Uncertainty and Information CHAPTER 19 C H A P T E R C H E C K L I S T When you have completed your study of this chapter, you will be able to 1 Explain.

Uncertainty and Information

CHAPTER19

C H A P T E R C H E C K L I S T

When you have completed your study of this chapter, you will be able to

1 Explain how people make decisions when they are uncertain about the consequences.

2 Explain how markets enable people to buy and sell risk.

3 Explain how markets cope when buyers and sellers have private information.

19.1 DECISIONS IN THE FACE OF UNCERTAINTY

Tania, a student, is trying to decide which of two alternative summer jobs to take.

1. She can work as a house painter and have $2,000 in at the end of the summer and there is no uncertainty about the income from this job.

2. The other job is working as a telemarketer. Tania thinks there is a 50 percent chance that she will earn $5,000

and a 50 percent chance that she will earn $1,000.

Which job does she prefer?


Expected Wealth

Expected wealth is the money value of what a person expects to own at a given point in time.

An expectation is an average calculated by using a formula that weights each possible outcome with the probability (chance) that it will occur.

For Tania, the probability that she will have $5,000 is 0.5 (a 50 percent chance) and the probability that she will have $1,000 is also 0.5.

Expected wealth = ($5,000 × 0.5) + ($1,000 × 0.5)

= $3,000.


Expected Wealth

Expected wealth is the money value of what a person expects to own at a given point in time.

An expectation is an average calculated by using a formula that weights each possible outcome with the probability (chance) that it will occur.

What is Tania’s expected wealth from the telemarketing job?


The probability that Tania will have $5,000 is 0.5 (a 50 percent chance).

The probability that she will have $1,000 is also 0.5.

Expected wealth = ($5,000 × 0.5) + ($1,000 × 0.5)

= $3,000.

Tania can now compare the expected wealth from two jobs:

• $2,000 for non-risky painting job

• $3,000 for the risky telemarketing job


Will Tania take the risky job?

It will depend on how much Tania dislikes risk.

Risk Aversion

Risk aversion is the dislike of risk.

We measure a person’s attitude toward risk by using a utility of wealth schedule and curve.

Greater wealth brings greater total utility, but the marginal utility of wealth diminishes as wealth increases.

Utility of Wealth

Figure 19.1 shows that as Tania’s utility of wealth curve.

1. If Tania’s wealth is $2,000

2. She gets 70 units of utility.


Tania’s total utility increases when her wealth increases.

But the marginal utility of wealth diminishes.

Each additional dollar of wealth brings successively smaller increments in total utility.


Because of diminishing marginal utility,

for a loss of wealth

or a gain of wealth of equal size,

3. Tania’s pain from the loss exceeds her pleasure from the gain.


Expected Utility

When there is uncertainty, people do not know the actual utility they will get from taking a particular action.

But they know the utility they expect to get.

Expected utility is the utility value of what a person expects to own at a given point in time.


Figure 19.2 shows how Tania calculates her expected utility.

1. Tania has a 50 percent chance of having $5,000 of wealth and total utility of 95 units.


2. Tania has a 50 percent chance of having $1,000 of wealth and a total utility of 45 units.

3. Tania’s expected wealth is $3,000 and

4. Her expected utility is 70 units.


5. With $3,000 wealth and no

uncertainty, utility is 83 units.

For a given expected wealth, the greater the range of uncertainty, the smaller is expected utility.


Making a Choice with Uncertainty

Faced with uncertainty, a person chooses the action that maximizes expected utility.

To select the job that gives her the maximum expected utility, Tania must calculate

1. The expected utility from the risky telemarketing job.

2. The expected utility from the safe painting job.

3. Compare the two expected utilities.


Figure 19.3 shows the choice under uncertainty.

1. In a telemarketing job, there is a 50 percent chance that Tania will make $5,000 and a 50 percent chance that she will make $1,000.

Her expected wealth is $3,000.


2. Tania expected utility is 70 units.

Tania would have the same 70 units utility with wealth of $2,000 and no risk, so

3. Tania’s cost of bearing this risk is $1,000.


Tania is indifferent between

The job that pays $2,000 with no risk and

The job that offers an equal chance of $5,000 and $1,000.


19.2 BUYING AND SELLING RISK

Just as buyers and sellers gain from trading goods and services, they can also gain from trading risk.

Risk is a bad, not a good, so the good that is traded is risk avoidance.

A buyer of risk avoidance can gain because the value of avoiding risk is greater than the price that must be paid to get someone else to bear that risk.

The seller of risk avoidance faces a lower cost of risk than the price that people are willing to pay to avoid that risk.

Insurance Markets

Insurance reduces the risk that people face by sharing or pooling risks.

When people buy insurance against the risk of an unwanted event, they pay an insurance company a premium.

If the unwanted event occurs, the insurance company pays out the amount of the insured loss.


Why People Buy Insurance


Figure 19.4 illustrates.

Dan owns a car worth $10,000, and that is his only wealth.

There is a 10 percent chance that Dan will have a serious accident that makes his car worth nothing.


