Managerial Economics & Business StrategyOverviewThe MeanThe Variance & Standard DeviationUncertainty and Consumer BehaviorExamples of How Risk Aversion Influences DecisionsPrice Uncertainty and Consumer SearchConsumer Search RuleConsumer SearchConsumer Search: Rising Search CostsUncertainty and the FirmExample: Profit-Maximization in Uncertain EnvironmentsUncertainty and the MarketAsymmetric InformationTwo Types of Asymmetric InformationAdverse SelectionMoral HazardPossible SolutionsSlide 19AuctionsEnglish AuctionFirst-Price, Sealed-bidSecond-Price, Sealed-bidDutch AuctionInformation StructuresOptimal Bidding Strategy in an English AuctionOptimal Bidding Strategy in a Second-Price Sealed-Bid AuctionOptimal Bidding Strategy in a First-Price, Sealed-Bid AuctionExampleOptimal Bidding Strategies with Correlated Value EstimatesThe Winner’s CurseExpected Revenues in Auctions with Risk Neutral BiddersConclusionManagerial Economics & Business StrategyChapter 12The Economics of InformationMcGraw-Hill/IrwinMichael R. Baye, Managerial Economics and Business StrategyCopyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.OverviewI. The Mean and the VarianceII. Uncertainty and Consumer BehaviorIII. Uncertainty and the FirmIV. Uncertainty and the MarketV. Auctions12-2The Mean •The expected value or average of a random variable.•Computed as the sum of the probabilities that different outcomes will occur multiplied by the resulting payoffs:E[x] = q1 x1 + q2 x2 +…+qn xn, where xi is payoff i, qi is the probability that payoff i occurs, and q1 + q2 +…+qn = 1.•The mean provides information about the average value of a random variable but yields no information about the degree of risk associated with the random variable.12-3The Variance & Standard Deviation•VarianceA measure of risk.The sum of the probabilities that different outcomes will occur multiplied by the squared deviations from the mean of the random variable:s2 = q1 (x1- E[x])2 + q2 (x2- E[x])2 +…+qn(xn- E[x])2 •Standard DeviationThe square root of the variance.•High variances (standard deviations) are associated with higher degrees of risk12-4Uncertainty and Consumer Behavior•Risk AversionRisk Averse: An individual who prefers a sure amount of $M to a risky prospect with an expected value, E[x], of $M.Risk Loving: An individual who prefers a risky prospect with an expected value, E[x], of $M to a sure amount of $M.Risk Neutral: An individual who is indifferent between a risky prospect where E[x] = $M and a sure amount of $M.12-5Examples of How Risk Aversion Influences Decisions•Product qualityInformative advertisingFree samplesGuarantees•Chain stores•Insurance12-6Price Uncertainty and Consumer Search•Suppose consumers face numerous stores selling identical products, but charge different prices.•The consumer wants to purchase the product at the lowest possible price, but also incurs a cost, c, to acquire price information.•There is free recall and with replacement.Free recall means a consumer can return to any previously visited store.•The consumer’s reservation price, the at which the consumer is indifferent between purchasing and continue to search, is R.•When should a consumer cease searching for price information?12-7Consumer Search Rule•Consumer will search until•Therefore, a consumer will continue to search for a lower price when the observed price is greater than R and stop searching when the observed price is less than R.  .cREB 12-8Consumer SearchThe Optimal Search Strategy.c cEBReservation PriceAccept RejectR$P012-9Consumer Search: Rising Search Costsc cEBR$P0An increase in search costs raises the reservation price.R*c*c*12-10Uncertainty and the Firm•Risk AversionAre managers risk averse or risk neutral?•Diversification“Don’t put all your eggs in one basket.”•Profit MaximizationWhen demand is uncertain, expected profits are maximized at the point where expected marginal revenue equals marginal cost: E[MR] = MC.12-11Example: Profit-Maximization in Uncertain Environments•Suppose that economists predict that there is a 20 percent chance that the price in a competitive wheat market will be $5.62 per bushel and an 80 percent chance that the competitive price of wheat will be $2.98 per bushel. If a farmer can produce wheat at cost C(Q) = 20+0.01Q, how many bushels of wheat should he produce? What are his expected profits?•Answer:E[P] = 0.2 x $5.62 + 0.8 x $2.98 = $3.508In a competitive market firms produce where E[P] = MC. Or, 3.508 = 0.01Q. Thus, Q = 350.8 bushels.Expect profits = (3.508 x 350.8) – [1000 + 0.01(350.8)] = 1230.61-1000-3.508 = $227.10.12-12Uncertainty and the Market•Uncertainty can profoundly impact market’s abilities to efficiently allocate resources.12-13Asymmetric Information•Situation that exists when some people have better information than others.•Example: Insider trading12-14Two Types of Asymmetric Information•Hidden characteristicsThings one party to a transaction knows about itself, but which are unknown by the other party.•Hidden actionsActions taken by one party in a relationship that cannot be observed by the other party.12-15Adverse Selection•Situation where individuals have hidden characteristics and in which a selection process results in a pool of individuals with undesirable characteristics.•ExamplesChoice of medical plans.High-interest loans.Auto insurance for drivers with bad records.12-16Moral Hazard•Situation where one party to a contract takes a hidden action that benefits him or her at the expense of another party.•ExamplesThe principal-agent problem.Care taken with rental cars.12-17Possible Solutions1. SignalingAttempt by an informed party to send an observable indicator of his or her hidden characteristics to an uninformed party.To work, the signal must not be easily mimicked by other types. Example: Education.12-18Possible Solutions2. ScreeningAttempt by an uninformed party to sort individuals according to their characteristics.Often accomplished through a self-selection device•A mechanism in which informed parties are presented with a set of options, and the options they choose reveals their hidden characteristics to an uninformed party.Example: Price discrimination12-19Auctions•UsesArtTreasury billsSpectrum rightsConsumer goods (eBay and other Internet auction