Welfare Change and Price Indices

Change in the price of one good

Suppose P1 increases from P10 to P11 , other prices remaining constant.
How much compensation is needed to make the consumer as well off as before (same utility)?
compensation needed e( P11 , P20 ,U ) e( P10 , P20 ,U )
welfare change (drop in utility):
compensating variation (CV) e( P11 , P20 ,U ) e( P10 , P20 ,U ) e( P10 , P20 ,U ) e( P11, P20 ,U )

e( P , P , U ) e ( P , P , U )
0
1

0
2

1
1

0
2

P10

P11

P10
e( P1 , P20 , U )
dP1 1 h1 ( P1 , P20 ,U )dP1
P1
P1

P1

CV
P11

B
A
P10
h1 ( P1 , P20 , U )

x1
x10

If the demand is locally linear, then

negative

CV [area(A B) B] (P1 )( x10 ) ( P1 )( x1 )U U

2

1
1 x

P1 x10 (x1 )U U P1 x10 1

P1
2
2 P1 U U

Inverse of slope of compensated demand curve

53
Consumer Surplus
Consider an individual with an income of m . Suppose he is only allowed to buy good y (OG )
initially, at a price of $1 per unit. He will then buy m units of y, which gives him a utility of U 0 .
Next, suppose he is allowed to buy x at price $P / unit , then he is going to buy x1 [the consumption
bundle is ( x1 , y1 ) ] which gives him a utility of U1 .
What is the maximum amount of money he would have been willing to pay to get x1 ?

Question:
y

bundle consumed

m
consumer surplus

U1

y1

slope P

y2

U0

x
x1
From the above diagram, we can see that the consumer is indifferent between enjoying his initial bundle
(0,m) or enjoying the bundle ( x1 , y 2 ) , hence the maximum amount the consumer is willing to pay for x1
is m y2 , and he is actually paying m y1 .
Definition:

The consumer surplus on a good x

maximum amount a consumer would be willing to pay the amount he actually pays

Consumer surplus max $ willing to pay $ actually paid (m y2 ) (m y1 ) y1 y2

x1

x1

Maximum $ willing to pay MRS yx ( x,U 0 ) dx P ( x) dx

where P ( x) MRS yx ( x,U 0 )

y per x

The maximum amount a consumer would be willing to

pay is the area under the compensated or Hicksian
demand curve, and not the Marshallian or ordinary
demand curve.
DH P( x)

The Marshallian demand curve will be the same as

the Hicksian demand curve if there is no income
effect.

53

54
x1

Consumer surplus MRS yx ( x, U 0 ) P dx

Remark:

(measured in y )

Remark:

Consumer surplus cannot be more than his total income.

All-or-nothing demand curve

For x1 , the most the individual would be willing to pay per unit is

m y2
, this is the all-or-nothing
x1

demand curve.
Lets take different value of x and compute for each of them the all-or-nothing price.
x

1
The all-or-nothing price P *( x) P(q) dq
x0

where P( x) MRS yx ( x,U 0 )

Since P( x) is decreasing in x P *( x) P( x) .
y per x

P *( x1 )

P ( x1 )

DH P( x)

x1

54

shaded area
P ( x1 )
x1

55
y per x

all-or-nothing price P * ( x)
DH P( x)

x
Note that at any x , P *( x) x area under the demand curve

1
d xP *( x)
P *( x) P(q) dq P *( x) x P(q) dq

x0
dx
0

55

d P(q) dq
0

dx

P( x)

56
IV.

Consumer Choice Under Uncertainty

Review of probability theory

Expectation
Suppose that a random variable X has a discrete distribution for which the probability function is f .
Then the expectation is
E ( X ) xf ( x)
x

Note: is called the expected value, the average, or the mean.

Example:
-2
0.1

X
P

0
0.4

1
0.3

4
0.2

E ( X ) (2)(0.1) (0)(0.4) (1)(0.3) (4)(0.2) 0.9

Variance ( 2 ) and Standard Deviation ( )

n

2 E[( X ) 2 ] ( X i ) 2 P( X X i ) or
i 1

(x )

f ( x)dx

2 E[( X )2 ]

Example:

X
P

5
1/ 3

7
1/ 3

12
1/ 3

5 7 12
8
3

var

(5 8) 2 (7 8) 2 (12 8) 2 9 1 16 26
26

SD
2.94
3
3
3
3

56

57
Covariance
Cov( X , Y ) E{[ X i E( X )][Yj E(Y )]}

Cov 0 negatively correlated

.
... .
.... .
. .. . . .
. . . . . . . . ..
. . .. .. . . . . . . ..
. .. . . ..
. .. .
. .. .. . ..

Cov 0 positively correlated

. .. .. .. .
..
.. .
.. . . . ..
.. . .. . . . ..
.. . . . . . .. .
.. . . .. .
. . . .. . . .. .
.. . .. .

Cov 0 uncorrelated
. .. . . . . .
..
...
... ......
....
..
. .. .
. . ..
.. ..
.. . .
. .. .
..
. .

.. .. ..

.. .. .. ..

.. .. .. .

. . .

