information

asymmetric information

the seller may not know information than the buyer, the buyer knows this and has uncertainty about buying the good. this causes a issue with allocating resources efficiently

incomplete information

one agent has more information than the other before the interaction has taken place

asymmetric information in the job market

applicants have better information about their own capabilities compared to the firm

adverse selection

situations where individuals have hidden characteristics and in which a selection process results in a pool of individuals with undesirable characteristics

adverse selection in insurance market

an insurance company will raise its prices, the only people who are willing to pay higher are those that know they are more likely to make accidents, good drivers would not be willing to pay this ask they know they are not likely to benefit much from the insurance

signaling

a method to mitigate the problem of adverse selection, an informed party sends an observable indicator of their characteristics or hidden actions to an uniformed party

example of signaling

firms signal the quality of the product, money back guarantee, free trial periods ect

for effective signaling

• observable

• reliable indicator

• difficult for other parties with other characteristics to easily mimic

moral hazard

where one party to a contract takes a hidden action that benefits him or her at the expense of another party, cannot be observed by the other party

eg if a manager cannot monitor a workers effort then the workers effort is a hidden action

incentive contract

mitigates moral hazard probability by providing financial ties to indicators

contracting

mitigating adverse selection through screening, an attempt by an uninformed party to sort individuals according to their characteristics

screening

performed through a self selection device, informed parties are presented with a set of options, the options they choose reveal hidden characteristics

measuring uncertain outcomes

known as a random variable x, this could represent profits price of output, consumer income, the true value of x is always unknown but we do know the probability of x

information about uncertain outcomes

can be summarised by the mean or expected value and the variance of a random variable

mean or expected value

eg the probability is any number between 1 and 6 1/6

the expected value is

E(x) = 1/6 (1) + 1/6 (2) + 1/6 (3) + … + 1/6 (6) = 3.5

they do not know for certain by on average they will earn 3.5

the mean of a random variable

if x1 ×2…xn denotes the outcome of random variable q1 q2.. qn

E(x) = q1×1 + q2×2 + qnxn which = 1

the mean and risk

does not provide information about the degree of risk associated with the random variable

Eoption1 (x) = ½ (1) + ½ (-1) = 0

variance

the sum of all probabilities that different outcomes will occur multiplied by the squared deviation form the mean of resulting pay offs

example of variance

option 2 is now more risky because it has a higher variance

risk aversion

when the expected utility is less than the utility of expected wealth, has greater utility from a sure outcome than a gamble

risk loving

prefers a risky prospect, with a greater expected value of m than a sure amount of m

risk neutral

is indifferent between a risky prospect with an expected value of m and a sure amount of m

consumer search

a consumer observing the lowest price at 40 should stop there as this is the lowest price

a risk neutral consumer search

a risk neutral consumer sees a price of 100 and does not know any other prices

¼ of the time there is a cheaper product and saves 100 - 40 = 60

but ¾ of the time the consumer will save nothing as the actual price is 100

so a consumer should search for a lower price as long as the additonal benefits are greater than the cost of earching

reservation price

a price where a customer is indifferent between purchasing at that price and searching for a lower price

where EB (additional serach) = cost (additional search)

firm diversification

by investing in multiple projects risk has potential to be reduced, whether this is optimal depends on the risk preference and incentives provided to the manager

profit maximisation and uncertainty

if demand is uncertain and the manager is risk neutral, then the manager will want to maximise expected profits by producing the output where expected MR is equal to MC