Introduction to the Economics of Uncertainty and Information

Topics: Decision theory, Utility, Preference Pages: 57 (12988 words) Published: September 13, 2013
Introduction to the

Economics of Uncertainty and Information
Timothy Van Zandt INSEAD
November 2004

Copyright 2004 Preliminary and incomplete: Use only with the permission of the author.

Author’s address: Voice: +33 1 6072 4981 INSEAD Boulevard de Constance Fax: +33 1 6074 6192 77305 Fontainebleau CEDEX Email: tvz@insead.edu FRANCE WWW: faculty.insead.edu/vanzandt

Table of Contents

1 Choosing among Uncertain Prospects 1.1 Introduction to decision theory . . . . . . . . . . . . . . . . . . . . . . . 1.2 Lotteries and objective expected utility . . . . . . . . . . . . . . . . . . . 1.3 States of nature and subjective expected utility . . . . . . . . . . . . . . 2 Choosing when there is new information 2.1 Representing information . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2 Bayes’ Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3 Independence and Exchangeability . . . . . . . . . . . . . . . . . . . . . 3 Risk Preferences 3.1 Money outcomes and risk aversion . . . . . . . . . . . . . . . . . . . . . 3.2 Comparing the risk aversion of people . . . . . . . . . . . . . . . . . . . 3.3 Comparing the riskiness of acts . . . . . . . . . . . . . . . . . . . . . . . 4 Market Decisions in the Presence of Risk 4.1 Demand for a state-contingent contract . . . . 4.2 Techniques for characterizing market decisions 4.3 Comparative statics . . . . . . . . . . . . . . . . 4.4 State-dependent utility . . . . . . . . . . . . . .

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79 . 79 . 85 . 96 . 103

5 Markets for state-contingent contracts 109 5.1 Gains from sharing risks . . . . . . . . . . . . . . . . . . . . . . . . . . . 110 5.2 Insurance market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117 6 Asset Markets 6.1 The nature of asset markets . . . . . 6.2 Market equilibrium . . . . . . . . . . 6.3 Complete versus incomplete markets 6.4 Capital Asset Pricing Model . . . . . 121 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

121 125 139 148

7 Contracting with Hidden Actions 153 7.1 Efficient contracts with moral hazard . . . . . . . . . . . . . . . . . . . . 153 7.2 Contracts that give one party the gains from trade . . . . . . . . . . . . 154 8 Monopolistic screening with hidden valuations 157 8.1 Nonlinear pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157 8.2 Differentiated products . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157 8.3 Bundling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158 9 Screening with adverse selection 9.1 The nature of adverse selection . . . . . . . . . . 9.2 Screening . . . . . . . . . . . . . . . . . . . . . . 9.3 Efficient contracts with adverse selection . . . . . 9.4 The efficient contracts with zero expected profits Economics of Uncertainty and Information

159 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

159 161 168 170

©2004 Timothy Van Zandt

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Economics of Uncertainty and Information

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Monopolistic screening . . . . . . . . . . . . . . . . . . . . . . . . . . . 178

10 Signaling 181 10.1 The difference between screening and signaling . . . . . . . . . . . . . . 181 10.2 Signaling in labor markets . . . . . . . . . . . . . . . . . . . . . . . . . . 181 11 Long-term versus short-term contracting 183 11.1 Ex-ante versus ex-post efficiency . . . . . . . . . . . . . . . . . . . . . . 183 11.2 Long-term and short-term insurance contracts . . . . . . . . . . . . . . . 185

Chapter 1

Choosing among Uncertain Prospects
1.1
1.1.1

Introduction to decision theory
Why individual decision theory in economics?

In microeconomics, we build...
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