The correlation coefficient ( X , Y ) between 2 random variables Ri and R j :

( X , Y ) XY

Cov( X , Y )
( X ) (Y )

Properties of Correlation
1 ( X , Y ) 1
1.
1 : perfectly negatively correlated
2.
0:
uncorrelated
1 : perfectly positively correlated

57

58
Example:

2 random variables with a joint density function

Y
1

0
1
f (X )

0
0.24
0.16
0.40
0.80

1
0.06
0.14
0.00
0.20

g (Y )
0.30
0.30
0.40
1.00

E ( X ) (0.3)( 1) (0.3)(0) (0.4)(1) 0.1

E (Y ) (0.8)(0) (0.2)(1) 0.2

Var ( X ) E[ X E ( X )]2 (1 0.1) 2 (0.3) (0 0.1) 2 (0.3) (1 0.1) 2 (0.4) 0.69

Var (Y ) E[Y E (Y )]2 (0 0.2) 2 (0.8) (1 0.2) 2 (0.2) 0.16
Cov( X , Y ) E{[ X E ( X )][Y E (Y )]} ( 1 0.1)(0 0.2)(0.24) ( 1 0.1)(1 0.2)(0.06)
(0 0.1)(0 0.2)(0.16) (0 0.1)(1 0.2)(0.14) (1 0.1)(0 0.2)(0.40) (1 0.1)(1 0.2)(0) 0.08

Var ( X ) Cov( X , Y ) 0.69 0.08

Variance-Covariance Matrix
Var (Y ) 0.08 0.16
Cov( X , Y )

58

59
Theorem
1)
If Y aX b , then E (Y ) aE ( X ) b
E ( X1 ... X n ) E ( X 1 ) ... E ( X n )
2)
3)
4)

If X 1 ,..., X n are n independent random variables, then E ( X 1 ... X n ) E ( X 1 )...E ( X n ) .

Var ( X ) 0 c R such that P( X c) 1
(i.e. we are sure that X must take the value of c )

5)

Var (aX b) a 2Var ( X )

6)
7)

Var ( X ) E ( X 2 ) [ E ( X )]2
If X 1 ,..., X n are n independent random variables, then
i)

Var ( X 1 ... X n ) Var ( X 1 ) ... Var ( X n )

ii)

Var (a1 X1 ... an X n ) a1 Var ( X1 ) ... an Var ( X n )

2

Theorem
1.
Cov( X , Y ) E ( XY ) E ( X ) E (Y )
2.

If X and Y are independent random variables, then Cov( X , Y ) ( X , Y ) 0

[ E ( XY ) E ( X ) E (Y ) if X and Y are independent.]
The converse is not true.

3.

Let Y aX b, a 0 .
If a 0 , then ( X , Y ) 1 .
If a 0 , then ( X , Y ) 1 .

4.

Var ( X Y ) Var ( X ) Var (Y ) 2Cov ( X , Y )

5.

Var ( X i ) Var ( X i ) 2 Cov( X i , X j )

i 1

i 1

i j

59

60
Conditional Probabilities and Statistical Independence
P( AB)
P( A B)
P( AB)
or
P( B)
P( B)
Example:
1
P (4 and spade)
1
P(4spade)
52
13
P(spade)
13
52
1
P(4 of spade and black)
1
P(4 of spadeblack)
52
26
P(black)
26
52

Statistical independence and dependence

Independent Events
Dependent Events
P( A | B) P( A)
P( A | B) P( A)
P( B | A) P( B)
P( B | A) P( B)
P( A B) P( A) P( B)
P( A B) P( A) P( B)
Example:
2 cards are selected with replacement, from a standard deck. Find the probability of selecting a king and
a queen.
4
P(QK )
P (Q ) independent
52
4 4
1
P( K Q) P( K ) P(Q)

52 52 169

Multiplication Rule
P( A B) P( AB) P( B)
Example:
Two cards are selected, without replacement, from a standard deck. Find the probability of selecting a
king and then selecting a queen.
Since the first card is not replaced, the events are dependent.
4 4
16
P( K Q) P(QK ) P( K )

0.006
52 51 2652

60

61
Bayes' Theorem
P( AB)
P( B | A) P( A)
P( B A) P( A)
P( A B)

C
P( B)
P( BA) P( BA ) P( B A) P( A) P( B AC ) P( AC )
P( A) is the prior probability

P( A B) is the posterior probability

or

P( Ai | B)

P( B | Ai ) P( Ai )
P( B | A1 ) P( A1 ) P( B | A2 ) P( A2 ) P( B | A3 ) P( A3 )

or

P( Ai | B)

P( B | Ai ) P( Ai )
n

P( B | A ) P( A )
i 1

i 1, 2, ..., n

61

i 1, 2, 3

62
Example:
Consider a manufacturing firm that receives shipments of parts from 2 different suppliers.
Let A1 denote the event that a part is from supplier1 and A2 denote the event that a part is from
supplier2. Currently, 65% of the parts purchased by the company are from supplier 1 and the remaining
35% are from supplier 2. The quality of the purchased parts varies with the source of supply. Historical
data suggest that the quality ratings of the 2 supplies are as follow:

P(G | A1 ) 1

P ( B | A1 ) 0

P(G | A2 ) 0.9

P ( B | A2 ) 0.1

G : the event that a part is good

where

B : the event that a part is bad

Suppose now that the parts from the 2 suppliers are used in the firm's manufacturing process and that a
machine breaks down because it attempts to process a bad part.
Given that the part is bad, what is the probability that it comes from supplier 1? From supplier
2?
P( B A1 ) P( A1 )
(0)(0.65)
P( A1 B)

0
P( B A1 ) P( A1 ) P( B A2 ) P( A2 ) (0)(0.65) (0.1)(0.35)

P( A2 B)

P( B A2 ) P( A2 )

P( B A2 ) P( A2 )

P( B A2 ) P( A2 ) P( B A1 ) P( A1 )

P( B A1 ) P( A1 ) P( B A2 ) P( A2 )

(0.1)(0.35)
1
(0)(0.65) (0.1)(0.35)

P( A1 G)
P( A2 G)

P(G A1 ) P( A1 )
P(G A1 ) P( A1 ) P(G A2 ) P( A2 )

