Risk & Asymmetric Information

What is probability?

The relative frequency with which an event occurs.

Define expected value.

The average outcome from an uncertain gamble, calculated as the odds of an event happening multiplied by the expected payout.

What is a fair gamble?

A gamble where the expected dollar values of winning and losing are equal.

Why might a fair dollar bet not be a fair utility bet?

Because the utility lost from losing is greater than the utility gained from winning.

What characterizes a risk-neutral individual?

Their utility/income line is a straight line at a 45-degree angle.

What happens to a risk-seeker's expected utility compared to guaranteed dollars?

They derive greater utility from the thrill of potential gains than from guaranteed amounts.

How does insurance reduce risk?

By allowing individuals to pay a premium to avoid the uncertainty of a potential loss.

What is a fair premium in insurance?

The probability of an event multiplied by the loss incurred if the event occurs.

What is moral hazard in insurance?

When insured individuals change their behavior, making the insured event more likely to occur.

What is adverse selection in insurance?

When individuals with a higher likelihood of loss are more likely to seek insurance.

List four methods of reducing risk and uncertainty.

1. Insurance 2. Information 3. Flexibility 4. Diversification

How does diversification reduce risk?

By spreading investments across multiple outcomes to lower the probability of total loss.

What is the utility gained from diversification compared to no diversification?

Diversification provides a higher utility due to reduced risk.

What role does information play in reducing risk?

Better information allows for more informed decisions, reducing uncertainty.

What is the purpose of signaling in hiring?

To indicate the quality of an applicant to the employer.

What are weak and strong signals in the context of hiring?

Weak signals are low-cost indicators (e.g., wearing a suit), while strong signals are costly (e.g., a university degree).

What is a separating equilibrium?

A situation where good information allows firms to differentiate between high and low-quality workers.

What is a pooling equilibrium?

A situation where all workers are paid the same due to lack of information, leading to inefficiency.

What does flexibility in decision-making allow?

It allows decision-makers to adjust their choices based on future developments.

Give an example of flexibility in finance.

Purchasing an option to buy shares at a set price in the future.