Decision Making Under Uncertainty and Asymmetric information

Expected Utility Insurance Premium Risk Return Analysis Asymmetric information Moral Hazard (Hidden action) Adverse Selection (Hidden information) http://cepa.newschool.edu/het/home.htm
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Utility Function for Risk Averse Individual

Utility

U = ln (W )

EU = 1 ln(WL ) + (1 1 ) ln(WH )
Expected utility
EW = 1WL + (1 1 )WH

Expected wealth
0 WL

(1 1 )

WH

Wealth
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Utility Function for Risk Averse Individual Utility

ln(WH)

U = ln (W )
Expected utility EU = 1 ln(WL ) + (1 1 ) ln(WH )

ln(CEW)

ln(WL)

Insurance Premium

Expected wealth EW = 1WL + (1 1 )WH

WL

CEW

EW

WH

Wealth

(1 1 )

Utility Function for Risk Averse Individual

Utility

U = ln (W )

Pratt(1964) Measure of risk aversion:

1W2 1 U ' ' (W ) r (W ) = = 1W = W > 0 U ' (W )

WL

(1 1 )

WH

Wealth
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Utility Function for Risk Loving Individual

U = eW
Utility

U ' ' (W ) W 2 eW r (W ) = = = W < 0 W U ' (W ) We

0 WL

WH

(1 1 )

Utility Function for Risk Neutral Individual

U = a.W
Utility

U ' ' (W ) 0 r (W ) = = =0 U ' (W ) a

0 WL

WH

(1 1 )

Uncertainty and Expected Utility

Utility UH UEW

U = ln (W )

UCE

UL

Risk Premium

10000

20000

Wealth
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Uncertainty and Expected Utility and Insurance Payment

Utility 9.903 9.616

U = ln (W )

9.557

Risk premium 15000-14143 = 857 Insurance payment

9.201

10000

1 = 0.5

14143

EW=15000

(1 1 ) = 0.5

20000

Wealth

Preference of an Investor Toward Risks Returns

Rp
Return on a portfolio

R p = bRm + (1 b )R f
RST

0 < b <1
Market return risk free return

Rm

Rf
RB
0 Treasury Bill

Stocks give high return but are risky. Bonds have low risk but low risk.

Stocks

Risks
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Standard deviation of return to a portfolio

Optimal Portfolio
Expected Return on a portfolio

U2 U1

Rp RST
Not feasible M

p b= m

Rp = R f +

(R

Rm )

Optimal point

RB
0 Standard deviation of return to a portfolio

p
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Choices of Risk Averse vs Risk Lover in a Financial Market

Expected Return on a portfolio

Rp = R f +

(R

Rm )

U1

U2

R2 R1

Risk loving investor.

Risk averse investor.

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Standard deviation of return to a portfolio

Asymmetric information Equilibrium is affected when some economic agents have more information than others.
Market of used cars
Plums: good cars Lemons: bad cars

Seller knows his quality of cars but buyers does not Market for good cars disappear because of existence of bad cars in the market
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Akerlofs Model of Asymmetric Information

P Markets for good cars SH P SL 10 Markets for bad cars

7.5 5 DM DL 200 250 500 Q

7.5 DH 5 DM DL 500 750

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Sellers know exactly quality of cars but buyers do not. Demand for high quality car falls and that for low quality rise, ultimately all Low quality cars remain in the market.

Signalling for high quality

Warranty and Guarantee Providing warranty less costly for high quality cars They last long. warranty is costly for low quality cars as they frequently break down.
Principal agent problem
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Adverse Selection (hidden information) Problem Uncertainty about the quality of good low quality items crowd out high quality items; Theft insurance; health insurance; risky vs. gentle borrowers in the financial market. Healthy people are less likely to buy health insurance, people from safe area are less likely to buy theft insurance honest borrowers less likely to borrow at higher interest rates.
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Moral hazard (hidden action):

People who have theft insurance are likely to have easy to break locks in their bicycle (car) and most likely to claim insurances. Probability of event is affected by the action of the person Remedy: deductible amount; to ensure that some customers take care in security.
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Impacts of Asymmetric information

Equilibrium if inefficient relative to full information Government can improve the market by setting high standards Signalling: Warranty

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Education as a signal of quality of workers: Type 1 is less productive than type 2 worker but an employer cannot distinguish off-hand. The marginal productivity of type 1 is less than that of type 2, a1 < a1
Production function Equilibrium in Perfect information World:

y = a1 L1 + a 2 L2
w1 = a1

w = bw1 + (1 b )w2

w2 = a 2
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Education as a Signalling Device Market is inefficient, it drives out more productive workers. If workers can signal their quality by the level of educational attainment, then market may work well. Low quality workers may find obtaining certain education costlier than high quality workers, * * c1e c 2 e c1 c 2
a 2 a1 a 2 a1 * <e < c1 c2
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Education as a Signalling Device It is costly for low quality worker to get the specified education. It is beneficial for high quality worker to get education. so the low quality worker gets no education, but the higher quality worker gets education. Employers pay according to the level of education. Therefore education works as a signalling device and makes the market efficient. Education separates the equilibrium.

(a 2 a1 ) < c1e *

(a 2 a1 ) > c2 e *

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Incentive System: How can I get someone to do something for me? :Spence Model
If a worker puts x amount of effort, the land produces y = f (x ) Then the land owner pays worker s(y) . The land owner wants to maximise profit = f (x ) s( y ) = f (x ) s( f ( x )) Worker has cost of putting effort c(x) and has a reservation utility, u The participation constraint is given by . s( f ( x )) c( x ) u Including this constraint, the maximisation problem becomes Max f ( x ) s( f ( x )) s( f ( x )) c( x ) u subject to

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Incentive compatible contract (a) renting (Varian where the 36) the land Chapter workers pays a
fixed rent R to the owner and takes the residual amount of output, at equilibrium f (x ) c(x ) R = u (b) Take it or leave it contract where the owner gives some amount such as,, B * c(x * ) = u (c) hourly contract s( f ( x )) = wx + K (d) sharecropping, in which both worker and owner divide the output in a certain way. In (a)-(c) burden of risks due to fluctuations in the output falls on the worker but it is shared by both owner and worker in (d). Which of these incentives work best depends on the situation.
* *

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Readings Biswas T.K. (1997) Decision-Making Under Uncertainty, MacMillan. Nicholson W (1989) Microeconomics Principles and Extensions, Chapter 9. Pindyck and Rubinfeld (2005) Microeconomics, Chapter 5 and 17. Varian H (2003) Microeconomics, Chapters 12-13; 36.
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