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Chapter 05 - The Economics of Information and Choice Under Uncertainty

Chapter 5 The Economics of Information and Choice Under


Uncertainty
Answers to Questions for Review
1. If anyone can fake the signal, it will cease to be a signal at all since it would be meaningless
information.

2. The full disclosure principle means that advertisers will be eager to separate their products
from products with lesser qualities. An important role of advertising is to convince potential
buyers about the superiority of their product.

3. Interviewers will have an incentive to tell information about which the employer may have
concern even if the employer is not allowed to ask for the information. Employers may
expect the worst, so the applicant will make sure that the employer knows that the worst is
not true.

4. The low-risk types subsidise the high-risk people in the group, because the insurance
company will charge a premium to cover the average claim. It means that the low risk types
are paying too much, while high risk types may not pay enough.

5. The rate will be higher than it should be because those who are the best risks leave the pool
and self-insure. That raises the rates for those left, and the best risks left are again inclined to
self- insure. Thus the average premium keeps climbing.

6. It is logical that there are diminishing returns to wealth, and therefore risk aversion is normal.

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Chapter 05 - The Economics of Information and Choice Under Uncertainty

7. Gambling, playing the Lotto and bungee jumping might help you start your list.

8. Focus on the idea that insurance companies will need to cover their risk and make profits.
Over their lifetime, individuals can save more that they have to pay in insurance premiums.

9. The service contracts on small appliances and credit card insurance when the maximum loss
is only R1 000 are two of the obvious ones.

Answers to Chapter 5 Problems


1. If the general threshold for denying admission is 80, and if those who deny admission are
uniformly distributed between 80 and 100, then our best estimate of the messiness index of
someone who denies admission will be 90. The threshold will not be stable. Someone whose
messiness index is between 80 and 90 has good reason to let people in rather than be assumed
to have an index of 90. A threshold of 90 should be unstable for similar reasons, as indeed
will any disclosure threshold less than 100. In practice, the fact that some people do refuse to
let others see their messy apartments seems to indicate that actually seeing the mess firsthand
will be more damaging than having people conclude in the abstract that the apartment is
messy.

2. One salient fact about teenage males is that they have much higher car accident rates than
other groups. A company that charged the same rates to teenage males as it changes to all
other groups would therefore have to have higher premiums than those other companies
charge members of all other groups. There would then be no reason for these other group
members to remain with the company. In the end, the company with uniform rates for all

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Chapter 05 - The Economics of Information and Choice Under Uncertainty

groups would have to charge a premium high enough to cover the expected losses of
members in the highest risk group.

3. If all consumers value non-defective cars at R180 000 and used cars sell for only R30 000,
then no non-defective cars will be offered for sale in the used market. The only used cars for
sale will be defective, so we know that the value consumers place on a defective car must be
exactly R30 000. Since consumers are risk neutral, the expected value of a new car, En, is
simply the sum of the expected values of non-defective and defective cars:
En = (1-d)(180 000) + d(30 000) = 120 000, which solves for d = 0.4.

4. The expected value of a new motorcycle, En, is equal to En =90 000 = (1-d) 10 000 + d X,
where X is the price of a non-defective one and d is the proportion of defective motorcycles.
Therefore, 90 000 = 0.8X + 0.2(10 000), which solves for X = R110 000.

5. You know your car is not a lemon; but if you try to sell it, the market will assume it is, and
you will be unable to get full value for it. This makes it more worth your while to fix the car.

6. Because social workers receive very low salaries relative to the amount of education they
have, it is a reasonably safe inference that most of them chose that line of work for reasons
other than money. And if the primary motive for cheating at cards is monetary gain, it
follows that a social worker is not very likely to cheat. In the case of the used car
salesperson, by contrast, there is no similar presumption of non-defective motivation.
Moreover, there is at least some indication that the capacity to dissemble is linked to success
in selling.

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Chapter 05 - The Economics of Information and Choice Under Uncertainty

7. The college diploma or university degree is a signal to the employer about the smartness or
ability of an employee. Assume that the smartness of an employee is distributed between 0
and S. The only costs to education are monetary costs and the difficulty of passing courses,
which is lower for smarter students. Thus, for any two people with the same wealth, the
smarter one is likely to have more education. At the beginning of the century, lets say that
the average learner that passed grade 12 had smartness level of Sh and the average university
graduate had Sc, where Sc>Sh. Since the monetary costs of education went down, more
people are getting education, especially the ones who were smart but could not afford it
before. Also, smarter high school graduates will now be getting college diplomas or
university degrees. Assume the average smartness level of a learner that passed grade 12 now
is Nh and of a university graduate is Nc. Then Nh<Sh and Nc<Sc. Of these four quantities,
Sc is the highest and Nh is the lowest, but we do not exactly know the relationship between
Sh and Nc. If Nc<Sh, then banks might raise their education criterion.

