The Economics of Information and Uncertainty <ul><li>Risk aversion </li></ul><ul><li>Asymmetric information </li></ul>
The role of information <ul><li>assumption: free flow of information  </li></ul><ul><li>reality:  </li></ul><ul><ul><li>in...
Uncertainty & Risk <ul><li>Uncertainty </li></ul><ul><ul><li>which event will occur?  </li></ul></ul><ul><li>With uncertai...
concept:  expected value (EV) <ul><li>need </li></ul><ul><ul><li>probability of outcome </li></ul></ul><ul><ul><li>value o...
example 1: flip a coin <ul><li>2 outcomes: </li></ul><ul><ul><li>50% chance of heads </li></ul></ul><ul><ul><li>50% chance...
<ul><li>expect value of the game </li></ul><ul><ul><li>EV = (.5)0 + (.5)(20) </li></ul></ul><ul><ul><li>= $10 </li></ul></...
example 2:  Lottery <ul><li>$2 scatch off game </li></ul><ul><ul><ul><li>$0  80% </li></ul></ul></ul><ul><ul><ul><li>$2  1...
back to example 1, coin toss <ul><li>What if I gave you a choice…. </li></ul><ul><ul><li>(1) take $10 and walk away </li><...
<ul><li>If you take the $10 </li></ul><ul><ul><li>risk averse </li></ul></ul><ul><ul><li>prefer the risk free $10 to the g...
<ul><li>What if I gave you a choice…. </li></ul><ul><ul><li>(1) take $5 and walk away </li></ul></ul><ul><ul><li>(2) take ...
<ul><li>if you take the $5 </li></ul><ul><ul><li>still risk averse </li></ul></ul><ul><ul><li>“ paying” to avoid the gambl...
risk aversion <ul><li>all else equal , we do not like risk </li></ul><ul><li>basic assumption in finance </li></ul><ul><li...
then why does a lottery exist? <ul><li>risk aversion depends on what is at stake </li></ul><ul><ul><li>lottery is a leisur...
Risk Pooling & Insurance <ul><li>risk is inevitable </li></ul><ul><li>what to do? </li></ul><ul><ul><li>spread out risk am...
example <ul><li>$10,000 in stock market </li></ul><ul><li>(1)  all of it in Google </li></ul><ul><li>(2)  spread out among...
Insurance market <ul><li>based on </li></ul><ul><ul><li>customers paying to avoid risk </li></ul></ul><ul><ul><ul><li>risk...
Asymmetric Information  <ul><li>2 parties in a transaction </li></ul><ul><li>one has better info than the other </li></ul>...
<ul><li>Asym. info  affects </li></ul><ul><ul><li>buy/sell goods </li></ul></ul><ul><ul><ul><li>eBay, used cars </li></ul>...
2 problems: <ul><li>adverse selection </li></ul><ul><ul><li>occurs before the transaction </li></ul></ul><ul><li>moral haz...
Adverse selection <ul><li>people most who are most risky are more likely to </li></ul><ul><ul><li>seek insurance </li></ul...
<ul><li>why a problem? </li></ul><ul><ul><li>uninformed party may leave market </li></ul></ul><ul><ul><li>beneficial trans...
example 1:  life insurance <ul><li>adverse selection: </li></ul><ul><ul><li>sick/dying people more likely to want life ins...
example 2:  bank loan <ul><li>adverse selection: </li></ul><ul><ul><li>riskier people more likely to need money </li></ul>...
example 3:  used cars <ul><li>adverse selection: </li></ul><ul><ul><li>used cars for sale because owner wanted to dump it ...
example 4:  ebay <ul><li>adverse selection </li></ul><ul><ul><li>site attracts scam artists since buyer must pay first </l...
Moral Hazard <ul><li>after transaction, people likely to engage in risky behavior or not “do the right thing.” </li></ul><...
<ul><li>why a problem? </li></ul><ul><ul><li>uninformed party may leave market </li></ul></ul><ul><ul><li>beneficial trans...
example 1:  auto insurance <ul><li>moral hazard </li></ul><ul><ul><li>given coverage, drive less carefully or do not lock ...
example 2:  bank loan <ul><li>moral hazard </li></ul><ul><ul><li>get the loan and “blow the money” so cannot pay it back <...
example 3: ebay  <ul><li>moral hazard </li></ul><ul><ul><li>buyer pays for item, </li></ul></ul><ul><ul><ul><li>never gets...
Summary <ul><li>risk is central to most transactions </li></ul><ul><li>information is costly and not perfect </li></ul><ul...