P(G A2 ) P( A2 )
P(G A1 ) P( A1 ) P(G A2 ) P( A2 )

(1)(0.65)
0.673575
(1)(0.65) (0.9)(0.35)

(.9)(0.35)
0.326425
(1)(0.65) (0.9)(0.35)

Suppose the conditional probabilities are as follow:

P(G | A1 ) 0.5
P ( B | A1 ) 0.5

P(G | A2 ) 0.9
P( A1 B)
P( A2 B)

P ( B | A2 ) 0.1
P( B A1 ) P( A1 )

P( B A1 ) P( A1 ) P( B A2 ) P( A2 )
P( B A2 ) P( A2 )
P( B A1 ) P( A1 ) P( B A2 ) P( A2 )

(0.5)(0.65)
0.902778
(0.5)(0.65) (0.1)(0.35)

(0.1)(0.35)
0.097222
(0.5)(0.65) (0.1)(0.35)

Note that P( A1 | B) P( A2 | B) 1 .

62

63
Example:
Identifying the Source of a Defective Item
Three different machines M1, M2, and M3 were used for producing a large batch of similar
manufactured items. Suppose that 20% of the items were produced by machine M1, 30% by machine
M2, and 50% by machine M3. Suppose further that 1% of the items produced by machine M1 are
defective, that 2% of the items produced by machine M2 are defective, and that 3% of the items
produced by machine M3 are defective. Finally, suppose that 1 item is selected at random from the
entire batch and it is found to be defective. We shall determine the probability that this item was
produced by the 3 different machines.
Let M i be the event that the selected item was produced by machine M i ( i 1, 2,3 ), and let D be the
event that the selected item is defective. We must evaluate the conditional probability P(M1 | D) ,
P( M 2 | D), and P( M 3 | D) .
The probability P( M i ) that an item selected at random from the entire batch was produced by machine

M i is as follows, for i 1, 2,3 .

P( M1 ) 0.2, P( M 2 ) 0.3, P( M 3 ) 0.5 .
Furthermore, the probability P( D | M i ) that an item produced by machine M i will be defective is:

P( D | M1 ) 1%, P( D | M 2 ) 2%, P( D | M 3 ) 3%
By Bayes' Theorem, we have

P( M 1D)

P( M 2 ) P( DM 2 )
P ( M 1 ) P ( DM 1 ) P ( M 2 ) P ( DM 2 ) P ( M 3 ) P ( DM 3 )

(0.3)(0.02)
0.006

0.261
(0.2)(0.01) (0.3)(0.02) (0.5)(0.03) 0.023

P ( M 3D )

P( M 1 ) P( DM 1 ) P( M 2 ) P( DM 2 ) P( M 3 ) P ( DM 3 )

(0.2)(0.01)
0.002

0.087
(0.2)(0.01) (0.3)(0.02) (0.5)(0.03) 0.023

P ( M 2D )

P( M 1 ) P( DM 1 )

P( M 3 ) P( DM 3 )
P ( M 1 ) P ( DM 1 ) P ( M 2 ) P ( DM 2 ) P ( M 3 ) P ( DM 3 )

(0.5)(0.03)
0.015

0.652
(0.2)(0.01) (0.3)(0.02) (0.5)(0.03) 0.023

63

64
Example:
Quality Control
Suppose that when a machine is adjusted properly, 50% of the items produced by it are of high
quality and the other 50% are of medium quality. Suppose, however, that the machine is improperly
adjusted during 10% of the time and that, under these conditions, 25% of it are of high quality and 75%
of it are of medium quality.
Suppose that 5 items produced by the machine at a certain time is selected at random and
inspected. If 4 of them are of high quality and 1 item is of medium quality, what is the probability that
the machine was adjusted properly?
P( AP ) 0.9, P( NP ) 0.1
P( H | AP) 0.5, P( M | AP) 0.5, P( H | NP) 0.25, P( M | NP) 0.75

1st item (H):

P( APH )

P( HAP) P( AP)
P( HAP) P( AP) P( HNP) P( NP)

(0.5)(0.9)
0.947368
(0.5)(0.9) (0.25)(0.1)

(0.5)(0.947368)
0.972973
(0.5)(0.947368) (0.25)(0.052632)

(0.5)(0.972973)
0.986301
(0.5)(0.972973) (0.25)(0.027027)

(0.5)(0.986301)
0.993103
(0.5)(0.986301) (0.25)(0.013699)

(0.5)(0.993103)
0.989691
(0.5)(0.993103) (0.75)(0.006897)

2nd item (H):

P( APH )

P( HAP) P( AP)
P( HAP) P( AP) P( HNP) P( NP)

3rd item (H):

P( APH )

P( HAP) P( AP)
P( HAP) P( AP) P( HNP) P( NP)

4th item (H):

P( APH )

P( HAP) P( AP)
P( HAP) P( AP) P( HNP) P( NP)

5th item (M):

P( APM )

P( MAP) P( AP)
P( MAP) P( AP) P( MNP) P( NP)

64

65
Alternatively
1st item (M):

P( MAP) P( AP)

P( APM )

P( MAP) P( AP) P( MNP) P( NP)

(0.5)(0.9)
0.857143
(0.5)(0.9) (0.75)(0.1)

2nd item (H):

P( APH )

P( HAP) P( AP)
P( HAP) P( AP) P( HNP) P( NP)

(0.5)(0.857143)
0.923077
(0.5)(0.857143) (0.25)(0.142857)

(0.5)(0.923077)
0.9600
(0.5)(0.923077) (0.25)(0.076923)

(0.5)(0.96)
0.979592
(0.5)(0.96) (0.25)(0.04)

(0.5)(0.979592)
0.989691
(0.5)(0.979592) (0.25)(0.020408)

3rd item (H):

P( APH )

P( HAP) P( AP)
P( HAP) P( AP) P( HNP) P( NP)

4th item (H):

P( APH )

P( HAP) P( AP)
P( HAP) P( AP) P( HNP) P( NP)

5th item (H):

P( APH )

P( HAP) P( AP)
P( HAP) P( AP) P( HNP) P( NP)

65

66
Choice under uncertainty
Motivation:

Almost every choice involves elements of uncertainty.

