Week 11 - Risk, Asymmetric Information + International Trade Flashcards
Difference between risk and uncertainty
Risk – you don’t know the outcomes but know the probability of the outcome.
Uncertainty – you don’t know the outcomes and don’t know the probability of the outcome.
Expected value
The expected return of an action based on the probabilities of each possible outcome.
Calculated by finding the sum of all outcomes multiplied by its probability then subtracting the cost of the action from the sum.
Lottery
A tool in economics that can help determine someone’s attitude towards risk/ uncertainty.
How can you tell if a lottery is fair
The expected value of the lottery is 0.
What are the 3 categories of attitude towards risk
Risk neutral: A person who is only interested in whether the odds yield a profit on average – doesn’t care about risk, only expected value.
Risk averse: A person who will refuse a fair gamble.
Risk loving: A person who bets even when the odds are unfavourable.
Asymmetric information
A situation in which one side of an economic relationship has better information than the other.
What are the 2 types of asymmetric information
Hidden characteristics: Things that one side of a transaction knows about itself that the other side would like to know but does not know.
Hidden actions: Actions taken by one side of an economic relationship that the other side of the relationship cannot observe.
How does asymmetric information affect firms in imperfectly competitive markets
It makes price discrimination harder, reducing profits.
How does asymmetric information affect firms in competitive markets
The firm may not know if a worker is a high-ability or low-ability worker so it is unclear how much each should be paid.
The wage is calculated by finding the average wage of high and low ability and giving both types of workers the same wage.
High-ability workers are hurt by the lack of information so reveal themselves as high-ability workers.
Adverse selection
One party cannot distinguish between high-quality and low-quality goods or services, leading to a selection problem. In imperfectly competitive markets, firms/buyers can make decisions based on limited information.
This leads to lower-quality products/services dominate the market which reduces efficiency and welfare.
Moral hazard
One party takes greater risks because they are insulated from the consequences, often due to asymmetric information meaning they know how risky the action is.
Abuse of moral hazard can lead to inefficiencies, higher costs, or reduced trust in the market.
How do insurance companies reduce the effect of moral hazard.
They use co-insurance or excess.
Co-insurance: policy holder pays some percentage of the bill when there is a claim.
Excess: person buying insurance has to pay the initial damages up to a set limit.
Opportunity cost
The value of the next best alternative that must be forgone in order to undertake the opportunity.
Absolute advantage
One person has an absolute advantage over another if an hour spent in performing a task earns more than the other person can earn in an hour at the task.
Production possibilities curve
A graph that describes the maximum amount of one good that can be produced for every possible level of production of the other good.
What types of points are there for a production possibilities curve
- Efficient point: any combination of goods for which currently available resources do not allow an increase in the production of one good without a reduction in the production of the other.
- Inefficient point: any combination of goods for which currently available resources enable an increase in the production of one good without a reduction in the production of the other.
- Attainable point: any combination of goods that can be produced using currently available resources.
- Unattainable point: any combination of goods that cannot be produced using currently available resources.
Comparative advantage
One person has a comparative advantage over another in a task if his or her opportunity cost of performing a task is lower than the other person’s opportunity cost.
How do you find the opportunity cost of performing a task.
Assume someone can produce 8 units of bread and 6 units of beer in an hour.
The opportunity cost of bread is found by dividing the units of bread by beer: 8/6 = 0.75
Opportunity cost of producing 1 unit of bread = 0.75 beer.
What are the benefits of international trade
By just making the product you can make the most of and trading some of this for another product (E.g., making bread and trading some bread for some beer). you and you’re trading partner can end up with more of both goods.
International trade on the basis of comparative advantage improves global output.
Tariffs
An import tax that the importer will pay on imported goods.
Tariffs distort the operation of the market and so lead to a welfare loss.
