Session 7

Sisir Debnath
Indian School of Business

Sisir Debnath, Managerial Economics, Indian School of Business 1

 Today
6. Public Goods and Externalities (Async)
7. Individual Behavior under Uncertainty
► Utility and expected utility
► Risk aversion
► Insurance
► Adverse selection
► Signaling
► Moral Hazard
7. Market Competition
8. Simultaneous Games
9. Sequential and Repeated Games

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 Individual Behavior
• Individuals are the basic unit of decision-
making in firms and in the economy
• Individuals (students, consumers,
shareholders, managers) are faced with choices
everyday
• Uncertainty and lack of information are
common features of these choices
• The objective of today’s class is to analyze
uncertainty and missing information in
systematic ways

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 Utility
• According to traditional economists, our
behavior is motivated by rational self interest
• Two things determine choices:
► The pleasure of consumption
► The price of the product
• Goods and services increase utility, though
Bads decrease utility
• Financial payoffs are not the only
determinants of utility
• Individuals can gain utility from the act of
work, giving, happiness of others, relaxation
etc.
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 Total Utility and Marginal Utility
• Utility = Satisfaction
• Total utility is the total satisfaction one gets
from consuming a product
• Marginal utility is the satisfaction you get
from the consumption of one additional unit of
the product
• The marginal utility of a product decreases as
you consume more of it
• Although the shape of the utility function for
wealth may vary depending on individual
preferences
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 Lottery
• A lottery is any event with an uncertain
outcome
• Example:
► Payoff from a equity share for an investor
► Outcome of a roulette wheel for a gambler
► Amount of rainfall for a farmer
• If you are to choose between
► Rs. 1 million for sure
► 25% chance of winning Rs. 4 million

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 Probability
• An event’s relative frequency in a large number of
trials is the probability of the event.
• Probability of event i ( pi ) =

► N: Large number of trials

► ni : Number of times event i occurs in those trials
• Probabilities cannot be less than zero or greater
than one
• Given a list of mutually exclusive, collectively
exhaustive events, the sum of the probabilities of the
events must be equal to one

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 Expected Value
• When dealing with uncertain events, we need
a way to characterize the level of risk that you
face.
• Expected Value refers to the most likely
outcome (i.e. the average)
N
E ( x)   piVi
i 1

Probability of event i Payout of event i

• Note: if all the probabilities are equal, then

the expected value is the average.

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 Expected Value: Example
• You are offered the following choice
• .01% chance of winning Baisakhi Bumper
(Rs.1 Million)
• 0.05% chance of winning Rakhi Bumper
(Rs.5 Million)
• E(Baisakhi Bumper) = ?
• E(Rakhi Bumper) =?

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 Risk Averse Managers
• Between two lotteries that offer equal
expected wealth, a risk averse manager prefers
the one with less risk
• Suppose that a manager has to choose
between:
► 50% chance of earning Rs.200 (B), 50%
chance of earning Rs.100 (A)
► Rs.150 for Sure
• Expected value of the lottery, E(L)?
U(E(L)) = U(150) > ½ ×U(200) + ½ ×U(100) = E(U(L))

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 Risk Averse Managers
Expected
value of the
lottery: E(L)
U(B=200)
Utility from
U(E(L)=150)
the Expected
value of the
E(U(L)) lottery:
U(E(L))
Expected
U(A=100)
Utility of the
Lottery:
E(U(L))

A (100) E(L) = 150 B (200)

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 Risk Neutral Manager
• A risk neutral individual is indifferent
between a lottery with a more certain outcome
and one with a less certain outcome, as long as
each lottery offers equal expected wealth.
• Suppose that a manager has to choose
between:
► 50% chance of earning Rs.200 (B), 50%
chance of earning Rs.100 (A)
► Rs.150 for Sure
U(E(L)) = U(150) = ½ ×U(200) + ½ ×U(100) = E(U(L))

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 Risk Neutral Manager
Expected value
of the lottery:
E(L)
U(B=200)
Utility from
the Expected
value of the
lottery: U(E(L))
U(E(L)=150)
=
E(U(L))
Expected
Utility of the
Lottery:
E(U(L))
U(A=100)

A(100) E(L) = 150 B (200)

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 Risk Loving Managers
• Between two lotteries that offer equal
expected wealth, a risk lover manager prefers
the one with larger spread
• Suppose that a manager has to choose
between:
► 50% chance of earning Rs.200 (B), 50%
chance of earning Rs.100 (A)
► Rs.150 for Sure
U(E(L)) = U(150) < ½ ×U(200) + ½ ×U(100) = E(U(L))

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 Risk Loving Preferences
Expected
value of the
lottery: E(L)

U(B=200)
Utility from
the Expected
value of the
lottery:
U(E(L))
E(U(L))
Expected
U(E(L)=150) Utility of the
Lottery:
E(U(L))

U(A=100)

A (100) E(L) = 150 B (200)

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 Preferences Towards Risk
Type Condition Example
Risk Loving U ' ' (I )  0 U (I )  I 2
Risk Neutral U ' ' (I )  0 U (I )  2I

Risk Averse U ' ' (I )  0 U (I )  I

• Suppose you have to choose between:

► Rs.1 million for sure
► 25% chance of winning Rs. 5 million
• What is the expected value of the lottery?

