ECE1010-11 - UNIT IV: INFORMATION & WELFARE 12/17...

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• Decision under Uncertainty • Bargaining Games • Externalities & Public Goods • Review 12/17
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Decision under Uncertainty In UNIT I we assumed that consumers have perfect information about the possible options they face (their income and prices); and about the utility consequences of their choices (their preferences). Then, we extended our model to deal with more realistic cases in which decisions are made without perfect information. We can distinguish between 2 sources of uncertainty: • The behavior of other actors (strategic uncertainty) • states of nature (natural uncertainty) Next, we will combine both types of uncertainty and study bargaining games.
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Decision under Uncertainty Expected Value v. Expected Utility Risk Preferences Reducing Risk: Insurance Contingent Consumption Adverse Selection (and Moral Hazard)
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Adverse Selection Consider the market for drivers insurance: “Good” drivers have accidents with prob = 0.2 “Bad” = 0.8 Good and bad drivers are equally distributed in population. At the actuarially fair price of $0.50/$1 coverage: – for good drivers price is too high -> don’t insure – for bad too low -> insure Bad drivers are “selected in”; good are “selected out” What price would an actuarially fair insurance company charge?
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Adverse Selection Consider the market for drivers insurance: “Good” drivers have accidents with prob = 0.2 “Bad” = 0.8 Good and bad drivers are equally distributed in population. At the actuarially fair price of $0.50/$1 coverage: – for good drivers price is too high -> don’t insure – for bad too low -> insure Bad drivers are “selected in”; good are “selected out” Driver quality is a hidden characteristic
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Adverse Selection Consider the market for drivers insurance: “Good” drivers have accidents with prob = 0.2 “Bad” = 0.8 Good and bad drivers are equally distributed in population. At the actuarially fair price of $0.50/$1 coverage: – for good drivers price is too high -> don’t insure – for bad too low -> insure Bad drivers are “selected in”; good are “selected out” Asymmetric Information
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BUYER represents Company A (the Acquirer), which is currently considering make a tender offer to acquire Company T (the Target) from SELLER. BUYER and SELLER are going to be meeting to negotiate a price. Company T is privately held, so its true value is known only to SELLER. Whatever the value, Company T is worth 50% more in the hands of the acquiring company, due to improved management and corporate synergies. BUYER only knows that its value is somewhere between 0 and 100 ($/share), with all values equally likely. Source:
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ECE1010-11 - UNIT IV: INFORMATION & WELFARE 12/17...

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