Extra Credit for ECO 550 week 8
GRANTKS2
Week8TownHallDrSlinskyPresenting.pptxECO550 Town Hall: Risk and Uncertainty
Spring 2020
Tonight’s Town Hall Will Be Presented by Dr. Stephen Slinsky
Welcome to the Week 8 Town Hall
The purpose of the Town Hall this quarter will be to answer your questions.
The instructional team will be taking tunes providing this opportunity, so you will have an opportunity to hear from all three of us during the quarter.
Consider us your panel of experts.
There will be a double reward. In weeks 4 and 8 you will have an opportunity to share with us your reflections on what you found most interesting or informative about one of the Town Halls. What you share will get 25 bonus points in week 4 and 25 bonus points in week 8. The other benefit is we hope you will enjoy the discussion. Here are the details.
Now: How To Ask a Question
Everyone is currently muted, but if you want to ask a question, you should see a little button/hand. Click and I will be able to see that you want to ask a question. I will unmute you, so if you have muted yourself remember you may have to unmute as well.
The other way to ask a question is to type you question into the chat box. I will watch the chat box for any questions.
While you are thinking about or typing your question, I am going to share some thoughts.
Risk vs. Uncertainty
Asymmetric Information
Adverse Selection
Moral Hazzard
Principal Agent Problem
Imperfect Information and Signaling
Three Things I Am Thinking About
RISK is when we know the potential outcomes in advance, and we may even know the odds of these outcomes in advance.
Risk vs. Uncertainty
An example of risk is rolling a pair of dice.
Before we roll, we know in advance what the odds are for each possible outcome (provided that the dice are fair).
Knowing these odds forms the basis for all of the games of chance that we can play.
UNCERTAINTY is when we don’t even know the possible outcomes in advance, let alone their probabilities. Genuine uncertainty occurs in complex systems, where lots of actors interact over time.
Example of a complex system is the general economy.
Risk vs. Uncertainty
Review:
In risk you can predict the possibility of a future outcome, while in uncertainty you cannot.
Risks can be managed while uncertainty is uncontrollable.
Risks can be measured and quantified while uncertainty cannot.
You can assign a probability to risks events, while with uncertainty, you can't.
Risk vs. Uncertainty
In contract theory and economics, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other.
Asymmetric Information
The used car market and the insurance market common examples of how asymmetric information affects the economy and causes market failure.
Adverse Selection
Moral Hazzard
Principal Agent Problem
Adverse Selection occurs when there is asymmetric (unequal) information between buyers and sellers. This unequal information distorts the market and leads to market failure.
Examples:
Buyers of insurance may have better information than sellers. Those who want to buy insurance are those most likely to make a claim. Therefore firms are reluctant to sell insurance.
Sellers of used cars may have better information about the true quality of the car than buyers. Therefore, buyers are reluctant to pay a decent price because they fear getting a ‘lemon’.
Asymmetric Information
Overcoming Adverse Selection
Insurance market: Because buyers of insurance may have better information than sellers and those that tend to want to buy insurance are those most likely to make a claim, insurance companies require buyers pay copays or deductibles when claims are made.
Used car market: Because sellers of used cars may have better information about the true quality of the car than buyers, sellers may offer warranties to reduce potential costs of buying a ‘lemon’.
Asymmetric Information
Moral Hazzard occurs is when one party gets involved in a risky event or changes his/her behavior in the face of risk knowing that it is protected against the risk and the other party will incur the cost. It arises when both the parties have asymmetric (unequal) information about each other.
Examples:
Comprehensive insurance policies decrease the incentive to take care of your possessions.
Government promising to bail out struggling companies can encourage companies to take greater risks.
Asymmetric Information
Overcoming Moral Hazzard
There are several ways to reduce moral hazard, including incentives, policies to prevent immoral behavior and regular monitoring.
Asymmetric Information
Adverse Selection vs. Moral Hazzard
The main difference is when it occurs.
In a moral hazard situation, the change in the behavior of one party occurs after the agreement has been made.
However, in adverse selection, there is a lack of symmetric information prior to when the contract or deal is agreed upon.
Asymmetric Information
Principal Agent Problem occurs when one person (the agent) is allowed to make decisions on behalf of another person (the principal).
The agent usually has more information than the principal.
In this situation, there are issues of moral hazard and conflicts of interest.
Asymmetric Information
Imperfect Information and Signaling
Signaling, in contract theory, is the idea that one party (termed the agent) credibly conveys some information about itself to another party (the principal).
Signaling in the hiring process:
Resume provides signals to employers how well the applicant “fits”
Education level
Bachelor Degree – applicant capable of finishing challenging tasks and is trainable
Master Degree – applicant competent in basic skills of specific area of concentration
Doctorate Degree – applicant capable of creating value within the specific area of concentration.
The Floor is Open
What are your questions?
