Chapter 06 - The Economics of Information and Choice Under UncertaintyChapter 6THE ECONOMICS OF INFORMATIONAND CHOICE UNDER UNCERTAINTYBoiling Down Chapter 6The notion that we have free perfect information was great while it lasted. Alas,information is very fragmented and never free. Complicating matters is the fact that it canbe manipulated for personal benefit by those transmitting it. Therefore, the goals and themessage of the provider of information must be interpreted together.Believable information has two properties. First, like good money, it cannot easily becounterfeited, and second, it will elicit information from others who cannot afford towithhold similar information lest they appear less adequate than their competitors. Anexample of the first principle can be seen when a potential employee presents a verifiablelist of volunteer service to the community. This signals that he is concerned about othersand does not function out of a narrow self interested framework. Adam Smith commentedthat a person who joins a religious sect that teaches honesty and disciplines its waywardmembers is likely to enhance his own commerce as well. A degree from a high qualityinstitution or a family reputation are far more credible signaling devices than an honestface or a well-prepared promise because a face and a story are easy to counterfeit.The second principle, that of full disclosure, has many economic applications. Just asall toads will croak to convince the world that they are not the smallest toad, so producerswill offer warranties, even if they are inferior to other warranties. This will at least signalthat they are better than the product with no warranty at all. Efforts to hide demographiccharacteristics in the labor market will be unsuccessful because those with the mostdesirable demographics will be eager to volunteer that information. Accordingly, anyonewho hides demographic data will be suspected of having the least favorable characteristicsand therefore will have a difficult time getting a job. Clearly, everyone but the person withthe least desirable demographics will have incentive to disclose full information.The full-disclosure principle helps explain why used equipment sells for much lessthan new equipment. Since defective things are likely to be sold and good things kept, theproportion of defective things in the used market will be much higher than the defectiveshare of the new market. This lowers the value of used things and makes it unlikely thatowners of good used things will want to sell their merchandise. In order to sell a non-defective used item, the owner must make a special effort to prove that her merchandise isnot faulty.6-1Chapter 06 - The Economics of Information and Choice Under UncertaintyIndirect types of signaling are helpful in forming relationships. Being too eager to forma relationship or joining a matching service may indicate that a person has no friends forgood reason or is unable to initiate relationships on his own for some reason. Indirectsignaling occurs also if people seek to form exchange pools for insurance. Insuranceseekers are likely to be higher risks, particularly if the insurance covers small lossesagainst which low-risk people wisely self-insure. This crowding of undesirables intogroups is referred to as adverse selection.Conspicuous consumption is a signal of ability, since income is generated by ability inmany cases. This is particularly true where selling or other types of impersonal customercontact is required and where other methods of finding out about a person are costly.However, in academia, where concentrated thinking is required, high consumption is oftendisdained as a distraction and this distraction signals poorer performance. To the degreethat high consumption becomes a positional quality, it is a necessary, but not sufficient,condition for good signaling.When little specific information is known about a product or a laborer, consumers oremployers have little choice but to group the product or employee according to someavailable screening device. In the case of insurance, premium rates are determined by theaverage risk of the group so that those most careful in avoiding claims are discriminatedagainst.The last factor in this chapter that can influence time preference behavior is the factthat people can seek out commitment arrangements that force certain behavior that theywant but have a hard time achieving. A person who encourages a spouse to hide moneybefore a shopping trip so that the coming vacation will not be jeopardized will exhibit amore negative time preference than would have been the case without the commitmentdevice.This chapter explores the effect of people's attitudes toward risk as well as their timepreference. Some people pay to avoid risk, while others pay to absorb risk. We call thesepeople risk averse and risk lovers, respectively. A risk-neutral person is indifferent betweenany alternatives of the same expected value no matter how much or how little risk isinvolved in the various alternatives.The tools for exploring risk-averse behavior are based on the fact that wealth hasdiminishing marginal utility for risk-averse people. The figure below shows that if startingincome is $100, a gain of $50 will bring less additional utility than a loss of $50 will costin utility foregone. Utility50 80 100 150 $ Figure 6-16-2Chapter 06 - The Economics of Information and Choice Under UncertaintyTherefore, a fair gamble, one in which the expected value of the gamble is 0, will notbe accepted because the expected utility of the gamble is less than the actual utilityreceived when the risk is avoided. In other words, this person will not accept a coin-tossgamble that would bring her $50 for tails and cost her $50 for heads. The chord thatconnects the two outcomes of the coin toss shows the utility level of the expected dollaroutcomes. It is easy to see that the person represented on the graph would be just as happywith $80 of certain money than with $100 expected value from the coin toss. In otherwords, she would be willing to pay $20 to avoid the gamble if she had to. If she was forcedto gamble, she would be willing to pay an insurance company $20 to guarantee her the$100 she started with before she entered the coin toss. The insurance company would make$70 ($50 + her