8. The expected value of one toss of a six-sided dice is


EV = (1/6)(1+2+3+4+5+6)=21/6=3.5 .

9. The expected value of the gamble is given by


EV = (1/4)(20) + (1/4)(9) + (1/4)(-7) + (1/4)(-16) = +1.5 .

10. EU = (1/4) 36 + (1/4) 25 + (1/4) 9 + (1/4) 0 = 6/4 + 5/4 + 3/4 = 3.5.


Your utility without the gamble is

16 = 4.0; so you will not accept the gamble.

11. a) 40% with probability 0.3


-100% with probability 0.2

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Chapter 05 - The Economics of Information and Choice Under Uncertainty

10% with probability 0.5


E(interest rate)= 0.3(0.4) + 0.2(-1) + 0.5(0.1) = -0.03 = -3%

11. b) EU(govt. bond) = (1.08x100 000)2 = 11 664 000 000


EU(junk bond) = 0.3(1.4x100 000)2 + 0.2(0)2 + 0.5(1.1x100 000)2 = 11 930 000 000
Since EU(junk bond) > EU (govt. bond), you will invest in the junk bond.

11. c) EU(govt. bond)

= 328.63

EU(junk bond) = 0.3

+ 0.2 0 + 0.5

= 262.58 .

Since EU(junk bond) < EU (govt. bond), you will invest in the govt. bond.

12. EU(with ticket) = 0.25(1 100)2 + 0.75 (1 000)2

= 1 052 500.

The wealth level to give the same utility for sure is w =

= 1 025.91.

Thus you would be willing to sell the ticket for 25.91.

13. . EU (without insurance) = 0.99999

= 1 999.98 .

The wealth level to give the same utility is

w = (1999.98)2 = 3 999 920 .

So he would be willing to pay R80 for this insurance.

14. With one trip, EU1 = (1/2)

+ (1/2) 0 = 50

With two trips, there are four equally likely outcomes:

First Trip

Second Trip

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Income

Probability

Chapter 05 - The Economics of Information and Choice Under Uncertainty

1.

0 break

0 break

10 000

1/4

2.

5 000 break

0 break

5 000

1/4

3.

0 break

5 000 break

5 000

1/4

4.

5 000 break

5 000 break

1/4

EU2 = (1/4)

+ (1/4)

+ (1/4)

+ (1/4) 0 = 25 + 17.7 + 17.7 =

60.4 So it is better to take two trips than one, even though the expected number of eggs
broken is the same either way. Moral: Don't put all your eggs in one basket!

15. a) EV = (1/2)15 - (1/2)13 = 1.0

15. b) EU = (1/2) 64 + (1/2) 36 = 4 + 3 = 7


15. c) EV = 0
EU = (1/2) 64 + (1/2) 34 = 4 + 5.83/2 = 6.91
Without gamble U = 7 .

15. d) Let x = the most you would pay to get out of the gamble. Then ( 49 x ) = 6.91
49-x = 47.75
x = 1.25

16. a) EU = ( 144 )/2 + ( 81 )/2 = 10.5 < 111 = 10.536, so Malusi will not make the
investment.

16. b) With 2 equal partners, EU = [ (111 11) ] /2 + ( 101) /2 = 10.55 >


so Malusi will make the investment.

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111 = 10.536

Chapter 05 - The Economics of Information and Choice Under Uncertainty

17. Expected utility without info = max[ 81 , (.2 900 + 0.8 25 )] = max (9, 10) = 10.
So without info, he will choose to become a lawyer.

Suppose info costs P;

Pay P
Interview
"You'll become a partner."

"You won't become a partner."


prob = 0.8

prob = 0.2
Choose law

Choose teaching

earn 900

earn 81

Expected utility with info = 0.2 (900 P) + 0.8 (81 P)


Set EU with info = EU without info = 10 and solve for P:
P = 53.68. For any price less than this amount, he should pay Smith for his evaluation.

18. Assume that Smith has the policy that he will charge only if he tells the person he will
become a lawyer, and also assume that he never lies since he wants to make a reputation to
stay in this business. Thus, he charges Rp with probability 0.2 and charges R0 with
probability 0.8. The maximum amount John will be willing to pay for this deal will be given
by,
EU(with info) = EU(without info)
0.2 (900 p) + 0.8

81 = 10 which solves for p = R704. So Smith would do much better

if he employs this policy!

