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UB ECO 182 - Chapter 20

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Slide 1After studying this chapter, you will be able to:Slide 3Decisions in the Face of UncertaintyDecisions in the Face of UncertaintyDecisions in the Face of UncertaintyDecisions in the Face of UncertaintyDecisions in the Face of UncertaintyDecisions in the Face of UncertaintyDecisions in the Face of UncertaintyDecisions in the Face of UncertaintyDecisions in the Face of UncertaintyDecisions in the Face of UncertaintyDecisions in the Face of UncertaintyDecisions in the Face of UncertaintyDecisions in the Face of UncertaintyDecisions in the Face of UncertaintyBuying and Selling RiskBuying and Selling RiskBuying and Selling RiskBuying and Selling RiskBuying and Selling RiskBuying and Selling RiskBuying and Selling RiskBuying and Selling RiskBuying and Selling RiskBuying and Selling RiskPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationPrivate InformationUncertainty, Information, and the Invisible HandUncertainty, Information, and the Invisible HandUncertainty, Information, and the Invisible Hand20UNCERTAINITY AND INFORMATION© 2014 Pearson Addison-WesleyAfter 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-WesleyWhen 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-WesleyDecisions in the Face of UncertaintyTania, 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-WesleyDecisions in the Face of UncertaintyExpected WealthExpected 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-WesleyDecisions in the Face of UncertaintyThe 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-WesleyDecisions in the Face of UncertaintyWill Tania take the risky job?It will depend on how much Tania dislikes risk.Risk AversionRisk 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-WesleyDecisions in the Face of UncertaintyUtility of WealthFigure 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-WesleyDecisions in the Face of UncertaintyTania’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-WesleyDecisions in the Face of UncertaintyBecause of diminishing marginal utility, for a loss of wealthor a gain of wealth of equal size,Tania’s pain from the loss exceeds her pleasure from the gain.© 2014 Pearson Addison-WesleyDecisions in the Face of UncertaintyExpected UtilityWhen 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-WesleyDecisions in the Face of UncertaintyFigure 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-WesleyDecisions in the Face of UncertaintyTania’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-WesleyDecisions in the Face of UncertaintyMaking a Choice with UncertaintyFaced with uncertainty, a person chooses the action that maximizes expected utility.To select the job that gives her the maximum expected utility, Tania must calculate1. 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-WesleyDecisions in the Face of UncertaintyFigure 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-WesleyDecisions in the Face of UncertaintyTania 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-WesleyDecisions in the Face of


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