1. Dan’s wealth (the value of his car) is $10,000.

2. His utility is 100 units.

With no insurance, if Dan has a crash,

3. He has no wealth and

4. No utility.


With a 10 percent chance of a crash,

5. Dan’s expected wealth is $9,000.

($10,000 × 0.1)

6. His expected utilityis 90 units.

So with no insurance, Dan’s expected utility is 90 units.


Figure 19.5 shows the situation when Dan buys insurance.

If Dan had $7,000 of wealth with no risk,

he would have the same utility as has with $10,000 of wealth and 10 percent risk of loss.


1. If Dan pays $3,000 for insurance, his wealth is $7,000 and

2. His utility is 90 units.

3. So $3,000 is the value of

insurance for Dan.


If there are lots of people like Dan, each with a $10,000 car and each with a 10 percent chance of having an accident,

an insurance company pays out $1,000 per person on the average.


The insurance company can provide coverage for people like Dan for $1,000.

4. If Dan pays $1,000 for insurance,

5. His expected wealth is $9,000 and

6. His expected utilityis 98 units.


7. Dan gains from insurance.

Dan is willing to pay up to $3,000 for insurance that costs the insurance company $1,000, so there is a gain from trading risk of $2,000 per person.

19.3 PRIVATE INFORMATION

In the markets that you’ve studied so far, the buyer and the seller are well informed about the features and value of the good, service, or factor of production being traded.

But in some markets, either the buyers or the sellers are better informed about the value of the items being traded than the person on the other side of the market.

These buyers or sellers have private information.

Examples are your knowledge about the quality of your driving, your work effort, the quality of your car, and whether you intend to repay a loan


Private information is information possessed by either buyers or sellers about the value of the item being traded that is not available to the persons on the other side of a transaction.

Examples are your knowledge about the quality of your driving, your work effort, the quality of your car, and whether you intend to repay a loan.

When either buyers or sellers have private information, the market has asymmetric information.


Asymmetric Information: Examples and Problems

Asymmetric information creates two problems:

1. Adverse selection

2. Moral hazard


Adverse Selection

Adverse selection is the tendency for people to enter into agreements in which they can use their private information to their own advantage and to the disadvantage of the less informed party.

For example, if Jackie advertises jobs for salespeople at a fixed wage, she will attract lazy salespeople.

Hardworking salespeople will prefer to work for someone who pays by results, rather than a fixed wage.

The fixed-wage contract adversely selects those with private information about their work effort.


Moral Hazard

Moral hazard exists when one of the parties to an agreement has an incentive after the agreement is made to act in a manner that brings additional benefits to himself or herself at the expense of the other party.

For example, Jackie hires Mitch as a salesperson and pays him a fixed wage regardless of how much he sells.

Mitch faces a moral hazard.

He has an incentive to put in the least possible effort, benefiting himself and lowering Jackie’s profits.


A variety of devices have evolved that enable markets to function in the face of adverse selection and moral hazard.

We’ve just seen one, the use of incentive payments for salespeople.

We’re going to look at how three markets cope with adverse selection and moral hazard. They are

• The market for used cars

• The market for loans

• The market for insurance


The Market for Used Cars

A used car might be a lemon—a car that is worth less than a car with no defects.

But only the seller knows whether a car is a lemon.

Lemon problem is the problem that in a market in which it is not possible to distinguish reliable products from lemons, too many lemons and too few reliable products traded.

How does a market work when it has a lemon problem?


The Lemon Problem in a Used Car Market

The market has two types of cars: • Lemons worth $5,000 each.• Cars without defects worth $25,000 each.

Whether the car is a lemon or not is private information of the current owner.

A buyer discovers a lemon only after buying it.


Because buyers can’t tell the difference between a lemon and a good car, the price they are willing to pay reflects the fact that the car might be a lemon.

The highest price that a buyer will pay must be less than $25,000 because the car might be a lemon.

Some people with low incomes and time to fix a car are willing to buy lemons as long as they know what they are buying and paying for.

What is the price of a used car?


So the most that the buyer knows is the probability of buying a lemon.

If half of the used cars sold turn out to be lemons, the buyer know that he has a 50 percent chance of getting a good car and a 50 percent chance of getting a lemon.

The price that a buyer is willing to pay for a car of unknown quality is more than the value of a lemon because the car might be a good one.

But the price is less than the value of a good car because it might turn out to be a lemon.


Sellers of used cars know the quality of their cars.

Someone who owns a good car is going to be offered a price that is less than the value of that car to the buyer.

Many owners will be reluctant to sell, so fewer good cars will be supplied than if the price reflected its value.

But someone who owns a lemon is going to be offered more than the value of that car to the buyer.

Owners of lemons will be eager to sell, so more lemons will be supplied than if the price reflected its value.

In the used car market:

Adverse selection exists because there is a greater incentive to offer a lemon for sale.

Moral hazard exist because the owner of a lemon has little incentive to take good care of the car, so it is likely to become even worse.

The market for used cars is not working well.



Figure 19.6 illustrates the used car market. Part (a) shows the used car market.

1. Equilibrium price is $10,000 a car and 2. 400 cars traded.


Part (b) shows the demand for good cars and the supply of good cars.

