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Chapter 6 THE ECONOMICS OF INFORMATION AND CHOICE UNDER UNCERTAINTY The tools for exploring risk-averse behavior are based on the fact that wealth has diminishing marginal utility for risk-averse people. The figure below shows that if starting income is $100, a gain of $50 will bring less additional utility than a loss of $50 will cost in utility foregone. Utility 50 80 100 150 $ Figure 6-1 Therefore, a fair gamble, one in which the expected value of the gamble is 0, will not be accepted because the expected utility of the gamble is less than the actual utility received when the risk is avoided. In other words, this person will not accept a coin-toss gamble that would bring her $50 for tails and cost her $50 for heads. The chord that connects the two outcomes of the coin toss shows the utility level of the expected dollar outcomes. It is easy to see that the person represented on the graph would be just as happy with $80 of certain money than with $100 expected value from the coin toss. In other words, she would be willing to pay $20 to avoid the gamble if she had to. If she was forced to gamble, she would be willing to pay an insurance company $20 to guarantee her the $100 she started with before she entered the coin toss. The insurance company would make $70 ($50 + her $20) if the coin came up heads, and lose $30 ($50 - her $20) if the coin came up tails. Since the insurance company is involved in hundreds of events like this, it ends up $20 ahead on the average for each coin toss. Even if the insurance company had to charge a bit less than the $20 charge to sell the insurance policy, it would be to its advantage to do so.
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CHAPTER 6: The economics of information and choice under uncertainty Chapter Outline 1. Information is not free, and so economic principles apply to the generation and allocation of it. 2. Information must be costly to fake. a. Strategic entry deterrence comes from high fixed costs, which are hard to fake. b. Product quality assurance appears more credible when a firm has high fixed costs. c. A trustworthy employee can signal his loyalty by highlighting his significant volunteer contributions to society. 3. Good information results in the full disclosure of other relevant information. a. If someone guarantees his product below what its quality will merit, people will think it is worth less than it is. b. If someone does not volunteer good information about herself in an interview, the interviewer may assume the worst on the issue in question. 4. A corollary of the full-disclosure principle is the lemon principle. a. Used merchandise will have a higher defect rate than the overall merchandise population, because the lemons in the population will find their way into the market at a greater rate than the worthy goods. b.
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This note was uploaded on 05/25/2008 for the course ECON 73-150 taught by Professor Dubra during the Spring '08 term at Carnegie Mellon.

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