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100A-4 ECONOMICS OF INFORMATION AND CHOICE UNDER
UNCERTAINTY
INITIAL SECTIONS OF CHAPTER DEVOTED TO SEVERAL
EXAMPLES OF INFORMATION THEORY
1. SIGNALS BETWEEN ADVERSARIES--A)
MUST BE COSTLY TO FAKE—(education as a signal)
QUALITY ASSURANCE EXAMPLE—(reputation, length of time in
the business….)
CHOOSING A RELIABLE EMPLOYEE—(cultural background,
religious, previous experience, quality of degree…)
B)
FULL-DISCLOSURE PRINCIPLE
NO SIGNAL >>>>WORST CASE SITUATION>>>>PRODUCT
WARRANTIES
CAN YOU KEEP FROM ASKING EMPLOYEES ABOUT
“DESIRABLE” YET POLITICALLY INCORRECT ATTRIBUTES,
e.g., marriage status, number of children….
LEMON PRINCIPLE---where owner has more knowledge
C)
ADVERSE SELECTION---(e.g., dating service, insurance, and
medical savings accounts…..)
D)
STATISTICAL DISCRIMINATION
FRANK USES EXAMPLE OF INSURANCE RATING---WITH
CONCLUSION THAT WITHOUT RATING, INSURANCE RATES
WILL TEND TO BE HIGHER FOR EVERYONE---or companies
will withdraw…)
DOES SAME ISSUE ARISE WITH STATISTICAL
DISCRIMINATION IN HIRING????
2
PROBABILITY AND UNCERTAINTY
CONCEPT OF EXPECTED UTILITY….OUTCOME FROM TWO OR
MORE EVENTS THAT CAN’T BE PREDICTED WITH
CERTAINTY….I.E., YOU ONLY KNOW PROBABILITIES
THE EXPECTED UTILITY OF A GAMBLE IS THE EXPECTED
VALUE OF THE UTILITY OVER ALL POSSIBLE OUTCOMES…..
E.G., E(Value) = SUM OF EXPECTED UTILITIES OF EACH OUTCOME
IN A FAIR BET, WIN OR LOSE, E(V) = _ (WINNING AMOUNT) + _ (WINNING AMOUNT) = E(V) OF 0, WHERE YOU STARTED
BUT FOR LARGE BETS, MOST PEOPLE ARE RELUCTANT TO
MAKE THE BET…….ASSUMES THAT FOR THE MOST PART, THE
WORLD IS RISK AVERSE
(FAIR ASSUMPTION BASED ON DECLINING MARGINAL UTILITY
OF INCOME---BUT THEORY IS OFTEN EXTENDED TO
PROBABILITY OF MAKING A KILLING…-----MANY
APPLICATIONS, INCLUDING FRANK’S BOOK ON WINNER TAKE
ALL SOCIETY
distinguishing between expected VALUE (gain in money) and expected
UTILITY
U
i.e., diminishing marginal utility of money
which would lead to the rejection of a fair gamble
Money
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Utility
B
E (go)
E (f)
A
after loss
start
after gain
E (go) = expected utility from bet with GOOD odds;
E (f) = expected utility from bet with fair odds (i.e., 50-50)
on a fair bet, E (U) = _ E(UA) + _ E (UB), i.e., mid-way along the chord>>>>>
a risk averse person will take bet only with “good” odds, and perhaps in the case of
“wild” gambles, where the chance of making a killing is small, but exists….e.g., at
some point the utility curve may be concave from above (which is the case for the risk
taker in general).
U
B
C
A
D
note, that even with a “small” chance of winning B (i.e., A is more likely), expected
utility is higher by taking the bet, than staying put at D
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PEOPLE SEEM TO PREFER A SURE THING, BUT ARE WILLING TO
GAMBLE MORE OFTEN IF UNCERTAINTY ENTERS INTO BOTH
OPTIONS…IRRATIONAL????????
FINAL THOUGHTS….SELF-INSURE AGAINST SMALL LOSSES--INSURE AGAINST LARGE LOSSES
IN THE FORMER CASE,
ADVERSE SELECTION PROCESS and MORAL HAZARD…
(those more likely to “need” insurance will get it, and then be more
likely to act carelessly….i.e., administrative costs of such insurance is
likely to be high…..case in point: THE EXTENDED WARRANTY
(don’t get it….unless you’re a totally flaky user of the equipment)
INSURANCE EXAMPLE:
C
D
B
A
fire [A]
X
Money
no fire [C]
B is Expected Utility without insurance (i.e., it’s far more likely that there will be no
fire: D is the certainty equivalent, that is, if insurance costs leave you to the right of X,
you should buy