Gamble 1:

If a coin comes up with a head, you win $100; if with a tail, you lose $1.
(0.5)($100) (0.5)($1)
with probability

and

Expected value (0.5)(100) (0.5)(1) $49.5

Gamble 2:

If a coin comes up with a head, you win $1000; if with a tail, you lose $10.
(0.5)($1000) (0.5)($10)
Expected value (0.5)(1000) (0.5)(10) $495

Gamble 3:

If a coin comes up with a head, you win $20,000; if with a tail, you lose $10,000.
(0.5)($20000) (0.5)($10000)
Expected value (0.5)(20000) (0.5)( 10000) $5000

In real world situations, most people will accept Gambles #1 and #2, but not #3. Given that the expected
value of Gamble #3 is larger than #2 and #3, we can conclude that people make their decisions not
according to expected value. An economic theory of choice among uncertain alternatives is established
to explain why. The formal theory was established by John von Neumann and Oskar Morgenstern. Its
central premise is that people choose the alternative that has the highest expected utility. The expected
utility of a gamble is the sum of the expected value of the utilities of each of its possible outcomes.

EU [ p(WA ) (1 p)(WB )] pU (WA ) (1 p)U (WB )

Example:
(A consumer who accepts Gamble #1 and #2, but not #3)
Let U M , M 0 10000
Gamble 1:

EU 0.5 10100 0.5 9999 (0.5)(100.498) (0.5)(99.99) 100.244 100

Gamble 2:

EU 0.5 11000 0.5 9990 (0.5)(104.88) (0.5)(99.95) 102.415 100

Gamble 3:

EU 0.5 30000 0.5 0 (0.5)(173.205) (0.5)(0) 86.6025 100 U (10000)

Definition:

A fair gamble is a gamble of which the expected value is equal to 0.

Definition:

A favorable gamble is a gamble of which the expected value is larger than 0.

Definition:

An unfavorable gamble is a gamble of which the expected value is less than 0.

Definition:

A risk-averse individual is an individual which will reject a fair gamble.

Definition:

A risk-lover is an individual which will accept a fair gamble.

Definition:

A risk-neutral individual is an individual which is indifference between accepting or

rejecting a fair gamble.

66

67
Consider a gamble p (G) (1 p) ( L) where EV p (G) (1 p) ( L) 0 (fair gamble)
i)

Consider an individual with a strictly concave utility function and an initial wealth W .
EU pU (W G ) (1 p)U (W L) U [ p (W G ) (1 p )(W L)] U (W )
the individual will reject the fair gamble risk averse individual

a risk-averse individual is one who has a strictly concave utility function

U (W )
U (W L)

U (W G)

EU pU (W G) (1 p)U (W L)

W L

ii)

W G

Consider an individual with a strictly convex utility function and an initial wealth W .
EU pU (W G ) (1 p)U (W L) U [ p(W G ) (1 p )(W L)] U (W )
the individual will accept the fair gamble risk-seeker or risk-lover

a risk-lover is one who has a strictly convex utility function

EU pU (W G) (1 p)U (W L)

U (W L)

U (W G)

U (W )

W L

W G

67

68
iii)

Consider an individual with a linear utility function and an initial wealth W .

EU pU (W G ) (1 p)U (W L) U [ p(W G ) (1 p )(W L)] U (W )
risk-neutral

U (W L)

U (W G)

U (W ) pU (W G) (1 p)U (W L)

W L

W G

68

69
Numerical example: Risk-averse individual (Decreasing MU)

U(M)
U(15000)
U(10000)

EU (0.5)U (5000) (0.5)U (15000)

U(5000)

M
5000

Example:

MCE

10000

15000

M 0 10000; p 0.5 winning $5000, 1 p 0.5 losing $5000; U (M ) M

EU (0.5) 15000 (0.5) 5000 (0.5)(122.47) (0.5)(70.71) 96.59

What is the maximum amount of money the individual is willing to pay in order to avoid facing
the gamble?
Let X be the amount.

10000 X 96.59 10000 X 9329.63 X 670.37

M CE 10000 670.37 $9329.63

M CE : Certainty Equivalent Income

For a risk-averse individual,

M CE W0 for a fair gamble, and
i)
M CE E (W ) E (W0 ) E (gamble) for other gambles
ii)

69

70
Numerical example: Risk-seeker/risk-lover (Increasing MU)

U(M)
U(15000)

EU (0.5)U (5000) 0.5U (15000)

U(10000)

U(5000)
M
5000

Example:

10000

M CE

15000

M 0 10000; p 0.5 winning $5000, 1 p 0.5 losing $5000; U (M ) M 2

EU (0.5)(15000)2 (0.5)(5000)2 (0.5)(225, 000, 000) (0.5)(25, 000, 000) 125, 000, 000
What is the minimum amount of money the individual is willing to accept in order to give up
facing the gamble?
Let X be the amount.

