13. The Economics of Information and Uncertainty

1. 13. The Economics of Information and Uncertainty • Risk aversion • Asymmetric information • (pages 333-342)

2. 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

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

4. 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

5. 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

6. 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

7. 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

8. back to example 1, coin toss • What if I gave you a choice…. (1) take $10 and walk away (2) take the gamble

9. 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 don’t care • risk neutral

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

11. if you take the $5 • still risk averse • “paying” to avoid the gamble

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

13. 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.

14. Risk Pooling & Insurance • risk is inevitable • what to do? • spread out risk among many • loss for any one event is small • = risk pooling

15. 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

16. 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

17. 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

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

19. 2 problems: • adverse selection • occurs before the transaction • moral hazard • occurs after the transaction

20. 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

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

22. example 1: life insurance • adverse selection: • sick/dying people more likely to want life insurance • solution • health history, blood work, etc. • or group membership

23. example 2: bank loan • adverse selection: • riskier people more likely to need money • solution • credit history, references….

24. example 3: used cars • adverse selection: • used cars for sale because owner wanted to dump it • solution: • VIN checks, certified, warranty

25. example 4: ebay • adverse selection • site attracts scam artists since buyer must pay first • solution • screening: feedback system • backround check (not done)

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

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

28. 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

29. 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

30. example 3: ebay • moral hazard • buyer pays for item, • never gets it or defective • seller disappears • solution • feedback consequences • PayPal & credit card protection

31. 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