9-11-09 - Economics 448 Class Notes Adverse selection where one party to a transaction knows things that a are relevant to the transaction b unknown to

Economics 448 – Class Notes – 9/11/09 Adverse selection : where one party to a transaction knows things that: a. are relevant to the transaction b. unknown to the 2 nd party c. Difficult to transfer a. It’s difficult for seller to transfer information, say about a used car. i. If it’s a great car, the seller wants to transfer that information ii. If it’s a bad car or someone who does not know about the quality of the car, it’s hard to transfer that information (especially if you don’t have that information) Adverse selection is Ex ante  pre-existing condition • You have a pre-existing condition ( you know something before you go into the transaction, like with insurance) Moral Hazard – Where one party to a transaction may undertake certain actions that: a. Affect the other party’s valuation of the transaction b. The 2 nd party cannot monitor perfectly. Moral hazard is ex post  after the fact • Moral hazrard refers to actions or behavior taken after the transaction o I.e  you have insurance so you are more risky Risk-Preference 1. Risk-neutral  you don’t care about risk, you just care about the anticipated payoff or return a. You just concern yourself with the size of the expected payoff b. Example: i. 2 investments 1. 15% rate of return, but its REALLY RISKY (you might lose a lot) 2. 6% rate of return – 6% is a sure thing ii. The risk neutral doesn’t care about the risk  I am going to go for the highest expected return on my investment 2. Risk-averse  Avoiding risky situations a. People will tend to avoid risk and risky situations and investments. They will prefer the option with the lowest risk.