(10000 X )2 125, 000, 000 10000 X 11180.34 X 1180.34

M CE 10000 1180.34 $11180.34

For a risk lover,

M CE W0 for a fair gamble.
i)
ii)

M CE E (W ) E (W0 ) E (gamble) for other gambles

70

71
Numerical example: Risk-neutral (Constant MU)
U(M)
U(15000)

EU 0.5U (5000) 0.5U (15000)

U(10000)

U(5000)

M
5000

Example:

10000

15000

M 0 10000; p 0.5 winning $5000, 1 p 0.5 losing $5000; U ( M ) M

EU (0.5)(15000) (0.5)(5000) 10, 000 U (10000)

For a risk-neutral person,

M CE W0 for a fair gamble.
i)
ii)

M CE E (W ) E (W0 ) E (gamble) for other gambles

71

72
Example:

Insuring against bad outcomesReservation price of insurance

Suppose a risk-averse individual faces the prospect of a loss. What is the most a consumer would pay
for insurance against the loss?
Let W0 $10000 and U ( M ) M
no accident: loses $0
p 0.90
accident:
loses $5000 p 0.10

EU (0.9) 10000 0 (0.1) 10000 5000 (0.9)(100) (0.1)(70.711) 97.071

Let X be the most a consumer is willing to pay for the insurance against a loss.
Assume full coverage.
no accident:
accident:

final outcome 10000 0 X 10000 X

final outcome 10000 5000 X 5000 10000 X

p 0.90
p 0.10

10000 X 97.071 10000 X 9422.78 X $577.22

M CE $10000 $577.22 $9422.78

Note: After an insurance policy is purchased, the outcome will be the same regardless whether there is
an accident or not, i.e. the individual no longer faces uncertainty.
If I $577.22 is the actual price of the insurance policy, then the consumer will buy the policy
and get a consumer surplus $577.22 I .
Remark:

In the above example, we assume that the insurance company provides full coverage to a
risk-averse consumer which is not seen in the real world. There is always coinsurance or
deductible. This is due to the problem of Moral Hazard: the tendency whereby people
spend less effort protecting those goods that are insured against theft or damage. For
example, many people whose cars are insured will not take great care to prevent them
from being damaged or stolen.

Remark:

In insurance, there is also the problem of Adverse Selection: it is the process in which
undesirable members of a population of buyers or sellers are more likely to participate
in a voluntary exchange. For example, those who know that they are not good drivers
will buy insurance.

Because of this problem, insurance company usually tries to obtain as much information from a
potential policy holder as possible. For example, smokers have to pay higher life insurance
premium and younger drivers have to pay higher auto insurance premium.

72

73
Moral Hazard vs Adverse Selection
1.

In a model with adverse selection problem, one player knows some piece of information or
type, but the other player does not. This type is determined by nature, and cannot be affected by
either player. Adverse selection problems involve a hidden type.

2.

In a model with moral hazard problem, one player can take an action which is not observed by
the other player. Moral hazard problems involve a hidden action.

Example:
Consider a college hiring a new professor. The professor may spend 20 hours preparing one hour of
lecture or may not prepare at all for the lecture. In this case, the professor takes an action which is
hidden from the university. This is a moral hazard problem.
Example:
Consider the situation between a landlord and a tenant. Before the tenant moves into the apartment, she
knows whether she is a good tenant or a poor tenant. The tenant can take action which determines
whether she is a good tenant or bad tenant, but this action is hidden from the landlord. The
informational asymmetry between the two people involves a hidden action. This is a moral hazard
problem.
There is another moral hazard problem in this relationship. The landlord may be a very good or a very
bad landlord. The landlord has control over whether he is a good landlord or a bad landlord, but before
the tenant moves into the apartment, the tenant does not know whether the landlord is good or bad. In
this case, the hidden action is taken by the landlord.

Example:
Consider the case for a minivan salesman. The salesman knows whether the minivan is a high- or lowquality vehicle. But whether the minivan is a lemon or not was decided by nature, not by the salesman.
The type of the minivan is known by the salesman but is not known by the consumer. This is an
adverse selection problem, since it involves a hidden type.

73

74
Certainty equivalent adjustment factor ( )
Example:

M 0 10000; p 0.5 winning $5000, 1 p 0.5 losing $5000; U (M ) M

EU (0.5) 15000 (0.5) 5000 (0.5)(122.47) (0.5)(70.71) 96.59

What is the maximum amount of money the individual is willing to pay in order to avoid facing
the gamble?
Let X be the amount.

10000 X 96.59 10000 X 9329.63 X 670.37

M CE 10000 670.37 $9329.63

M CE
9329.63

0.9329
Expected wealth 10000

Example:

M 0 10000; p 0.5 winning $5000, 1 p 0.5 losing $5000; U ( M ) ln M

EU (0.5) ln(15000) (0.5) ln(5000) (0.5)(9.6158) (0.5)(8.5172) 9.0665

What is the maximum amount of money the individual is willing to pay in order to avoid facing
the gamble?
Let X be the amount.

ln(10000 X ) 9.0665 10000 X e9.0665 8660.26 X $1339.74

M CE 10000 1339.74 $8660.26

M CE
8660.26

0.866026
Expected wealth 10000

Note: Other things being equal, a smaller M CE will lead to a smaller . Hence, more risk-averse
individuals, who have smaller M CE , will have smaller certainty equivalent adjustment factor
.