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Bec doms ppt on the economics of information and uncertainty

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Bec doms ppt on the economics of information and uncertainty

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Bec doms ppt on the economics of information and uncertainty

  1. 1. The Economics of Information and Uncertainty <ul><li>Risk aversion </li></ul><ul><li>Asymmetric information </li></ul>
  2. 2. The role of information <ul><li>assumption: free flow of information </li></ul><ul><li>reality: </li></ul><ul><ul><li>information is costly </li></ul></ul><ul><ul><ul><li>time and money </li></ul></ul></ul><ul><ul><li>decisions under uncertainty </li></ul></ul><ul><ul><ul><li>lack of complete information </li></ul></ul></ul><ul><ul><ul><li>some parties have more information </li></ul></ul></ul>
  3. 3. Uncertainty & Risk <ul><li>Uncertainty </li></ul><ul><ul><li>which event will occur? </li></ul></ul><ul><li>With uncertainty, comes risk </li></ul><ul><li>Risk </li></ul><ul><ul><li>= possibility of a bad outcome </li></ul></ul><ul><ul><ul><li>financial or property loss </li></ul></ul></ul><ul><ul><ul><li>illness </li></ul></ul></ul><ul><ul><ul><li>death </li></ul></ul></ul>
  4. 4. concept: expected value (EV) <ul><li>need </li></ul><ul><ul><li>probability of outcome </li></ul></ul><ul><ul><li>value of outcome </li></ul></ul><ul><li>EV = sum of (probability)(value) for each outcome </li></ul><ul><li>EV is like the “average outcome” </li></ul><ul><ul><li>actually center of distribution of outcomes </li></ul></ul>
  5. 5. example 1: flip a coin <ul><li>2 outcomes: </li></ul><ul><ul><li>50% chance of heads </li></ul></ul><ul><ul><li>50% chance of tails </li></ul></ul><ul><li>game: flip a coin </li></ul><ul><ul><li>if heads, you get $0 </li></ul></ul><ul><ul><li>if tails, I pay you $20 </li></ul></ul>
  6. 6. <ul><li>expect value of the game </li></ul><ul><ul><li>EV = (.5)0 + (.5)(20) </li></ul></ul><ul><ul><li>= $10 </li></ul></ul><ul><ul><li>Note: $10 is not a possible outcome </li></ul></ul><ul><ul><li>But, played over and over, expect to average $10/game </li></ul></ul>
  7. 7. example 2: Lottery <ul><li>$2 scatch off game </li></ul><ul><ul><ul><li>$0 80% </li></ul></ul></ul><ul><ul><ul><li>$2 12% </li></ul></ul></ul><ul><ul><ul><li>$5 7.9% </li></ul></ul></ul><ul><ul><ul><li>$500 .1% </li></ul></ul></ul><ul><li>EV = .8(0) + .12(2) + .079(5) </li></ul><ul><li>+ .001(500) = 1.135 </li></ul>
  8. 8. back to example 1, coin toss <ul><li>What if I gave you a choice…. </li></ul><ul><ul><li>(1) take $10 and walk away </li></ul></ul><ul><ul><li>(2) take the gamble </li></ul></ul>
  9. 9. <ul><li>If you take the $10 </li></ul><ul><ul><li>risk averse </li></ul></ul><ul><ul><li>prefer the risk free $10 to the game with EV of $10 </li></ul></ul><ul><li>If you take the gamble </li></ul><ul><ul><li>risk preference/risk loving </li></ul></ul><ul><li>If you don’t care </li></ul><ul><ul><li>risk neutral </li></ul></ul>
  10. 10. <ul><li>What if I gave you a choice…. </li></ul><ul><ul><li>(1) take $5 and walk away </li></ul></ul><ul><ul><li>(2) take the gamble </li></ul></ul>
  11. 11. <ul><li>if you take the $5 </li></ul><ul><ul><li>still risk averse </li></ul></ul><ul><ul><li>“ paying” to avoid the gamble </li></ul></ul>
  12. 12. risk aversion <ul><li>all else equal , we do not like risk </li></ul><ul><li>basic assumption in finance </li></ul><ul><li>explains </li></ul><ul><ul><li>insurance market </li></ul></ul><ul><ul><li>risk/return tradeoff in financial assets </li></ul></ul>
  13. 13. then why does a lottery exist? <ul><li>risk aversion depends on what is at stake </li></ul><ul><ul><li>lottery is a leisure activity </li></ul></ul><ul><ul><li>different attitudes with retirement, college savings, etc. </li></ul></ul>
  14. 14. Risk Pooling & Insurance <ul><li>risk is inevitable </li></ul><ul><li>what to do? </li></ul><ul><ul><li>spread out risk among many </li></ul></ul><ul><ul><li>loss for any one event is small </li></ul></ul><ul><ul><li>= risk pooling </li></ul></ul>
  15. 15. example <ul><li>$10,000 in stock market </li></ul><ul><li>(1) all of it in Google </li></ul><ul><li>(2) spread out among 500 stocks, including Google </li></ul><ul><li>What if Google loses 20% of value? </li></ul><ul><li>option 2 takes less of a hit </li></ul><ul><ul><li>offset by gains in other stocks </li></ul></ul>