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Chapter 05 - The Economics of Information and Choice Under Uncertainty

19. a) For group 1, the reservation price of insurance is found by solving

(100 x1 ) = 0.5 100 + 0.5 64 = 9, which yields x1 = 19.


(100 x2 ) = 0.9 100 + 0.1 64 = 9.8, which yields x2 = 3.96.

For group 2, we get

19. b) If members of the two groups are indistinguishable, an insurance company will have to
charge the same premium to each. If its policyholders consisted of equal numbers of people
from each group, this premium would have to cover the expected loss, which is
[(0.5)(36)+(0.1)(36)]/2=10.8. Since this exceeds the reservation price of members of group
2, nobody from that group would buy insurance. And with only group 1 members remaining
in the insured pool, the premium would have to rise to 18 in order to cover the expected loss
for members of that group.

19. c) If a company has the test described, and the test says a person is a member of group 2, then
the expected benefit payout from insuring that person is
x(0.1)(36) + (1-x)(0.5)(36) = 18 - 14.4x = E(L). Setting E(L) equal to the reservation price
for group 2 we get 18 - 14.4x = 3.96, or

x = 0.975. The test would have to be accurate

97.5% of the time in order for a member of group 2 to find insurance an acceptable buy.

20. a) Let X1 denote the reservation price for members of group 1. X1 must satisfy the equation

(144 X1 ) = 0.5 100 + 0.5 144 = 11, which solves for X1 = 23. The reservation price for
group 2 must satisfy

(144 X2 ) = 0.1 100 + 0.9 144 = 11.8, which solves for X2=4.76.

20. b) The most an insurance company can charge and still include group 2 members is X2=4.76.
Let p be the proportion of group 1 members in the potential client pool. If the price is low
enough to attract group 2 members, it will necessarily also attract members of group 1. The

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Chapter 05 - The Economics of Information and Choice Under Uncertainty

expected benefit payouts for members of the two groups, denoted B1 and B2, are given by
B1= 0.5(44) = 22 and B2=0.1(44)=4.4. The expected benefit payment per client, B, is thus a
weighted average of these expected payouts, where the weights are the respective population
shares in the client pool: B=p(22) + (1-p)(4.4)= 4.4 + 17.6p. Equating this expected benefit
payment to the reservation price X2, we have 4.4 + 17.6p = 4.76, which solves for p =
0.36/17.6 = 0.02. Thus, if more than 2% of the potential client pool consists of members of
group 1, it will be impossible to include members of group 2.

21. Let m be Errols initial wealth, and u be his utility function.


Picking A over B => uA = u(m+100) > EuB = 0.8u(m+150) + 0.2u(m)
Picking D over C => EuD = 0.4u(m+150) + 0.6u(m) > EuC = 0.5u(m+100) + 0.5u(m)
Rearranging terms of the last inequality, we have 0.5u(m+100) < 0.4u(m+150) + 0.1u(m).
Dividing both sides by 0.5 gives u(m+100) < 0.8u(m+150) + 0.2u(m), which is the reverse
order of the inequality implied by the choice of A over B, hence the inconsistency.

22. The expected value of the largest of 100 estimates is (100/101)(C). If you win the auction,
your estimate will be the largest of the 100. If its value is 50, your best estimate of C will be
C* = (101/100) 50 = 101/2. Since the expected value of the money is C/2, you should bid
C*/2 = 101/4 = R25.25.

23 If your company bids P and X is greater than P, then Bumbler will refuse the offer and the
deal is off. Your company earns zero profit in that case. If Bumbler accepts your company's
offer, then we know that X<P. Since X is uniformly distributed between 0 and 100, the
expected value of X, given that X<P, is P/2. This means that the expected value of
Bumbler's oil field to your company is P/2 + 40.

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Chapter 05 - The Economics of Information and Choice Under Uncertainty

a) If your company bids P and Bumbler accepts, then the expected profit of your company
will be P/2 + 40 - P = 40 - P/2. Equating this expression to zero, we see that the most your
company can bid without expecting to make a loss is 80.
b) The probability your company acquires Bumbler at a bid of P is equal to the probability
that X is less than P, which is P/100. If your company fails to acquire Bumbler (i.e., if X >
P), then your company's profits from transaction will be zero.
Expected profit from a bid of P is thus given by
E ( ) = (P/100) (40 - P/2) + (1 - P/100) (0) = 40P/100 - P2/200.
The first-order condition for maximum expected profit is given by
dE ( ) /dP = 40/100 - P/100 = 0, which solves for P* = 40.

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