread+ 2 beer
(spend 30 minutes on producing each good)

Question 51

What are the welfare effects on imposing tariffs?

Answer 51

A tariff (tax on imports) makes foreign goods more expensive, which typically reduces the volume of imports. The extent of this reduction depends on how sensitive demand is to price changes (i.e., the price elasticity of demand for the goods)

Like (many) other taxes, they distort the operation of the market and so lead to a welfare loss

Question 52

How may other countries retaliate to a country imposing tariffs?

Answer 52

Other countries may retaliate by imposing tariffs on the country’s exports, which could hurt the exporting industries. This trade war dynamic can harm both the exporting and importing country, leading to reduced global trade and further welfare losses

Question 53

Look at powerpoint for tariff diagram