74

75
Example:
Suppose a risk-averse consumer has an initial wealth of $10,000 (including a car which worth $5000 and
some jewelry which worth $4000). She estimates that her chance of getting into a car accident is 20%.
Assume that a car accident will destroy her car completely. To insure against the potential loss of her
car, she is willing to pay a maximum of $3000 for insurance premium.
Suppose the chance of her jewelry being stolen is 5%. What is the maximum amount of money she is
willing to pay for a theft insurance policy for the jewelry?
Solution:
For the car accident:
with an accident
20%
without an accident 80%

W $10000 $5000 $5000

W $10000

Expected wealth (0.2)($5000) (0.8)($10000) $9000

M CE
10000 3000 7000 7

Expected wealth
9000
9000 9

For the loss of jewelry:

stolen
5%
not stolen
95%

W $10000 $4000 $6000

W $10000

Expected wealth (0.05)($6000) (0.95)($10000) $9800

M CE
7
10000 X

9
Expected wealth
9800

7
X 10000 ( )(9800) $2377.78
9

75

76
Example:
Mary was suing a fast food restaurant for spilling hot coffee on her. She retained a law firm to file a
lawsuit in state court for $500,000 in damages. Prior to filing suit, the attorney estimated legal, expert
witness, and other litigation costs to be $2,000 for a fully litigated case, for which Mary had a 2%
chance of receiving a favorable judgment. Assume that a favorable judgment will award 100% of the
damage sought, whereas an unfavorable judgment will result in her receiving $0 damages award.
Assume that $5000 is the most Mary would be willing to pay to sue restaurant.
Calculate Marys certainty equivalent adjustment factor ( ) for this investment project.
cost of litigation

M CE
$5000
$5000

0.5
Expected wealth ($500, 000)(2%) ($0)(98%) $10000

Now assume that after Mary goes into court, incurring $1000 in litigation costs, a damaging testimony
by an expert witness dramatically changes the outlook of the case in the fast food restaurants favor.
Given that Mary now only has a 1% chance of obtaining a favorable judgment of the case, if the fast
food restaurant wants to settlement the case, how much out-of court settlement offer will Mary be
willing to accept?
M CE
M CE
M

CE 0.5
Expected wealth ($500, 000)(1%) ($0)(99%) 5000
M CE (0.5)(5000) $2500
Since she will save $1000 of litigation cost if she accepts the out-of-court settlement, so long as the fast
food restaurant pays her $1500, she will settle the case.

76

77
Taylor Expansion

f ( x) f ( x*) f '( x*)( x x*)

f ( x h) f ( x) f '( x)h

Example:
f ( x) e x

f "( x*)( x x*) 2

f n (a)( x x*) n
...
2!
n!

f "( x)h 2
f n (a)h n
...
2!
n!

a ( x, x*)

a ( x, x h )

Expand f ( x) e x around x* 0
f (0) 1

f '( x) e x

f '(0) 1

f ''( x) e x

f ''(0) 1

...

f ( x) f (0) f '(0)( x 0)

f ''(0)
f '''(0)
x 2 x3 x 4
( x 0) 2
( x 0)3 ... 1 x

...
2!
3!
2! 3! 4!

Example:
Expand f ( x) ln(1 x) around x* 0 .
f ( x) ln(1 x)
f '( x) (1 x)

f ''( x) 1(1 x)

f (0) 0
f '(0) 1

f ''(0) 1
3

f '''( x) (2)(1 x) =(2!)(1 x)

f '''(0) 2!

f 4 ( x) 2(3)(1 x) 4 = (3!)(1 x) 4

f 4 (0) 3!

f 5 ( x) (2)(3)(4)(1 x) 5 (4!)(1 x) 5

f 5 (0) 4!

...
f ''(0)
f '''(0)
( x 0) 2
( x 0)3 ...
2!
3!
2
3
4
(1) x
(2!) x
(3!) x
(4!) x5
x 2 x3 x 4 x5 x 6
f ( x) 0 x

... x

...
2!
3!
4!
5!
2
3
4
5
6
f ( x) f (0) f '(0)( x 0)

77

78
Definition:

Cost of risk (C ) expected value of a gamble MCE

EU pU ( M 0 ) (1 p )U ( M 1 )

M0

MCE

EValue

M1

cost of risk
N

U ( M C ) PU
(M i )
i

i 1, 2,..., N state of nature

i 1

LHS: U ( M C ) U ( M ) U '( M )C
N

RHS:

N
1
PU
(
M
)

Pi [U ( M ) U '( M )( M i M ) U "( M )( M i M ) 2 ]

i
i
2
i 1
i 1
N
N
1 N
PU
( M ) PU
'( M )( M i M ) PU
"( M )( M i M ) 2 ]
i
i
i
2 i 1
i 1
i 1

N
N
N
1
U ( M ) Pi U '( M ) Pi ( M i M ) U "( M ) Pi ( M i M ) 2
2
i 1
i 1
i 1
1
U ( M ) U '( M )(0) U "( M )Var ( M )
2
1
U ( M ) U "( M )Var ( M )
2
1
LHS and RHS U ( M ) U '( M )C U ( M ) U "( M )Var ( M )
2
1
U '( M )C U "( M )Var ( M )
2
Var ( M ) U "( M )
C
[
]
2
U '( M )
U "( M )
The cost of risk is proportional to the variance of M and
.
U '( M )

Note: The formula is not valid for large variances.

