20 UNCERTAINITY AND INFORMATION After studying this chapter you will be able to Explain how people make decisions when they are uncertain about the consequences Explain how markets enable people to buy and sell risk Explain how markets cope when buyers and sellers have private information Explain how uncertainty and incomplete information influence the efficiency of markets 2014 Pearson Addison Wesley When you buy a car you could get stuck with a lemon How do you make a decision when you don t know what its consequences will be Although markets do a good job of allocating resources efficiently they face some obstacles Can markets lead to an efficient outcome when there is uncertainty and incomplete information 2014 Pearson Addison Wesley Decisions in the Face of Uncertainty Tania a student is trying to decide which of two alternative summer jobs to take 1 She can work as a house painter and have 2 000 by the end of the summer There is no uncertainty about the income from this job 2 She can work as a telemarketer with a 50 percent chance that she will earn 5 000 and a 50 percent chance that she will earn 1 000 Which job does she prefer 2014 Pearson Addison Wesley Decisions in the Face of Uncertainty Expected Wealth Expected wealth is the money value of what a person expects to own at a given point in time An expectation is an average calculated by using a formula that weights each possible outcome with the probability chance that it will occur What is Tania s expected wealth from the telemarketing job 2014 Pearson Addison Wesley Decisions in the Face of Uncertainty The probability that Tania will have 5 000 is 0 5 The probability that she will have 1 000 is also 0 5 Expected wealth 5 000 0 5 1 000 0 5 3 000 Tania can now compare the expected wealth from the two jobs 2 000 for the non risky painting job 3 000 for the risky telemarketing job 2014 Pearson Addison Wesley Decisions in the Face of Uncertainty Will Tania take the risky job It will depend on how much Tania dislikes risk Risk Aversion Risk aversion is the dislike of risk We measure a person s attitude toward risk by using a utility of wealth schedule and curve Greater wealth brings greater total utility but the marginal utility of wealth diminishes as wealth increases 2014 Pearson Addison Wesley Decisions in the Face of Uncertainty Utility of Wealth Figure 20 1 shows Tania s utility of wealth curve If Tania s wealth is 2 000 she gets 70 units of utility 2014 Pearson Addison Wesley Decisions in the Face of Uncertainty Tania s total utility increases when her wealth increases But the marginal utility of wealth diminishes Each additional 1 000 of wealth brings successively smaller increments in total utility 2014 Pearson Addison Wesley Decisions in the Face of Uncertainty Because of diminishing marginal utility for a loss of wealth or a gain of wealth of equal size Tania s pain from the loss exceeds her pleasure from the gain 2014 Pearson Addison Wesley Decisions in the Face of Uncertainty Expected Utility When there is uncertainty people do not know the actual utility they will get from taking a particular action But they know the utility they expect to get Expected utility is the utility value of what a person expects to own at a given point in time 2014 Pearson Addison Wesley Decisions in the Face of Uncertainty Figure 20 2 shows how Tania calculates her expected utility Tania has a 50 percent chance of having 5 000 of wealth and total utility of 95 units Tania has a 50 percent chance of having 1 000 of wealth and a total utility of 45 units 2014 Pearson Addison Wesley Decisions in the Face of Uncertainty Tania s expected wealth is 3 000 and her expected utility is 70 units With 3 000 wealth and no uncertainty utility is 83 units For a given expected wealth the greater the range of uncertainty the smaller is expected utility 2014 Pearson Addison Wesley Decisions in the Face of Uncertainty Making a Choice with Uncertainty Faced with uncertainty a person chooses the action that maximizes expected utility To select the job that gives her the maximum expected utility Tania must calculate 1 The expected utility from the risky telemarketing job 2 The expected utility from the safe painting job 3 Compare the two expected utilities 2014 Pearson Addison Wesley Decisions in the Face of Uncertainty Figure 20 3 shows the choice under uncertainty In a telemarketing job there is a 50 percent chance that Tania will make 5 000 and a 50 percent chance that she will make 1 000 Her expected wealth is 3 000 and her expected utility is 70 units 2014 Pearson Addison Wesley Decisions in the Face of Uncertainty Tania would have the same 70 units utility with wealth of 2 000 and no risk so Tania s cost of bearing this risk is 1 000 2014 Pearson Addison Wesley Decisions in the Face of Uncertainty Tania is indifferent between the job that pays 2 000 with no risk and the job that offers an equal chance of 5 000 and 1 000 2014 Pearson Addison Wesley Buying and Selling Risk Just as buyers and sellers gain from trading goods and services they can also gain from trading risk Risk is a bad not a good so the good that is traded is risk avoidance A buyer of risk avoidance can gain because the value of avoiding risk is greater than the price that must be paid to get someone else to bear that risk The seller of risk avoidance faces a lower cost of risk than the price that people are willing to pay to avoid that risk 2014 Pearson Addison Wesley Buying and Selling Risk Insurance Markets Insurance plays a huge role in our lives How Insurance Reduces Risk Insurance reduces the risk that people face by sharing or pooling risks When people buy insurance against the risk of an unwanted event they pay an insurance company a premium And if the unwanted event does occur the insurance company pays out the amount of the insured loss 2014 Pearson Addison Wesley Buying and Selling Risk Why People Buy Insurance Dan owns a car worth 10 000 and that is his only wealth There is a 10 percent chance that Dan will have a serious accident that makes his car worth nothing Would Dan buy insurance 2014 Pearson Addison Wesley Buying and Selling Risk Risk Taking without Insurance Figure 20 4 illustrates Dan s wealth the value of his car is 10 000 and his utility is 100 units With no insurance if Dan has a crash he has no wealth and no utility 2014 Pearson Addison Wesley Buying and Selling Risk With a 10 percent chance of a crash Dan s expected wealth is 9 000 10 000 0 1 With no