3. At $10,000 a car, 200 good cars are traded.


4. Buyers are willing to pay $25,000 for a good car.

5. Too few good cars are traded and a deadweight loss is created.


Part (c) shows the demand for and the supply of lemons.

6. At $10,000 a car, 200 lemons are traded.


7. Buyers are willing to pay $5,000 for a lemon.

8. Too many lemons are traded and a deadweight loss is created.


A Used Car Market with Dealers’ Warranties

Buyers of used cars can’t tell a lemon from a good car, but car dealers sometimes can.

To convince a buyer that it is worth paying $10,000 for what might be a lemon, the dealer offers a warranty.

The dealer signals which cars are good ones and which are lemons.

Signaling occurs when an informed person takes actions that send information to less-informed persons.

Warranties enable the market to trade good used cars.


Figure 19.7 shows how warranties solve the lemon problem.

Part (a) shows the market for good cars.

1. With warranties, the price of a good car is $20,000.

2. 400 good cars are traded.

3. The market for good cars is efficient.


Part (b) shows the market for lemons.

Because buyers can now spot a lemon (a car without a warranty)

4. The price of a lemon is $6,667.

5. 150 lemons are traded.

6. The market for lemons is efficient.


Pooling Equilibrium and Separating Equilibrium

Without warranties, only one message is visible to the buyer: All cars look the same.

The market equilibrium when only one message is available and a less-informed person cannot determine quality is a pooling equilibrium.


In a market with warranties, there are two messages:

Cars with warranties are good cars and cars without warranties are lemons.

The market equilibrium when signaling provides full information to a previously less-informed person is a separating equilibrium.


The Market for Loans

Borrowers demand loans.

The lower the interest rate, the greater is the quantity of loans demanded— the demand curve for loans is downward-sloping.

Banks and other lenders supply loans.

For a given credit risk, the higher the interest rate the greater is the quantity of loans supplied.


The risk that a borrower, also called a creditor, might not repay a loan is called credit risk or default risk.

The credit risk depends on the quality of the borrower.

Low-risk borrowers always repay.

High-risk borrowers frequently default on their loans.

The market for loans determines the interest rate and the price of credit risk.


A Pooling Equilibrium

Suppose that banks cannot tell whether they are lending to a low-risk or a high-risk customer.

In this situation, all borrowers pay the same interest rate and the market is a pooling equilibrium.

The market for loans has the same problems as the used car market without warranties.


If all borrowers pay the same interest rate, low-risk customers borrow less than they would if they were offered the low interest rate appropriate for their low credit risk.

High-risk customers borrow more than they would if they faced the high interest rate appropriate for their high credit risk.

So banks face an adverse selection problem.

Too many borrowers are high risk and too few are low risk.


Signaling and Screening in the Market for Loans

Lenders don’t know how likely it is that a given loan will be repaid, but the borrower does know.

Low-risk borrowers have an incentive to signal their risk by providing lenders with relevant information.

Signals might include information about a person’s employment, home ownership, marital status, and age.


High-risk borrowers might be identified simply as those who have failed to signal low risk.

These borrowers have an incentive to mislead lenders; and lenders have an incentive to induce high-risk borrowers to reveal their risk level.

Inducing an informed party to reveal private information is called screening.

Figure 19.8 shows the gains from separating borrowers.


Part (a) shows the pooling equilibrium in the market for loans.

1. The equilibrium interest rate is 8 percent a year.

2. The equilibrium quantity of loans is $16 million.


Part (b) shows the demand for loans and the supply of loans to low-risk borrowers.

3. At 8 percent a year, the quantity of loans is $8 million.


4. If low-risk borrowers can signal their low risk, the interest rate for these borrowers would fall to 4 percent a year.

5. The equilibrium quantity of loans increases to $12 million.

6. The deadweight loss from too few low-risk loans is avoided.


Part (c) shows the demand for loans and the supply of loans to high-risk borrowers.

7. At 8 percent a year, the quantity of loans is $8 million.


8. If lenders can screen high-risk borrowers, the interest rate for these borrowers would rise to 12 percent a year.

9. The equilibrium quantity of loans decreases to $4 million.

10. Deadweight loss from too many high-risk loans is avoided.

The Market for Insurance

People who buy insurance face moral hazard, and insurance companies face adverse selection.

Moral hazard arises because a person with insurance against a loss has less incentive than an uninsured person to avoid the loss.

Adverse selection arises because people who create greater risks are more likely to buy insurance.


Insurance companies have an incentive to find ways around the moral hazard and adverse selection problems.

By doing so, they can lower premiums for low-risk people and raise premiums for high-risk people.

Insurance companies use two devices to avoid moral hazard and adverse selection:

• The “no-claim” bonus

• A deductible


Uncertainty and Information CHAPTER 19 C H A P T E R C H E C K L I S T When you have completed your study of this chapter, you will be able to 1 Explain.

Documents

face of uncertainty

utility of wealth figure

marginal utility of

face of uncertainty

utility of wealth schedule

given expected wealth

tanias wealth

units of utility