ECON 221 Lecture 20Outline of Last Lecture I. Oligopoly characteristics II. Game theory a. Strategic Interactionb. Dominant Strategy III. Maximizing Profits IV. Tacit Collusion Outline of Current Lecture I. UncertaintyII. Asymmetric Informationa. Adverse Selectionb. Moral Hazard III. Expected ValueIV. Risk Aversion Current LectureAsymmetric Information – Lecture 21 - How do we model decision making under uncertainty?- Example - Why does a used car (even if barely used) cost so much less? o Buying a car, especially used is hard. - Is the car going to break down soon? Are there issues with the car? Hard to tell.o Uncertainty lowers the price. – What does that mean? These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute. People with NICE used cars (that should receive a higher than average price) won’t sell. Can’t get the money the car deserves.  So all (or most) of the used cars being sold are probably have trouble that the OWNER knows about, but the buyer doesn’t. - Increases uncertainty even more... lowers price even more... Uncertainty - “Asymmetric information”: one party (seller) has better information than the other (buyer).o Has an impact on economic behavior and outcomes o Lots of situations like this...  Is the local nursing home taking good care of my grandparents?  Is this private school really going to do a better job of educating my kids?  Is the person I’m hiring going to be a good worker? - Two big problems that can arise under asymmetric info.o Adverse selectiono Moral hazardAdverse Selection- As in the car example, asymmetric information can lead to adverse selection o Because the seller has more info than the buyer, the seller has an incentive to sell the worst things o Similarly, when deciding whether to buy insurance or not, you don’t know whether you’re going to get sick, but you know more about your lifestyle than the insurance company  As a result, people who expect to be healthy don’t buy insurance  Those that expect to be sick, buy insurance o The presence of private information and selection based on this information makes health insurance very different than markets for most standard goods (like broccoli)  This is one argument for government involvement that can improve efficiency by preventing this spiral from occurring Moral Hazard - Another problem that results from asymmetric information is moral hazard – when individuals know more about their actions than others do o Problematic when cost of action (or inaction) is suffered by others  If I’m a worker in an office, my boss can’t perfectly observe my ac0ons, so I have little incentive to work hard, but he still has to pay me  A solution: Changing decision-maker’s environment so she must respond to relevantincentives (e.g., give employee shares of stock, franchising fast-food restaurants, etc.) Adverse Selection and Moral Hazard- These concepts sound similar, but keep in mind: o Adverse selection arises when one party knows more about the state of the world  Another example: You apply for a job. The employer is unsure whether you’re productive or unproductive, in part because every worker makes themself look as though they’re productive. (Resulting inefficiency?) o Moral hazard arises when one party knows more about her own actions  Another example: Your buy insurance against theft in your apartment and, after doing so, you become less careful about locking doors, etc. (Resulting inefficiency?) - How are these situations modeled?o We need to back up and think about how economists model any situation where people are uncertaino Key question: How do we think about “willingness to pay” when I’m uncertain of what I’m buying?  Choices measure willingness to pay for a good where you were uncertain of its value- Expected Value o Expected value measures what you can EXPECT the outcome to be, NOT what you “should” be willing to pay. - Risk Aversion – Max willing-to-pay is lower than Expected Value o Modeled after Diminishing Marginal Benefit o Consider the market for insurance The market for insurance is entirely driven by the presence of risk • Ex. A family decides whether to buy health insurance each year  There’s a 50% chance someone will get sick – without insurance, medical bills would be $10,000  But there’s also a 50% chance the insurance is unnecessary ($0 in medical bills even w/o insurance) o Medical expenses in this example are a random variable (a variable with an uncertain outcome in the future) – they might be either $0 or $10,000 in a given year o We don’t know whether someone will get sick, but we can calculate how much they would expect to pay per year o Expected Value of Medical Expenses per year = (Good outcome) X (1/2) + (Bad outcome) X (1/2) = 10,000*(1/2) + 0*(1/2)=5,000  The family w/o insurance can expect to pay $5,000 a year (even though some years they’ll pay $0 and some years they’ll pay $10,000) o This tells us something about how much they’d be willing to pay for insurance They’d almost certainly buy any insurance plan that costs less than or equal to $5,000 a year  Why? If insurance costs $5000, in the long-run costs are the same - No insurance: $10,000 x 25 = $250,000 - Insurance: $5,000 x 50 = $250,000 o As a result this is called a fair insurance policy o Anything less than $5,000 and expected payment is strictly lower with