Chapter 22 Frontiers of Microeconomics Uncertainty Information Asymmetry Uncertainty expected value expected average value of an event if it is repeated many times calculated by taking every outcome and adding the probabilities together Payoff 1 4 9 16 25 36 Probability 1 6 1 6 1 6 1 6 1 6 1 6 Expected Value Payoff x Probility 1 6 4 6 9 6 16 6 25 6 36 6 26 6 Dice Die Number 1 2 3 4 5 6 Insurance fair insurance expected value of the claims of the company will have to pay is exactly equal to the premiums they will collect risk averse person prefers a less risky situation holding fixed its expected value risk neutral care only about expected value indifferent to alternatives SHOULD buy if o Loss is loss compared to income o Insurance is only a little unfair o You are risk averse SHOULD NOT buy if o Loss is small compared to income o Insurance is very unfair o You are a little risk averse 10 chance of a fire costing 30k damage Insurance is a 3k premium Ex House is worth 40k Equity is worth 30k Value is 70k Investments Expected value one method to reduce risk is to diversify your portfolio w o insurance 90 of No Fire x 70k 10 of Fire x 40k 67k w insurance 70k 3 premium 67k Asymmetric Information another asymmetric information one side of an economic relationship has more information than hidden characteristics known only to one side of the transaction used cars insurance hidden actions actions taken by one side of an economic relationship real estate agents doctors prescribing extra tests adverse selection tendency for the mix of unobserved attributes to become undesirable from the standpoint of an uninformed party buyer isn t sure if car is plum or lemon so does not buy screening action taken by uninformed party to induce informed party to reveal information signaling action taken by informed party to reveal information to uninformed party warranty moral hazard tendency of a person who is imperfectly monitored to engage in dishonest behavior agent person who is performing an act for another person principal person for whom another person agent is performing some act
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