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 Measures of Risk
• Managers often rely on standard deviation as
a measure of risk
• Standard Deviation is the square root of the
expected value of squared differences from the
mean
N

 p V  E ( x)
2
SD( x)  i i
i 1

Probability of event i Squared difference between

the payout of each event
and the expected value

• What is the SD of the lottery?

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 Certainty Equivalence and the
Market for Insurance
• The certainty equivalent is the guaranteed
payoff at which a person is indifferent between
certain wealth and a lottery with uncertain
wealth.

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 Risk Averse Expected
value of the
lottery: E(L)

U(B)
Expected
Utility of the
lottery:
E(U(L)) E(U(L))

Certainty
Equivalent
U(A) of the
lottery:
CE(L)

A CE(L) E(L) B

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 Market for Insurance
• Seinfeld Insurance Company is risk neutral
and is willing to buy Kramer’s bond, i.e., take
on Kramer's risk
• What is the maximum Seinfeld will pay for
the bond?
• What is the minimum Kramer will accept for
the bond?
• The difference is the risk premium
• Works only for risk averse preferences

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 Adverse Selection
• Buyer and seller have different information
• Market breakdown; even though sellers are
willing to sell goods and buyers willing to
purchase goods at the same price
• The reason is hidden information.
• The mechanism is adverse selection.

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 The Lemons Problem
• Two types of cars: Peaches and Lemons
• Both look the same, but Peaches work and
Lemons don't
• Peaches are a fraction 0.6 of the market
• Lemons are a fraction 0.4 of the market
• Buyers cannot distinguish between the two,
but sellers can.
• Peaches are worth Rs. 2 lakh to buyers
• Lemons are worth Rs. 1 lakh to buyers
• Market clearing price for new cars should be
(0.6 × 2) + (0.4 × 1) = Rs. 1.6 lakh

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 The Lemons Problem
• But the market will not clear at Rs. 1.6 lakh!
• Recall that buyers cannot distinguish between
Lemons and Peaches
• Sellers know which car is which
• At Rs. 1.6 lakh, sellers will gladly sell Lemons,
but not Peaches
• Buyers know that the only cars offered are
Lemons
• Market clearing price will be Rs. 1 lakh
• Only Lemons are sold, all Peaches are unsold
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 Car Insurance
• Asymmetric information case
• Insurer cannot distinguish between High and
Low risk drivers
• Average premium is 50
• High risk drivers will buy insurance at this
price, but Low risk drivers will not
• Since only High risk drivers will buy
insurance, insurance premium increases to 75
• Asymmetric information implies no insurance
for Low risk drivers

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 Signalling
• Overcoming Adverse Selection
• Definition: A signal is a costly action that
sellers undertake to convey credible
information about a product's quality.

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 Warranties as Signals
• Adverse Selection in the Product Market
• Experience goods: Goods whose quality can be
evaluated only after they have been consumed
• If quality cannot be discerned by consumers
then there would be a single market
• Incentive for high-quality producers to
separate their product from others and increase
buyer’s willingness to pay
• Product warranties act as a separating
mechanism

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 Warranties as Signals
• Notation:
High Quality Low Quality
Willingness to pay PH PL
Production cost CH CL

• Annual warrantee cost

• Number of years warrantee offered:
• is chosen by managers

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 Warranties as Signals (Case 1)
• Consumers believe that any good with a warranty is a
high-quality good
• Consumers will pay only PL for any product that does
not have warrantee
• Profit from high quality good with warranty

• Profit from high quality good without warranty

• High quality producer will issue a warranty if

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 Warranties as Signals (Case 1)
• Profit from low quality good with warranty

• Profit from low quality good without warranty

• Low quality producer will not issue a warranty if

• Credible warranty requires

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 Warranties as Signals (Case 2)
• Consumers believe that goods with longer
warranties are of higher quality
• Longest warranty low quality producer can afford
to offer

• Longest warranty high quality producer can

afford to offer

• Since WL > WH → YH > YL

• High quality product will have warranty
YH = YL + 1
• Low quality product will not have warranty

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 The Principal-Agent Relationship
• The Principal owns resources
• The Agent is hired by the principal and given
stewardship over resources
• Contract imperfectly describes future
contingencies
• Post-contractual behaviour of the agent must
be either monitored or properly motivated
• Incentive problem exists within firms as
owners and employers have fundamentally
different objective.

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 Moral Hazard
• Market breakdown
• The principal cannot observe, verify or enforce
all actions of the agent
• Agents change actions to suit their own
welfare, rather than principal's welfare
• Impossible to write contracts
• The reason is hidden action
• The mechanism is moral hazard

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 Takeaways from this Session
• Analysis of individual choice and decisions
► The objective of an individual is to maximize
utility
► But, uncertainty and lack of information
complicate decision-making
► Most people in most situations are risk averse
and try to reduce uncertainty
• Insurance can mitigate uncertainty
► But, insurance markets suffer from adverse
selection and moral hazard
• Signaling is one way to overcome adverse
selection
• Pay-for-performance is one way to overcome
moral hazard

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