wk 11 - Uncertainty Flashcards
Define Expected Value
E(v): The sum of all possible outcomes, weighted by its respective probability of occurrence
Define Fair Game
A game with an expected outcome of 0
Define Expected utility E(u)
E(u) The expected utility of a gamble is the E(v) of utility over all possible outcomes
Define Diminishing marginal utility
Each additional unit of gain leads to an ever-smaller increase in subjective value
Define risk neutral
indifferent about taking risk
Define Risk Averse
Unwilling to take a fair game
Define a risk lover
Willing to take a fair game
What does a convex utility function show
Diminishing marginal utility
- Slope is increasing
What does a concave marginal utility mean
Increasing marginal utility
- Slope is decreasing
Define asymetric information
When one side of the market has more information about the product being traded than the other
Define Principle
Player offering the contract in the principle-agent model
Define Agent
Player who performs under the contract in the principle-agent model
Define the principle-agent problem
The conflict in interests and priorities that arises when the agent acts on behalf of the principle.
What are the 2 problems that arise as a result of asymetric information
Adverse Selection
Moral hazard
Define Adverse selection
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
Define Moral Hazard
Where one party has an incentive to increase its exposure to risk because it does not bear the full costs of that risk.
Example of Adverse selection and moral hazard
- Insurance company does not know whether you are high or low risk (AS)
- Drivers are less careful since they are insured (MH)
Define signalling
the idea that one party (the agent) credibly conveys some information about itself to another party (the principal)
What is the costly to fake principle
To signal high quality credibly, a signal must be costly to fake
e.g. Product quality assurance
What is the full disclosure principle
Individuals must disclose unfavorable qualities or their silence will be taken to mean they are hiding something worse
e.g. Interviews
