Uncertainty & Asymmetric

Information
(Based on OS 16 & CFO Ch. 17)

Department of Economics
Universidad de Piura

Prof. Tilsa Oré Mónago

Introduction
• Before we assumed that consumers and firms make decisions based on
perfect information and full information. Given that, economic agents
would take their optimal decision.
• However, perfect information is not seen in the real world, and even more,
symmetric information is not reached in many markets.
• It is usual that economic agents make decisions with limited information.
• We usually are uncertain of things, of the future for example, but we can
take actions that reduce or increase the uncertainty. Two key concepts:
• Von Neumann-Morgenstern utility:
• Expected value over uncertain events

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Definitions
Von Neumann-Morgenstern utility:
• Individual’s well-being increases with her
𝑈(𝑦)
buying power (income, wealth, or net Utility rises with income
assets.)
• If we denote by 𝒚 the income and wealth,
then the Utility function in terms of buying
power is given by 𝑈(𝑦).
• Utility increases with income but at a
decreasing rate
• The Marginal Utility (MU) of income is the
change of utility due to a change in income.
• Then, 𝑈(𝑦) exhibit diminishing marginal
utility: MU decreases as income rises. 𝑦

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Diminishing Marginal Utility
• The effect of extra income will differ according the level of income.

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Diminishing Marginal Utility
• The curve gets flatter as income increases.

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Definitions
Expected Value
• Payoff : The amount that comes from a possible outcome or result.
• Expected value (EV): The sum of the payoffs associated with each
possible outcome of a situation, weighted by its probability of
occurrence.
• Expected utility (EU): The sum of the utilities coming from all possible
outcomes of a deal, weighted by the probability of each occurrence.
• Fair game or fair bet: A game whose expected value is zero.

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Expected Value
• Let’s suppose I give you a job, but I offer you two
salary options: get $40K now or play a lottery. 𝑈(𝑦)
Utility rises with income
• If you take the lottery, you may have good luck and
bad luck, which happens with probabilities:
𝑃 𝐺 = 0.5, then 𝑃 𝐵 = 1 − 𝑃 𝐺 = 0.5
• The possible related incomes (or payoffs) are:
𝑦 % = 60000 and 𝑦 & = 20000
• Therefore the expected income or just expected
value (EV) is:
𝑬𝑽 = 𝑷 𝑮 ∗ 𝒚𝑮 + 𝑷 𝑩 ∗ 𝒚𝑩
𝐸𝑉)*++,-. = 0.5 ∗ 60000 + 0.5 ∗ 20000 = 40000
𝑦
• With the lottery you get the same $40K. But which
would you prefer? That depends on your risk
aversion. And for that you need to know your EU.
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Expected Utility
• Each income level is associated to a utility level, 𝑈(𝑦)
so now we weight the utility levels by the Utility rises with income
probability of each event, and get the expected
utility.

14
𝑬𝑼 = 𝑷 𝑮 ∗ 𝑼(𝒚𝑮) + 𝑷 𝑩 ∗ 𝑼(𝒚𝑩)
𝐸𝑈 = 0.5 ∗ 18 + 0.5 ∗ 10 = 14
• As you can see
𝑈 40000 = 𝑈 𝐸𝑉)*++,-. = 15 > 𝐸𝑈(𝐿𝑜𝑡𝑡𝑒𝑟𝑦)
So given this and your utility function, you will not
𝑦
take the lottery, but get the $40K for sure that gives
you higher utility. You are a risk averse person.

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Attitudes toward risk
Risk always exists, what it changes is how agents perceive it. Economists distinguish
risk loving/seeking, risk neutral and risk averse agents.
• Risk-averse agents would prefer income with certainty (certain payoff CP) over an
uncertain one with the same expected value. They have concave utility functions
that reflects the diminishing marginal utility.
𝑈 𝐶𝑃 = 𝑈 𝐸𝑉)*++,-. > 𝐸𝑈(𝐿𝑜𝑡𝑡𝑒𝑟𝑦)
• Risk-neutral agents would be indifferent between having income with certainty
than without it. They have linear utility functions.
𝑈 𝐶𝑃 = 𝑈 𝐸𝑉)*++,-. = 𝐸𝑈(𝐿𝑜𝑡𝑡𝑒𝑟𝑦)
• Risk-loving agents would prefer having lottery (risky income) than income with
certainty CP (even if the certain payoff is higher than the EV of the lottery). They
have convex utility functions that show their increasing marginal utility.
𝑈 𝐶𝑃 = 𝑈 𝐸𝑉)*++,-. < 𝐸𝑈(𝐿𝑜𝑡𝑡𝑒𝑟𝑦)

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Attitudes toward risk
The attitudes toward risk can easily distinguished by the shape of the
individual’s utility.

Risk-averse Risk-neutral Risk-loving

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Insurance market
Insurance exist due to uncertainty about the future, and it is used to protect
individuals or agents against adverse events.
• Insurance premium: Money paid to an insurance company in exchange for
protection (compensation) if certain adverse event occurs.
• Expected value: Imagine you can get outcomes such 10, 100 and 50 with
probabilities 𝑝! , 𝑝" , and 𝑝# (and 𝑝! + 𝑝" + 𝑝# = 1), then,
EV = 10𝑝! + 100𝑝" + 50𝑝#
• Actuarially fair insurance premium: amount of money just enough to
cover the expected compensation for the expenses, it is the expected value
of the loss.

