INTERMEDIATE
MICROECONOMICS:
INFORMATION
ECONOMICS
SUMMARY
@ECOsummaries
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,Intermediate Microeconomics Summary
Lecture 1 – Introduction and Uncertainty
Decisions under uncertainty: uncertainty when some information is missing. But parties have similar
information
Information economics: parties involved have different or asymmetric information.
- Before contract: before buying health insurance, farmer knows more about health status
- After contract: After buying health insurance, farmer can take action that can increase probability
of getting sick. If she gets sick, her doctor and herself know more than the insurance company.
Choice under Uncertainty: expectations and probabilities
Bad event probability = π → low payoff x
Good event probability = 1- π → high payoff y
Expected value: πx + (1- π)y
Risky asset
Example: lottery ticket for tom
- Tom has $100
- lottery ticket costs $6
- if he buys: win = $200 lose = $95
- if he doesn’t buy win = $100 lose = $100
Choice:
- Safe asset that preserves his wealth (ϴ) with certainty
2. Risky asset that reduces wealth to P(x) = π and P(y) = 1- π
Preferences under uncertainty
Utility function:
- perfect substitutes: U(x) = x and U(y) = y
- Cobb Douglas: U(x) = ln(x) and U(y) = y
Prefer the risky asset if :
Risk preferences
- if U(wealth) = U(risk) → risk-neutral → linear
- if U(wealth) > U(risk) → risk-averse → concave (diminishing marginal utility) → (women, elderly)
- if U(wealth) < U(risk) → risk-seeker → convex (increasing marginal utility) → (men)
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,Certainty Equivalent (CE):
guaranteed amount of income that would yield the same expected utility as the given risky asset.
(Amount of wealth equivalent to taking the gamble)
If CE < EV(wealth) → risk averse, since she is willing to leave out money in order to min. risk
Risk premium: EV – CE
Insurance: tool for reducing risk for risk-averse people
- trades wealth in different states
- transfer wealth from the good state to the bad state
- many people pay a premium to cover the losses of a few
- pooling risk: sharing all risks among a group of insurance companies
https://www.collinsdictionary.com/dictionary/english/risk-pooling
State-contingent: A contract that is implemented only when a particular state of nature occurs
e.g. the insurance company will only pay if he faces a loss
State-contingent consumption plan: how much wealth to have in each state of nature
- Needed Tom’s preferences
- Needed Tom’s state-contingent budget constraint
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, indifference curves of concave U function
x=Tom’s wealth if the bad state occurs
y=Tom’s wealth if the good state occurs
Calculating the MRS:
https://www.youtube.com/watch?v=tCreeXzCNRc → nice explaining video
Lecture 2 – Uncertainty and insurance game theory
Budget constraint (market opportunity line)
Without uncertainty: consumers choose consumption plan (x,y) from budget line
W = p1*x + p2*y
With uncertainty: market also determines the combinations of x and y from which individuals
is able to choose → market opportunity line
Market opportunity line: state-contingent budget constraint
See example: Insurance of Tom
• Probability 1% of getting $25.000 + C – pC (C=coverage, p=price)
• Probability 99% of getting $35.000 – pC
Budget line with slope
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