Wk8 DQ - Managerial Eonomics

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The Economics of Information

Chapter 12

Learning Objectives

Identify strategies to manage risk and uncertainty, including diversification and optimal search strategies.

Calculate the profit-maximizing output and price in an environment of uncertainty.

Explain why asymmetric information about “hidden actions” or “hidden characteristics” can lead to moral hazard and adverse selection, and identify strategies for mitigating these potential problems.

Explain how differing auction rules and information structures impact the incentives in auctions, and determine the optimal bidding strategies in a variety of auctions with independent or correlated values.

Measuring Uncertain Outcomes

A variable that measures the outcome of an uncertain event is called a random variable.

Probabilities can be attached to different values of a random variable that denote the chance that a value occurs.

Information about uncertain outcomes can be summarized by the mean (or, expected value) and variance of a random variable.

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The Mean and the Variance

Measuring Uncertain Outcomes: Mean

The mean of a random variable is the sum of the probabilities that different outcomes will occur multiplied by the resulting payoffs.

If denote the possible outcomes of the random variable and the corresponding probabilities of the outcomes, then the mean of is:

, where .

The mean does not provide information about the risk associated with the random variable.

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The Mean and the Variance

Measuring Uncertain Outcomes: Variance and Standard Deviation

The variance of a random variable is the sum of the probabilities that different outcomes will occur multiplied by the squared deviation from the mean of the resulting payoffs.

If denote the possible outcomes of the random variable, their corresponding probabilities are , and the expected value of is , then the variance of is:

The variance is a common measure of risk.

The standard deviation is the positive square root of the variance: .

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The Mean and the Variance

Risk Aversion

Attitudes toward risk differ among consumers.

A risk-averse consumer prefers a sure amount of to a risky prospect with an expected value of .

A risk-loving consumer prefers a risky prospect with an expected value of to a sure amount of .

A risk-neutral consumer is indifferent between a risky prospect with an expected value of and a sure amount of .

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Uncertainty and Consumer Behavior

Managerial Decisions with Risk-Averse Consumers: Product Quality

Risk analysis can used to examine situations where consumers are uncertain about product quality.

Consider a consumer who regularly uses Brand X. If a new product enters the market, Brand Y, under what conditions will the consumer be willing to try the new product?

Issues to overcome and consider:

Relative certainty about Brand X.

At equal prices among other things, a risk averse consumer will continue to purchase Brand X, since a risk averse consumer prefers the sure thing (Brand X) to a risky prospect (Brand Y).

Two tactics can be employed to induce a risk averse consumer to try a new product:

Lower the price of Brand Y.

Try to convince consumer the new product’s quality is higher than the old product.

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Uncertainty and Consumer Behavior

Managerial Decisions with Risk- Averse Consumers

Chain stores: may be in a firm’s best interest to become part of a chain store

Standardization, reputation, increased chance of survival

Online reviews

Insurance: the fact that consumers are risk averse implies they are willing to pay to avoid risk.

Consumer Search

To identify the low-price seller from among many firms selling an identical product, consumers sometimes incur a cost, , to obtain each price quote.

After observing each price quote, a consumer faces must weigh the expected benefit from acquiring an additional price quote with the additional cost.

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Uncertainty and Consumer Behavior

Consumer Search

Suppose that three-quarters of stores in a market charge and one-quarter charge .

A consumer observing a price of should stop searching since there is no price below .

What should a risk-neutral consumer do after observing a price of , if search occurs with free recall and with replacement?

One-quarter of the time the consumer will save .

Three-quarters of the time the consumer will save nothing.

The expected benefit from an additional search is: .

A consumer should search for a lower price as long as the expected benefits for an additional search are greater than the cost of an additional search.

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Uncertainty and Consumer Behavior

Optimal Search Strategy

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Uncertainty and Consumer Behavior

Price

Reservation price:

Price at which a consumer

is indifferent between

purchasing at that price and

searching for a lower price.

Expected

benefits

and costs

Acceptance Price Region

Rejection Price Region

Consumer’s Search Rule

The optimal search rule is such that the consumer rejects prices above the reservation price, , and accepts prices below the reservation price. Stated differently, the optimal search strategy is to search for a better price when the price charged by a firm is above the reservation price and stop searching when a price below the reservation price is found.

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Uncertainty and Consumer Behavior

Increasing Cost of Search

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Uncertainty and Consumer Behavior

Price

Expected

benefits

and costs

Due to

Increase

in search

costs.

Manager’s Risk Attitudes

While manager must understand the impact of uncertainty on consumer behavior, uncertainty also impacts the manager’s input and output decisions.

Manager’s risk profiles:

Risk averse: a manager who prefers a risky project with a lower expected value if the risk is lower than a project with a higher expected value.

Risk loving: manager who prefers a risky project with higher expected value and higher risk to one with lower expected value and lower risk.