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Insurance and uncertainty
• Under uncertainty, individuals maximize their expected utility, which refers
to the weighted average of the utilities over all possible uncertain
outcomes, each weighted by its probability of occurrence.
• For risk averse individuals, the utility of having an insurance (have a certain
outcome) is higher than the utility of not having one, even when the
expected income is the same.
• Due to their diminishing marginal utility, risk averse people tend to have a
preference for risk smoothing, reducing their income in high-earning
periods to protect themselves against major drops in consumption during
low-earning periods .
• Given that the curvature of the utility function vary with levels of risk
aversion; the demand for insurance depends on the curvature of the utility
function of the individuals.

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Insurance and uncertainty
• Risk premium refers to the extra amount (amount over the actuarially
fair premium) that a risk-averse person is willing to pay to guarantee
compensation if an adverse event occurs.
• Loading fee refers to the extra amount that the insurance company
charges above the actuarially fair premium.
• Risk pooling refers to charge a uniform premium to many individuals
that may have different risk aversion levels. Risk pooling allows
insurance companies to lower the total risk. The more people is in the
pool, the lower the costs.

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Asymmetric information
• Asymmetric information (AI): occurs when one of the parties to a
transaction has information relevant to the transaction that the other party
does not have. E.g. think of your doctor and you about your illness.
• Individuals know better if they are low-risk ( healthy) or high-risk (smoker, bad
nutrition habits) people.
• Insurance company do not have that private information, so they cannot distinguish
very well high-risk people from low-risk people.
• Also, physicians have more knowledge about diseases than patients, so patients may
trust on their medical doctors.
• Asymmetric information lead to two problems
• Adverse selection
• Moral hazard

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Adverse selection
A situation caused by asymmetric information, where the uninformed party
of the transaction ends trading with the wrong type of party.
In other words, the good type of agents are displaced from the market, only
the bad type stays and this causes inefficiencies since there are transactions
not done just because of a market failure (asymmetric information).
• Since Insurance companies cannot distinguish low-risk form high-risk
people, and set one insurance premium, low-risk people stays out of
insurance market due to high premiums.
• Used car markets, the lemons (bad cars) displace the peaches (good cars)
because lemons push average market price down, such that peaches‘
owners prefer not to sell their cars.

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Adverse selection and insurance
How to solve the adverse selection problem?
• Private sector uses tools to screen customers, charge different premium
according to different risk profiles (experience rating).
• Then, government is not needed to correct for this market failure.
• Experience rating may cause equity problems, after all firms are profit
maximizers. This is true particularly in the health Insurance market, since
many high-risk people (with pre-existing health conditions, or genetic
history of diseases) will not be provided by insurance company.
• Thus, government can make health insurance access mandatory and set
uniform premium rates, thus using community rating, low-risk people will
subsidize high-risk people. [Idea behind the Affordable Care Act of 2010 ]

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Adverse selection: example
• Market of used cars: suppose you are in the market to buy a 2005 VW
Passat.
• It is know that half of 2005 VW Passat are lemons (poor condition) and half are
peaches (excellent condition).
• You are willing to pay $8000 if you are assured the car is a peach, but if the car is a
lemon you would not pay higher than $1500. You as consumer do not know which
car is a lemon or a peach, but sellers know.
• This means that you would pay your $4750 for a car of unknown quality.
EV = 0.5 ∗ 8000 + 0.5 ∗ 1500 = 4750
• Suppose sellers of lemons will sell their cars for a minimum of $1000 or more,
whereas peach sellers will be willing to sell their cars for $6,500 or more.
• Then, by offering you $4750 to the market, you will only have sellers of lemons
willing to sell; the owners of peaches would receive $6500 as minimum, but you
offered lower than that, so they would prefer not to sell and leave the market.
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Adverse selection solutions
• Other examples of private solutions include:
• The Blue book and Carfax in the used car market.
• The credit rating agencies that give rating to people according to their profile.
• Market signaling: actions taken by buyers and sellers to communicate
quality in a world of uncertainty.
• In the college admission process, market signals include students’:
• Advanced placement courses
• Years of math, science, and foreign language
• Extracurricular activities
• In general, certifications are market signals in the job market (MA degree,
College degree) or quality certifications for firm processes (ISO
certification).
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Moral hazard
• A situation caused by asymmetric information, where one of the parties that
signed a contract changes her behavior in response to it (insurance protection)
and due to imperfect monitoring. Thus, obtaining insurance against an adverse
outcome leads to an increase in the likelihood of the outcome.
• It is also called unobserved or hidden action problem. E.g.
• By having a car insurance, it is likely that the insured individual drive less carefully, since
he/she is protected against damages.
• By having a health insurance, individuals may overuse the service for very small things or
people may be involved in riskier actions, or start having bad nutrition habits.
• By signing an unlimited period job contract or getting tenure, employees are more likely to
shirk.
• Moral hazard causes overuse of the contracted service (health service for
example), which generates additional services that otherwise would not have
been provided, thus, the costs are higher than the consumer benefits. It provokes
a deadweight loss.

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Moral hazard and DWL

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Moral Hazard solutions
• Mechanism design: area of economics that aims to reach optimal
outcomes overcoming problems such as asymmetric information; it is
broadly based on the use of incentives.
• How to solve the Moral Hazard problem? è through incentives
• Higher monitoring or supervision
• Make the individual to pay part of the service : e.g. a co-pay in the healthcare
industry encourages more careful use of healthcare, just as the insurance
company wants.
• Variable compensation for workers. This scheme can help firms get better
performance from their workforce.

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