Choice under Uncertainty

Question 1

What impact does the existence of uncertainty have on economic decision-making?

Answer 1

It means that there are risks involved because the payoff/benefit is not always clear

Question 2

What is the definition of uncertainty?

Answer 2

Where we don’t know the probability distribution

Question 3

What is the definition of risk?

Answer 3

Where we do know the probability distribution

Question 4

What does expected value capture?

Answer 4

It captures the long-term average benefit of playing a game so that the player can determine whether they want to play or not

Question 5

How is EV calculated?

Answer 5

By adding up the probability of all of the outcomes of the game

Question 6

What is an actuarially fair game?

Answer 6

A game where the expected outcome of a game = the input required to play the game

Question 7

What risks come from playing an actuarially fair game?

Answer 7

There is the potential that you can exceed your expected value but also a risk that you may get a payout lower than that expected value

Question 8

What will make the risks of an actuarially fair game increase?

Answer 8

If the stakes of the game increase, the risk increases because you lose more if you fail

Question 9

Diagram of husband and wife expected value example

Answer 9

Check notes

Question 10

What does the probability chord of an expected value diagram capture?

Answer 10

Shows the payoffs and utility possible from taking part in the game

Question 11

What is the relation of utility on the chord to on the curve on a utility diagram for an actuarially fair game?

Answer 11

The utility achieved on the chord will be lower for certain payoffs than the utility for when that payoff is guaranteed because of the risk involved in taking part in the game

Question 12

What shape is the utility curve for a risk averse person?

Answer 12

It will be convex, they have diminishing marginal utility of income -> as income increases the extra utility achieved will continue to decrease as income increases

Question 13

What shape is the utility curve for a risk seeker?

Answer 13

It will be concave, where their utility of income increases as income increases -> this is very rare

Question 14

What is expected utility?

Answer 14

It is the long term average utility achieved from taking part in a game

Question 15

How is EU calculated?

Answer 15

Same was as EV -> sum of probabilities of achieving each outcome

Question 16

Why may the answers for EU and EV differ?

Answer 16

The attitudes to risk are not factored into the EV calculations

Question 17

What are the different attitudes to risk?

Answer 17

Averse, neutral and seeker

Question 18

What attitude does a risk averse player have to an actuarially fair game?

Answer 18

They will not take part -> the level of utility of expected wealth > expected utility of wealth

Question 19

What attitude does a risk neutral player have to an actuarially fair game?

Answer 19

They are indifferent about whether they play or not -> the level of utility of expected wealth = expected utility of wealth

Question 20

What attitudes does a risk seeker have to an actuarially fair game?

Answer 20

They will take part -> the level of utility of expected wealth < expected utility of wealth

Question 21

What attitude to risk is most common and why?

Answer 21

Risk averse is most common because economic agents prefer certainty to uncertainty

Question 22

What will impact the level of risk aversion?

Answer 22

As the stakes/input increases, the level of aversion will increase because the risks increase

Question 23

How does insurance impact risk?

Answer 23

It reduces the risks that the player faces as it is passed on to a different agent

Question 24

How does insurance impact the outcomes of playing a game?

Answer 24

It makes the bad outcome better by giving up some of the payoff of the better outcome in the form of a premium

Question 25

How do we know that insurance is actuarially fair?

Answer 25

It will be actuarially fair if the expected utility of the EV is increased when insurance is purchased

Question 26

For a diagrammatical representation:

Answer 26

Check notes

Question 27

When is insurance actuarially unfavourable?

Answer 27

When the premium paid by the household > expected loss

Question 28

Why does actuarially unfavourable insurance exist?

Answer 28

Insurance will only be supplied if the providers can make a profit off of it

Question 29

How does unfavourable insurance affect household wealth?

Answer 29

Household wealth with insurance < expected wealth

Question 30

How will households react to unfavourable insurance?

Answer 30

Depending on how unfavourable the insurance is, it will mean that some households will not buy it

Question 31

When may households still buy unfavourable insurance?

Answer 31

When the expected loss of having insurance is below the maximum that a household is willing to pay for the insurance

Question 32

What is asymmetric information?

Answer 32

This is a scenario when there is hidden information, where one party has more information than the other

Question 33

What 2 key problems can arise from asymmetric information?

Answer 33

Adverse selection: when there is hidden information | Moral hazard: when there is hidden action

Question 34

For grade insurance example:

Answer 34

Check notes

Question 35

What is the summary of the grade insurance example?

Answer 35

When insurance is optional, the stronger in the market will drop out as their risk is very low

Question 36

How will the fact that some drop out of the insurance market impact those that remain in the market?

Answer 36

It will increase the payoff for those that remain in the market as the market has shrunk and the insurance provider has to spread their cost across fewer people

Question 37

What may happen to the insurance market if people continue to leave it?

Answer 37

Could see the market shrink or even completely disappear

Question 38

When does adverse selection occur?

Answer 38

When the customer has more info about their ability than the insurer

Question 39

What does adverse selection allow the consumer to do?

Answer 39

It means they have some control over the cost of the insurance

Question 40

How will adverse selection impact the larger insurance market?

Answer 40

It means that no competitive equilibrium will be reached

Question 41

What is moral hazard and how is it represented in consumer behaviour?

Answer 41

When there is action hidden -> consumers may change their behaviour when they are insured because they have the safety of that insurance

Question 42

How may the insurance provider react to moral hazard?

Answer 42

If every party in the market reacts this way then the provider can adjust the premium to balance out the market again

Question 43

Why is the market reaction by providers to moral hazard not necessarily realistic?

Answer 43

It assumes that all parties will act the same way, but the extent to which consumers change their behaviour will most likely differ, so different premiums will be needed for different people

Question 44

How will moral hazard affect the larger market equilibrium?

Answer 44

It means that no competitive equilibrium can be reached as the provider will not know who is exhibiting more moral hazard

Question 45

What are the 5 solutions to these insurance issues?

Answer 45

1) gather more info -> helps predict the risk of the player 2) use incentive schemes -> create bonuses that incentivise effort e.g. principal agent problem 3) Excesses -> how much voluntary excess are you willing to pay? - pay a small amount to contribute to insurance payouts 4) No claims bonus -> premium goes down if you don't claim 5) Signals -> make it clear to the provider that you are a good risk

Question 46

Why is signalling hard?

Answer 46

You can't simply say that you are a good risk because everyone will do that

Question 47

What example was used in the lectures to show why signalling is hard?

Answer 47

Used car market -> peaches and lemons

Question 48

What must a strong signal have for sellers of high quality goods?

Answer 48

It must have a low cost

Question 49

Example of a strong signal?

Answer 49

Warranties -> longer the warranty the stronger the signal of quality as the provider is confident that their product will not be faulty

Question 50

How may this example of a strong signal potentially put the provider at risk?

Answer 50

Exposes them to moral hazard -> consumers may behave differently if they know they are under warranty

Question 51

For diagrams about signalling:

Answer 51

Check slides

Question 52

What is screening?

Answer 52

When you gather info about the market to better inform you about the risk or cost of a consumer

Question 53

Why is screening an issue for providers?

Answer 53

It is an extra cost that they need to pay

Question 54

How can providers deal with the cost of screening?

Answer 54

They can pass the cost on to consumers

Question 55

Who does the use of screening impact most heavily?

Answer 55

The low cost clients because they will incur the majority of the cost

Question 56

Why do low cost clients incur the majority of the screening costs?

Answer 56

If the cost of the screening is put on high cost clients they will just go to a provider that does not screen

Question 57

For diagram about screening:

Answer 57

Check notes