Risk neutral: manager interested in maximizing expected profits; the variance of profits does not impact a risk-neutral manager’s decisions.

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Uncertainty and the Firm

Risk Aversion In Action: Problem

A risk-averse manager is considering two projects. The first project involves expanding the market for bologna; the second involves expanding the market for caviar. There is a 10 percent chance of recession and a 90 percent chance of an economic boom. The following table summarizes the profits under the different scenarios. Which project should manager undertake, and why?

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Uncertainty and the Firm

Project	Boom (90%)	Recession (10%)	Mean	Standard Deviation
Bologna	-$10,000	$12,000	-$7,800	$6,600
Caviar	20,000	-8,000	17,200	8,400
Joint	10,000	4,000	9,400	1,800
Safe (T-Bill)	3,000	3,000	3,000	0

Risk Aversion In Action: Answer

Managers should not invest in T-Bills

The joint project is assured of making at least $4,000, which is greater than $3,000 under the T-Bill scenario.

Since the expected returns of the bologna project are negative, neither a risk-neutral nor a risk-averse manager would choose to undertake this project.

The manager should adopt either the caviar project or the joint project. Which project will depend on his or her risk preferences.

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Uncertainty and the Firm

Project	Boom (90%)	Recession (10%)	Mean	Standard Deviation
Bologna	-$10,000	$12,000	-$7,800	$6,600
Caviar	20,000	-8,000	17,200	8,400
Joint	10,000	4,000	9,400	1,800
Safe (T-Bill)	3,000	3,000	3,000	0

Manager’s Risk Attitudes and Diversification

Notice from the previous problem that by investing in multiple projects, the manager may be able to reduce risk.

The process of potentially reducing risk by investing in multiple projects is called diversification.

Whether it is optimal to diversify depends on a manager’s risk preferences and the incentives provided to the manager to avoid risk.

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Uncertainty and the Firm

Producer Search

When producers are uncertain about the prices of inputs, an optimizing firm will use optimal search strategies.

These strategies mimic consumer search previously developed.

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Uncertainty and the Firm

Profit Maximization and Uncertainty

The basic principles of profit maximization can be modified to deal with uncertainty.

If demand (hence, revenue) is uncertain and the manager is risk neutral, then the manager will want to maximize expected profits by producing the output where the expected marginal revenue equals marginal cost:

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Uncertainty and the Firm

Profit Maximization and Uncertainty In Action: Problem

Appleway Industries produces apple juice and sells it in a competitive market. The firm’s manager must determine how much juice to produce before he knows what the market (competitive) price will be. Economists estimate that there is a 30 percent chance the market price will be $2 per gallon and a 70 percent chance it will be $1 per gallon when the juice hits the market. If the firm’s cost function is , how much juice should be produced to maximize expected profits? What are the expected profits of Appleway Industries?

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Uncertainty and the Firm

Profit Maximization and Uncertainty In Action: Answer

Appleway Industries’ profits are

Since price is uncertain, the firm’s revenues and profit are uncertain. To maximize expected profits, the manager equates expected price with marginal cost.

The expected price is: .

Therefore, manager should produce output where gallons.

Expected profits are $645.

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Uncertainty and the Firm

Asymmetric Information

Uncertainty can profoundly impact markets abilities to efficiently allocate resources.

Some markets are characterized by individuals who have better information than others.

Implication: Those individuals with the least information may choose not to participate in a market.

When some people have better information than others in a market, the information people have is called asymmetric information.

There are two specific manifestations related to asymmetric information in markets:

Adverse selection

Moral hazard

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Uncertainty and the Market

Asymmetric Information: Adverse Selection

Adverse selection refers to situations where individuals have hidden characteristics and in which a selection process results in a pool of individuals with undesirable characteristics.

In this context, a hidden characteristic is something that one party to a transaction knows about itself but which are unknown by the other party.

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Uncertainty and the Market

Asymmetric Information: Moral Hazard

Moral hazard refers to a situation where one party to a contract takes a hidden action that benefits his or her at the expense of another party.

In this context, a hidden action is an action taken by one party in a relationship that cannot be observed by the other party.

One way to mitigate the moral hazard problem is an incentive contract.

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Uncertainty and the Market

Signaling

Another way to mitigate the problem of moral hazard is signaling, which is an attempt by an informed party to send an observable indicator of his or her hidden characteristics to an uninformed party.

For signaling to be effective it must be:

observable by the uninformed party.

a reliable indicator of the unobservable characteristic(s) and difficult for parties with other characteristics to easily mimic.

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Uncertainty and the Market

Screening

A final way to mitigate the moral hazard problem is by screening, which is an attempt by an uninformed party to sort individuals according to their characteristics.

Screening may be achieved through a self-selection device.

A self-selection device is a mechanism in which informed parties are presented with a set of options, and the options they choose reveal their hidden characteristics to an uninformed party.

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Uncertainty and the Market

Types of Auctions

An auction is a mechanism where potential buyers compete for the right to own a good, service, or, more generally, anything of value.