  16. 16. Insurance market <ul><li>based on </li></ul><ul><ul><li>customers paying to avoid risk </li></ul></ul><ul><ul><ul><li>risk averse </li></ul></ul></ul><ul><ul><li>firm pooling the risks of many customers </li></ul></ul><ul><li>my home burning down is catastrophic for me, a small set back for State Farm </li></ul>
  17. 17. Asymmetric Information <ul><li>2 parties in a transaction </li></ul><ul><li>one has better info than the other </li></ul><ul><ul><li>could exploit this for advantage </li></ul></ul><ul><li>if not controlled, this leads to markets breaking down </li></ul>
  18. 18. <ul><li>Asym. info affects </li></ul><ul><ul><li>buy/sell goods </li></ul></ul><ul><ul><ul><li>eBay, used cars </li></ul></ul></ul><ul><ul><li>insurance market </li></ul></ul><ul><ul><li>lending market </li></ul></ul>
  19. 19. 2 problems: <ul><li>adverse selection </li></ul><ul><ul><li>occurs before the transaction </li></ul></ul><ul><li>moral hazard </li></ul><ul><ul><li>occurs after the transaction </li></ul></ul>
  20. 20. Adverse selection <ul><li>people most who are most risky are more likely to </li></ul><ul><ul><li>seek insurance </li></ul></ul><ul><ul><li>borrow money </li></ul></ul><ul><ul><li>sell their crappy stuff </li></ul></ul><ul><li>the adverse are more likely to be selected </li></ul>
  21. 21. <ul><li>why a problem? </li></ul><ul><ul><li>uninformed party may leave market </li></ul></ul><ul><ul><li>beneficial transactions do not occur </li></ul></ul><ul><li>solution? </li></ul><ul><ul><li>screening </li></ul></ul><ul><ul><li>certifications </li></ul></ul>
  22. 22. example 1: life insurance <ul><li>adverse selection: </li></ul><ul><ul><li>sick/dying people more likely to want life insurance </li></ul></ul><ul><li>solution </li></ul><ul><ul><li>health history, blood work, etc. </li></ul></ul><ul><ul><li>or group membership </li></ul></ul>
  23. 23. example 2: bank loan <ul><li>adverse selection: </li></ul><ul><ul><li>riskier people more likely to need money </li></ul></ul><ul><li>solution </li></ul><ul><ul><li>credit history, references…. </li></ul></ul>
  24. 24. example 3: used cars <ul><li>adverse selection: </li></ul><ul><ul><li>used cars for sale because owner wanted to dump it </li></ul></ul><ul><li>solution: </li></ul><ul><ul><li>VIN checks, certified, warranty </li></ul></ul>
  25. 25. example 4: ebay <ul><li>adverse selection </li></ul><ul><ul><li>site attracts scam artists since buyer must pay first </li></ul></ul><ul><li>solution </li></ul><ul><ul><li>screening: feedback system </li></ul></ul><ul><ul><li>backround check (not done) </li></ul></ul>
  26. 26. Moral Hazard <ul><li>after transaction, people likely to engage in risky behavior or not “do the right thing.” </li></ul><ul><li>hazard of lack of moral conduct </li></ul>
  27. 27. <ul><li>why a problem? </li></ul><ul><ul><li>uninformed party may leave market </li></ul></ul><ul><ul><li>beneficial transactions do not occur </li></ul></ul><ul><li>solution? </li></ul><ul><ul><li>monitoring </li></ul></ul><ul><ul><li>restrictions on allowed behavior </li></ul></ul>
  28. 28. example 1: auto insurance <ul><li>moral hazard </li></ul><ul><ul><li>given coverage, drive less carefully or do not lock up </li></ul></ul><ul><li>solution </li></ul><ul><ul><li>monitor for tickets </li></ul></ul><ul><ul><li>discount for anti-theft device </li></ul></ul>
  29. 29. example 2: bank loan <ul><li>moral hazard </li></ul><ul><ul><li>get the loan and “blow the money” so cannot pay it back </li></ul></ul><ul><li>solution </li></ul><ul><ul><li>collateral </li></ul></ul><ul><ul><li>insurance to protect collateral </li></ul></ul><ul><ul><li>consequences on credit report </li></ul></ul>
  30. 30. example 3: ebay <ul><li>moral hazard </li></ul><ul><ul><li>buyer pays for item, </li></ul></ul><ul><ul><ul><li>never gets it or defective </li></ul></ul></ul><ul><ul><ul><li>seller disappears </li></ul></ul></ul><ul><li>solution </li></ul><ul><ul><li>feedback consequences </li></ul></ul><ul><ul><li>PayPal & credit card protection </li></ul></ul>
  31. 31. Summary <ul><li>risk is central to most transactions </li></ul><ul><li>information is costly and not perfect </li></ul><ul><ul><li>(a big benefit of the internet is how it lowered the cost of information) </li></ul></ul><ul><li>all else equal, we do not like risk or uncertainty </li></ul><ul><ul><li>risk pooling, screening, & monitoring all manage this </li></ul></ul>

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