1. The Economics of Information and Choice Under Uncertainty
6-1

2. Drawing on Chapter 6
Original graphics Copyright © The McGraw-Hill Companies, Inc. All rights reserved.

3. Overview Economic aspects of information Choice under uncertainty
Insuring against bad outcomes
The economics of asymmetric information
6-3

4. Economic Aspects of Information
Information is
Valuable: it helps us make better choices
Often limited, leaving relevant things unknown or uncertain
Usually costly to obtain
Sometimes different (asymmetric) between decision makers
Uncertainty can often be quantified (as risk), assigning a probability to each possible event
6-4

5. Choice Under Uncertainty: Expected Value and Utility
Consider choices that have n outcomes with quantified values (M) and probabilities (p)
Expected value:
EV = p1M1 + p2M pnMn
Expected utility
EU = p1U(M1) + p2U(M2) pnU(Mn)
6-5

6. Expected Utility Maximization
Von Neumann & Morgenstern (1944) asked: What if people make choices to maximize expected utility?
This would not generally lead to the same choices as maximizing expected value
6-6

7. Expected Value and Utility
Fair gamble: its EV = 0
Consider utility as a function of wealth
Diminishing marginal utility: when the marginal utility declines as wealth rises
6-7

8. Types of Risk Preferences
A person is risk ____ if he/she has _____ marginal utility of wealth
averse diminishing
seeking increasing
neutral constant
6-8

9. Figure 6.2: A Concave Utility Function
6-9

10. Figure 6.3: A Risk-Averse Person Will Always Refuse a Fair Gamble
6-10

11. Figure 6.4: The Utility Function of a Risk-Seeking Person is Convex in Total Wealth
6-11

12. Figure 6.5: Risk Neutrality
6-12

13. The Value of Reducing Uncertainty
Two alternative medical treatments for a condition have different probabilities of outcomes, depending on its severity
When facing such uncertainty, why pay for additional tests?
6-13

14. Risk Pooling
Law of large numbers: implies that where participants’ outcomes are independent, their average outcome is less variable the more participate in the average
So pooling arrangements reduce risk exposure
Corporations and mutual funds
Pension plans
Insurance
6-14

15. Figure 6.9: The Reservation Price for Insurance
6-15