wk 11 - Uncertainty

Question 1

Define Expected Value

Answer 1

E(v): The sum of all possible outcomes, weighted by its respective probability of occurrence

Question 2

Define Fair Game

Answer 2

A game with an expected outcome of 0

Question 3

Define Expected utility E(u)

Answer 3

E(u) The expected utility of a gamble is the E(v) of utility over all possible outcomes

Question 4

Define Diminishing marginal utility

Answer 4

Each additional unit of gain leads to an ever-smaller increase in subjective value

Question 5

Define risk neutral

Answer 5

indifferent about taking risk

Question 6

Define Risk Averse

Answer 6

Unwilling to take a fair game

Question 7

Define a risk lover

Answer 7

Willing to take a fair game

Question 8

What does a convex utility function show

Answer 8

Diminishing marginal utility
- Slope is increasing

Question 9

What does a concave marginal utility mean

Answer 9

Increasing marginal utility
- Slope is decreasing

Question 10

Define asymetric information

Answer 10

When one side of the market has more information about the product being traded than the other

Question 11

Define Principle

Answer 11

Player offering the contract in the principle-agent model

Question 12

Define Agent

Answer 12

Player who performs under the contract in the principle-agent model

Question 13

Define the principle-agent problem

Answer 13

The conflict in interests and priorities that arises when the agent acts on behalf of the principle.

Question 14

What are the 2 problems that arise as a result of asymetric information

Answer 14

Adverse Selection
Moral hazard

Question 15

Define Adverse selection

Answer 15

When one party takes advantage of another party that does not have access to the same information to maximise their outcomes
- imposes a negative externality
- introduces inefficiencies in the market

Question 16

Define Moral Hazard

Answer 16

Where one party has an incentive to increase its exposure to risk because it does not bear the full costs of that risk.

Question 17

Example of Adverse selection and moral hazard

Answer 17

• Insurance company does not know whether you are high or low risk (AS)
• Drivers are less careful since they are insured (MH)

Question 18

Define signalling

Answer 18

the idea that one party (the agent) credibly conveys some information about itself to another party (the principal)

Question 19

What is the costly to fake principle

Answer 19

To signal high quality credibly, a signal must be costly to fake
e.g. Product quality assurance

Question 20

What is the full disclosure principle

Answer 20

Individuals must disclose unfavorable qualities or their silence will be taken to mean they are hiding something worse
e.g. Interviews