Economics Week 1: Asymmetric Information

Week 1

• Imperfect and Incomplete Information:
  • Asymmetric information: A situation where not all parties to an exchange have the same level of information.
  • Sellers often know more: About the quality of a product than buyers.
  • Exchange hindered: Asymmetric information can prevent mutually beneficial exchanges for high-quality goods.
  • Buyers and sellers adjust: Buyers and sellers might base their decisions on groups or other available information instead of detailed product quality.
  • Optimal amount of information: Consumers will continue to gather information until the marginal benefit equals the marginal cost. Beyond that, it is rational to remain uninformed.
  • Minimising the risk: Useful information is found when variation in price/quality is high, and the cost of searching for information is low.
  • Expected value: The average of the payoffs associated with all outcomes of a decision, weighted by their probabilities.

Attitudes toward risk

• Risk Neutral: Constant marginal utility (MU = 1), implying expected value (EV) is equal to utility expectation (EU).
• Risk Averse: Diminishing marginal utility (MU < 1), implying expected EV is less than expected EU – Individuals prefer a certain outcome to a risky outcome, and are willing to pay to avoid risk by purchasing insurance.
• Risk Loving: Increasing marginal utility (MU > 1), implying expected EU is less than expected EV – Individuals prefer risky outcomes to a certain outcome and engage in risky behaviours (gambling).

Week 2

• Risk: Deals with uncertainty about which outcome will occur, described in terms of probability distributions.
• Risk Pooling: Pooling together risks across individuals lowers the overall risk compared to individual risks.
• Insurance: A promise of payment in case of a particular event, in exchange for a premium.
• Consumption Smoothing: Using insurance to transfer consumption from periods of high consumption (low marginal utility) to periods of low consumption (high marginal utility).
• Demand for insurance: People seek insurance due to risk aversion – reducing uncertainty and providing security against bad outcomes.

Week 3 & 4

• Bayesian Nash Equilibrium: A broader concept of rationality considering hypothetical situations for all possible outcomes.
• Adverse Selection: In markets with hidden information, individuals with unfavorable traits have higher incentives to participate in the exchange.
• Correlation between riskiness and insurance coverage.
• Prevention of adverse selection: Allow insurance companies to predict risk, enabling for adjustments to premiums for more accurate pricing.

Week 5

• Externalities: Actions of one party create positive or negative impacts for other parties.
• Negative externalities: Occur when a firm's or individual's production/consumption harms others (no compensation).
• Positive externalities: Occur when one party's actions provide benefits to others (no compensation).
• Private vs Social Welfare: Private welfare considers individuals, while Social welfare aggregates individuals' welfare.

Week 7

• Public goods: Goods that are non-rivalrous (consumption by one does not reduce its availability to others) and non-excludable (no one can be prevented from consuming it). Examples are national defence and clean air.
• Impure public goods: Satisfy some but not all criteria of public goods - partly rivalrous and partly excludable .
• Market provision of public goods: The market does not generate the socially efficient quantity due to the free rider problem.
• Free Rider problem: Individuals benefit from the public good but do not contribute their fair share to its provision (lack of incentive for private provisioning).

Week 8

• The Lemons Problem: Describes a market where quality is uncertain or unclear. Sellers know more than buyers.
• Perfect Bayesian Equilibrium (PBE): A solution concept for sequential games with incomplete information used in game theory.
• Sequential rationality: Decisions of market participants are consistent with their beliefs at each stage of the game.

Week 10 & Short Answer Questions

• Principal-agent problem: A conflict of interest between a principal who delegates work and an agent who performs the work.
• Asymmetric information: The principal cannot observe the agent's behaviour completely.
• Information asymmetry creates moral hazard for agents
• Optimal provision of public goods: The government can determine the best level of public goods to provide through taxes that lead users to correctly value their worth.
• Moral hazard occurs when an individual's behavior changes after a payment is made, creating undesired actions.
• Adverse selection Occurs when one party knows more about the quality or risk of the product or service than the other party. This can lead to some high risk consumers overstating or hiding the quality of their need, which leads to decreased product value overall.