The Economics of Information and Choice under Uncertainty
The Economics of Information and Choice under Uncertainty
Potential parties to an economic exchange often have many
common goals, but in an important respect they must be
viewed as adversaries. In both product and labor markets,
both buyers and sellers face powerful incentives to misrepresent
their offerings.
For messages between potential adversaries to be credible,
they must be costly to fake. A firm with extensive sunk costs,
for example, can communicate credibly that it offers a reliable
product because if it fails to satisfy its customers, it
stands to lose a lot of money. By contrast, a street vendor, for
whom the costs of going out of business are very low, has a
more difficult time persuading buyers he offers high quality.
Messages between potential adversaries must also satisfy the
full-disclosure principle, which means that if one party is
able to disclose favorable information about itself, others
will feel pressure to disclose parallel information, even if considerably
less favorable. The producer of a low-quality product
does not want to signal his product's inferior status by
offering only limited warranty coverage. But unless he does
so, many buyers will make an even less favorable assessment.
When a trading opportunity confronts a mixed group of potential
traders, the ones who accept it will be different—and
in some way worse—on the average than those who reject it.
Cars that are offered for sale in the secondhand market are
of lower quality than those that are not for sale; participants
in dating services are often less worth meeting than others;
and so on. These are illustrations of the lemons principle.
The analytical tool for dealing with choice under uncertainty
is the von Neumann–Morgenstern expected utility
model. This model begins with a utility function that assigns
a numerical measure of satisfaction to each outcome,
where outcomes are defined in terms of the final wealth to
which they correspond. The model says that a rational consumer
will choose between uncertain alternatives so as to
maximize his expected utility, a weighted sum of the utilities
of the outcomes, where the weights are their respective
probabilities of occurrence.
The central insight of the expected utility model is that the
ordering of the expected values of a collection of gambles is
often different from the ordering of the expected utilities of
those gambles. The differences arise because of nonlinearities
in the utility function, which in turn summarize the consumer's
attitude toward risk. The concave utility function,
any arc of which always lies above the corresponding chord,
leads to risk-averse behavior. Someone with such a utility
function will always refuse a fair gamble, which is defined
as one with an expected value of zero. A person with a convex
utility function, any arc of which lies below the corresponding
chord, is said to be a risk seeker. Such a person
will always accept a fair gamble. A person with a linear utility
function is said to be risk neutral, and is always indifferent
between accepting and refusing a fair gamble.
Because of adverse selection, firms are under heavy competitive
pressure to find out everything they possibly can about
potential buyers and employees. This pressure often results
in statistical discrimination. In insurance markets, people
from groups with different accident rates often pay different
premiums, even though their individual driving records are
identical. This pricing pattern creates an understandable
sense of injustice on the part of individuals adversely affected
by it. In competitive markets, however, any firm that
abandoned this policy could not expect to survive for long.
Insurance purchased in private markets is generally an unfair
gamble, not only because of the administrative costs included
in insurance premiums, but also because of adverse
selection and moral hazard. The fact that most people
nonetheless buy substantial amounts of insurance is taken
as evidence of risk aversion. This observation is further supported
by the pervasiveness of risk-sharing arrangements
such as joint stock ownership.