78

79
Var ( M ) U "( M )
C Var ( M ) U "( M ) M
[
]

[
]
2
U '( M )
M
U '( M )
2M 2
U "( M )

:
degree of absolute risk aversion
U '( M )
U "( M ) M

: degree of relative risk aversion

U '( M )

Example:

U "( M )
M 2
1

1
U '( M )
M
M

i)

U ( M ) ln M

ii)

1
M 2
U "( M )
1
U (M ) M
4 1
U '( M )
2M
1 2
M
2

1
2

1
1

a person with the utility function U ( M ) ln M is more risk averse than a person
M 2M
with the utility function U ( M ) M
Since

79

80
Definition:

Cost of risk (C ) expected value of a gamble MCE

U (M )
cost of risk
cost of risk

EU pU ( M 0 ) (1 p )U ( M 1 )

EU
M0' M0 MCE' MCE

EValue

M1

M1'

U (M )
cost of risk
cost of risk

EU pU ( M 0 ) (1 p )U ( M 1 )

M0 MCE' MCE

EValue

M1

80

81
Risk-pooling and risk-sharing
Example: (risk-pooling)
Suppose there is n individuals, all of whom face the same gamble. Each persons income is a random
variable y with a given distribution, including mean and variance, which is the same for all individuals.
Assume the distribution of each persons income is independent of the distribution of each other
persons income.
Suppose these individuals get together and pool their incomes, agreeing that each shall draw the average
income out of the pool.
y ... yn
y
Var ( y) Var ( y)
Var ( 1
) nVar ( ) n

n
n
n
n2
y1 ... yn
Var ( y )
lim Var (
)
0 Cost of risk 0 as n
n
n
n

Example:
Suppose a student is choosing between 2 colleges.
Great job: lifetime income $1, 000, 000

P1 0.5

College A:

College B:

Poor job: lifetime income $360, 000

P2 0.5

Adequate job: lifetime income $670, 000

P 1.0

Let U ( M ) M

EU ( A) 0.5 1000000 0.5 360000 800

EU ( B) 670000 818.54

and

Since EU ( B) EU ( A) , the student will choose college B.

Now suppose 1000 students who are facing this gamble sign a contract agree to attend College
A together and share their lifetime income with each other.
According to the Law of Large Number,
(500)(1, 000, 000) (500)(360, 000)
lifetime income
$680, 000 .
1000
In this case, the students will choose College A over College B.
Theorem:
The Law of Large Number is a statistical law that says that if an event happens
independently with probability p in each of N instances, the proportion of cases in which the event
occurs approaches p as N .

81

82
Example:

Joint ownership of business enterprise

When a new business starts, it may be successful and it may fail.

Let W0 $10000 and U ( M ) M .
Succeed:
earns $20000
Psucceed : 0.5

Fail:

loses $10000

Pfail :

0.5

EU (business) (0.5) 10000 20000 0.5 10000 10000 0.5 30000 0.5 0 86.603
EU (W0 ) 10000 100
Because EU (business) EU (W0 ) , therefore the business will not be pursued.
Suppose 100 persons form a joint ownership.
Succeed:
earns $200
Psucceed : 0.5

Fail:

loses $100

Pfail :

0.5

EU (business) (0.5) 10000 200 0.5 10000 100 0.5 10200 0.5 9900 100.247
Because EU (business) EU (W0 ) , therefore the business will be pursued.

82

83
Optimal choice under uncertainty
Example:
Suppose a person has $M of money. If she puts the money in the bank, she can get a return of 10% over
a period. If she buys an asset X, she has 50% of chance to get 50% of return and 50% chance to suffer
from a loss of 15%. Determine the portfolio of the consumer if her utility function is U ln W .
Let x be the amount of money put into the risky asset.

max EU EU {(0.5)[110%( M x) (150%)( x)] (0.5)[110%( M x) x(85%)]}

x

EU {(0.5)(1.1M 0.4 x) (0.5)(1.1M 0.25 x)}

(0.5)U (1.1M 0.4 x) (0.5)U (1.1M 0.25 x)
0.5ln(1.1M 0.4 x) 0.5ln(1.1M 0.25 x)
FOC:
dEU
(0.5)(0.4)
(0.5)(0.25)

0
dx
1.1M 0.4 x 1.1M 0.25 x
(0.5)(0.4)
(0.5)(0.25)

1.1M 0.4 x 1.1M 0.25 x

(0.2)
(0.125)

1.1M 0.4 x 1.1M 0.25 x

(0.2)(1.1M 0.25 x) (0.125)(1.1M 0.4 x )

0.22M 0.05 x 0.1375M 0.05 x

0.22M 0.1375M 0.05 x 0.05 x
0.0825M 0.1x

x 0.0825

0.825 82.5%
M
0.1

83

84
Example:
Suppose a person has $M of money. If she puts the money in the bank, she can get a return of 10% over
a period. If she buys an asset X, she has 50% of chance to get 50% of return and 50% chance to suffer
from a loss of 80%. Determine the portfolio of the consumer if her utility function is U ln W .
Let x be the amount of money put into the risky asset.

max EU EU {(0.5)[110%( M x) (150%)( x)] (0.5)[110%( M x) x(20%)]}

x

EU {(0.5)(1.1M 0.4 x) (0.5)(1.1M 0.9 x)}

(0.5)U (1.1M 0.4 x) (0.5)U (1.1M 0.9 x)
0.5ln(1.1M 0.4 x) 0.5 ln(1.1M 0.9 x)
dEU
(0.5)(0.4)
(0.5)( 0.9)

0
dx
1.1M 0.4 x 1.1M 0.9 x
(0.5)(0.4)
(0.5)(0.9)
(0.2)
(0.45)

1.1M 0.4 x 1.1M 0.9 x

1.1M 0.4 x 1.1M 0.9 x
(0.2)(1.1M 0.9 x) (0.45)(1.1M 0.4 x)

FOC:

0.22M 0.18 x 0.495M 0.18 x 0.22M 0.495M 0.18 x 0.18 x

x 0.275

0.764
M
0.36
The person is not going to put any money in the risky asset.
0.275M 0.36 x

Using the Kuhn-Tucker Technique

max EU 0.5ln(1.1M 0.4 x) 0.5ln(1.1M 0.9 x)
x

s.t. 0 x M

L 0.5ln(1.1M 0.4 x) 0.5ln(1.1M 0.9 x) w1 x w2 (M x)