Sellers participating in an auction offer an item for sale, and wish to obtain the highest price.

Buyers participating in an auction seek to obtain the item at the lowest possible price.

Bidders’ risk preferences can affect bidding strategies and the expected revenue a seller receives.

Four basic auction types:

English (ascending-bid)

First-price, sealed-bid

Second-price, sealed-bid

Dutch (descending-bid)

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Auctions

Differences Among Auctions Types

The timing of bidder decisions (simultaneously or sequentially)

The amount the winner is required to pay.

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Auctions

English Auction

An English auction is an ascending sequential-bid auction in which bidders observe the bids of others and decide whether or not to increase the bid. The auction ends when a single bidder remains; this bidder obtains the item and pays the auctioneer the amount of the bid.

Bidders continually obtain information about one another’s bids.

Bidder who values the item the most will win.

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Auctions

First-Price, Sealed-Bid Auction

A first-price, sealed-bid auction is a simultaneous-move auction in which bidders simultaneously submit bids to an auctioneer. The auctioneer awards the item to the highest bidder, who pays the amount bid.

Bidders obtain no information about one another’s bids.

Bidder who values the item the most will win.

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Auctions

Second-Price, Sealed-Bid Auction

A second-price, sealed-bid auction is a simultaneous-move auction in which bidders simultaneously submit bids to an auctioneer. The auctioneer awards the item to the highest bidder, who pays the amount bid by the second-highest bidder.

Bidders obtain no information about one another’s bids.

Bidder who values the item the most will win, but pays the second-highest bid.

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Auctions

Dutch Auction

A Dutch auction is a descending sequential-bid auction in which the auctioneer beings with a high asking price and gradually reduces the asking price until one bidder announces a willingness to pay that price for the item.

Bidders obtain no information about one another’s bids throughout the auction process.

Bidder who values the item the most will win and pay the amount of his or her bid.

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Auctions

Strategic Equivalence of Dutch and First-Price Auctions

The Dutch and first-price, sealed-bid auctions are strategically equivalent; that is, the optimal bids by participants are identical for both types of auctions.

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Auctions

Information Structures

While the four auction types differ with respect to the information bidders have about the bids of other bidders, bidders also have different information structures about the value of their own bids.

Perfect information

Independent private values

Affiliated (or correlated) value estimates

Special case: common-value auctions

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Auctions

Optimal Bidding Strategies for Risk-Neutral Bidders

An optimal bidding strategy for risk-neutral bidders is a strategy that maximizes a bidder’s expected profit.

Optimal bids depends on the

type of auction.

information available to bidders at the time of bidding.

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Auctions

Strategies for Independent Private Value Auctions

With independent private values, bidders know his or her own values prior to the auction start.

English auction

Remain active until the price exceeds his or her own valuation of the object.

Second-price, sealed-bid auction

Bid his or her own valuation of the item. This is a dominant strategy.

First-price, sealed-bid auction (strategically equivalent to the Dutch auction)

Bid less than his or her valuation of the item. If there are bidders who all perceive valuations to be evenly (or uniformly) distributed between a lowest and highest possible valuations, and , respectively, then the optimal bid, , for a player whose own valuation is is:

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Auctions

Strategies for Independent Private Value Auctions In Action: Problem

Consider an auction where bidders have independent private values. Each bidder perceives that valuations are evenly distributed between and . Sam knows his own valuation is . Determine Sam’s optimal bidding strategy in:

A first-price, sealed-bid auction with two bidders.

A Dutch auction with three bidders.

A second-price, sealed-bid auction with 20 bidders.

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Auctions

Strategies for Independent Private Value Auctions In Action: Answer

Sam’s optimal bid in a first-price, sealed-bid auction with two bidders is .

Sam’s optimal bid in a Dutch auction with three bidders is .

Sam’s optimal bid in a second-price, sealed-bid auction with 20 bidders is to bid his true valuation, which is .

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Auctions

Strategies for Correlated Values Auctions

Bidders do not know their own valuations for an item, nor others’ valuations.

Implication: makes bidders vulnerable to the winner’s curse, which is the “bad news” conveyed to the winner that his or her estimate of the item’s value exceeds the estimates of all other bidders.

To avoid the winner’s curve in a common-value auction, a bidder should revise downward his or her private estimate of the value to account for this fact.

The auction process may reveal information about how much the other bidders value the object.

The winner’s curse is most pronounced in sealed-bid auctions since bidders don’t learn about other player’s valuation.

English auction, in contrast, provides bidders with information. Therefore, bidders may have to revise up their initial bids.

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Auctions

Expected Revenues in Alternative Types of Auctions

Comparison of expected revenue in auctions with risk-neutral bidders

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Auctions

Information structure	Expected revenues
Independent private values	English=Second-price = First-Price = Dutch
Affiliated value estimates	English > Second-price > First-price = Dutch