Lecture 6 Uncertainty

Cost of Risk Agents are said to be risk averse if they prefer the expected payoff from a gamble to the gamble itself

Since most agents are risk averse we see the existence of economic institutions and arrangements such as: –Insurance contracts –Wage contracts –Futures contracts –Warranties

Asymmetric Information Uncertainty arises because one agent has more information or better information than another When information is asymmetric two problems can arise: -adverse selection -moral hazard

Adverse Selection One party doesn’t know something about the other party’s characteristics -Agents enter into agreements in which they use their private information about their characteristics to their own advantage

Moral Hazard One party doesn’t know something about the other party’s actions (behaviour) -After agreement between agents, one agent has incentive to act in a way that brings additional benefit to himself at the expense of the other