13. The Economics of Information and Uncertainty

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13. The Economics of Information and Uncertainty

• Risk aversion
• Asymmetric information
• (pages 333-342)

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The role of information

• assumption free flow of information
• reality
• information is costly
• time and money
• decisions under uncertainty
• lack of complete information
• some parties have more information

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Uncertainty Risk

• Uncertainty
• which event will occur?
• With uncertainty, comes risk
• Risk
• possibility of a bad outcome
• financial or property loss
• illness
• death

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concept expected value (EV)

• need
• probability of outcome
• value of outcome
• EV sum of (probability)(value) for each outcome
• EV is like the average outcome
• actually center of distribution of outcomes

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example 1 flip a coin

• 2 outcomes
• 50 chance of heads
• 50 chance of tails
• game flip a coin
• if heads, you get 0
• if tails, I pay you 20

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• expect value of the game
• EV (.5)0 (.5)(20)
• 10
• Note 10 is not a possible outcome
• But, played over and over, expect to average
  10/game

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example 2 Lottery

• 2 scatch off game
• 0 80
• 2 12
• 5 7.9
• 500 .1
• EV .8(0) .12(2) .079(5)
• .001(500) 1.135

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back to example 1, coin toss

• What if I gave you a choice.
• (1) take 10 and walk away
• (2) take the gamble

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• If you take the 10
• risk averse
• prefer the risk free 10 to the game with EV
  of 10
• If you take the gamble
• risk preference/risk loving
• If you dont care
• risk neutral

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• What if I gave you a choice.
• (1) take 5 and walk away
• (2) take the gamble

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• if you take the 5
• still risk averse
• paying to avoid the gamble

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risk aversion

• all else equal, we do not like risk
• basic assumption in finance
• explains
• insurance market
• risk/return tradeoff in financial assets

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then why does a lottery exist?

• risk aversion depends on what is at stake
• lottery is a leisure activity
• different attitudes with retirement, college
  savings, etc.

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Risk Pooling Insurance

• risk is inevitable
• what to do?
• spread out risk among many
• loss for any one event is small
• risk pooling

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example

• 10,000 in stock market
• (1) all of it in Google
• (2) spread out among 500 stocks, including
  Google
• What if Google loses 20 of value?
• option 2 takes less of a hit
• offset by gains in other stocks

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Insurance market

• based on
• customers paying to avoid risk
• risk averse
• firm pooling the risks of many customers
• my home burning down is catastrophic for me, a
  small set back for State Farm

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Asymmetric Information

• 2 parties in a transaction
• one has better info than the other
• could exploit this for advantage
• if not controlled, this leads to markets breaking
  down

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• Asym. info affects
• buy/sell goods
• eBay, used cars
• insurance market
• lending market

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2 problems

• adverse selection
• occurs before the transaction
• moral hazard
• occurs after the transaction

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Adverse selection

• people most who are most risky are more likely to
• seek insurance
• borrow money
• sell their crappy stuff
• the adverse are more likely to be selected

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• why a problem?
• uninformed party may leave market
• beneficial transactions do not occur
• solution?
• screening
• certifications

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example 1 life insurance

• adverse selection
• sick/dying people more likely to want life
  insurance
• solution
• health history, blood work, etc.
• or group membership

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example 2 bank loan

• adverse selection
• riskier people more likely to need money
• solution
• credit history, references.

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example 3 used cars

• adverse selection
• used cars for sale because owner wanted to dump
  it
• solution
• VIN checks, certified, warranty

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example 4 ebay

• adverse selection
• site attracts scam artists since buyer must pay
  first
• solution
• screening feedback system
• backround check (not done)

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Moral Hazard

• after transaction, people likely to engage in
  risky behavior or not do the right thing.
• hazard of lack of moral conduct

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• why a problem?
• uninformed party may leave market
• beneficial transactions do not occur
• solution?
• monitoring
• restrictions on allowed behavior

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example 1 auto insurance

• moral hazard
• given coverage, drive less carefully or do not
  lock up
• solution
• monitor for tickets
• discount for anti-theft device

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example 2 bank loan

• moral hazard
• get the loan and blow the money so cannot pay
  it back
• solution
• collateral
• insurance to protect collateral
• consequences on credit report

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example 3 ebay

• moral hazard
• buyer pays for item,
• never gets it or defective
• seller disappears
• solution
• feedback consequences
• PayPal credit card protection

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Summary

• risk is central to most transactions
• information is costly and not perfect
• (a big benefit of the internet is how it lowered
  the cost of information)
• all else equal, we do not like risk or
  uncertainty
• risk pooling, screening, monitoring all manage
  this