Kuhn-Tucker conditions:
(0.5)(0.4)
(0.5)(0.9)
Lx

w1 w2 0
1.1M 0.4 x 1.1M 0.9 x
x 0, w1 0, xw1 0

(2)

1 x 0, w2 0, ( M x) w2 0

(3)

(1)

Case 1:
w1 0
(2) : w1 0 x 0
(3) w2 0
0.5 0.4 0.5 (0.9)
0.25
(1) : x 0

w1 0 w1
0 (consistent)
1.1M
1.1M
1.1M

84

85
Case 2:
w2 0
(3) : w2 0 M x 0 x M
(2) w1 0
0.5 0.4
0.5 (0.9)
(1) : x 1

w2 0
1.1M 0.4M 1.1M 0.9M
0.2
0.45 0.2(0.2 M ) 0.45(1.5M ) 0.04 M 0.675M
w2

1.5M 0.2M
0.3M
0.3M
0.635
w2
0
0.3
(inconsistent)
Hence x 0 is the solution.

85

86
Example:

Demand for insurance

Suppose a risk-averse consumer initially has monetary value $W . There is a probability p that he will
lose an amount $L . The consumer can however purchase insurance that will compensate him in the
event that he incurs the loss. The premium he has to pay for C of coverage is C . How much
coverage will the consumer purchase?

max EU{ p [W L C C ] (1 p) [W C ]} pU [W L C C ] (1 p)U [W C ]

C

FOC:
dEU
p(1 )U '[W L C C ] (1 p)( )U '[W C ] 0
dC
U '[W L C C ] (1 p)

(1)
U '[W C ]
p(1 )
If the event occurs, the insurance company receives $( C C ) .
If the event does not occur, the insurance company receives $ C .
In a competitive market, the expected profit should be equal to 0 (assuming no administrative cost),
therefore E ( profit ) p( C C ) (1 p) C p(1 )C (1 p) C 0 p(1 ) (1 p) .

U '[W L C C ] (1 p)

1
U '[W C ]
p(1 )
U '[W L C C ] U '[W C ]
(1)

Since U " 0 W L C C W C
C* L
Note that the optimal amount of compensation is not related to W .
If the expected profit has to be positive (in order to cover administrative cost), then
E ( profit ) p( C C ) (1 p) C 0
(1 p) C p(1 )C or (1 p) p(1 )
U '[W L C C ] (1 p)
(1)

1
U '[W C ]
p(1 )

U '[W L C C ] U '[W C ]
Since U " 0 W L C C W C C* L

86

87
Example:

Demand for insurance with Moral Hazard

Now suppose the consumer has some control over the probability of the event in question.
Let X denotes the level of care exercised by the consumer. We assume that the probability that the
accident will occur is a function of the level of care, i.e. p p( X ) where p '( X ) 0 . (i.e. being more
careful will lead to a small probability of having an accident)
However, there is cost involved in being careful. Let us assume that this cost can be represented in
terms of utility so that U (W , X ) U (W ) H ( X ) where H '( X ) 0 .

max EU { p( X ) [W L C C ] [1 p( X )] [W C ]} H ( X )
X ,C

p( X )U [W L C C ] [1 p( X )]U [W C ]} H ( X )
FOC:
EU
p( X )(1 )U '[W L C C ] [1 p ( X )] U '[W C ] 0
C
EU
p '( X ) U [W L C C ] p '( X ) U [W C ] H '( X ) 0
x

(1)
(2)

Case 1:
C* L (full coverage)
(2) p '( X ) U [W L C C ] p '( X ) U [W C ] H '( X ) 0

p '( X ) U [W C ] p '( X ) U [W C ] H '( X ) 0

H '( x) 0

(contradiction)

Case 2:
C* L (over-insured)
(2) p '( X ) U [W L C C ] p '( X ) U [W C ] H '( X ) 0

p '( X ){ U [W L C C ] U [W C ]} H '( X )
( )

()

( )

(inconsistent)

Since both case 1 and case 2 are impossible, we must have C* L (with deductible).
Case 3:
C* L (with deductible)
C* L W L C * C* W C *
U '[W L C * C*] U '[W C*]
U '[W L C C ] (1 p )

1
U '[W C ]
p (1 )
(1 p) p(1 )

(1 p) C p(1 )C
E ( profit ) p(1 )C (1 p) C 0

87

88
Allocation of wealth to risky assets
Suppose an individual has initial wealth W , which is to be divided between a safe asset whose rate of
return is 0 and a risky asset whose rate of return is a random variable R .
If he or she invests $x in the risky asset, final wealth will be (W x) x(1 R) W xR .
Problem:

max E[U (W xR)]

x

U (W xR) f ( R)dR

FOC:

dE[U (W xR )]

dx

d U (W xR ) f ( R )dR

dx

dU (W xR )
f ( R)dR
dx

U '(W xR) Rf ( R)dR E[U '(W xR) R] 0

(1)

SOC:

dE 2 [U (W xR)]

dx 2

d U '(W xR ) Rf ( R )dR

dx

U ''(W xR) R

f ( R )dR

E[U "(W xR) R 2 ] 0 ( U " 0 for a risk-averse individual)

(2)

The FOC defines the amount of investment in the risky asset as a function of initial wealth, x x *(W ).

(1) E[U '(W xR ) R ] E{U '[W x *(W ) R ]R} U '[W x *(W ) R]Rf ( R)dR 0

(3)

Differentiating (3) with respect to W , we have

dE{U '[W x *(W ) R]R}

dW

d U '[W x *(W ) R ]Rf ( R )dR

dW

dU '[W x *(W ) R ]
Rf ( R)dR
dW

U "[W x *(W ) R][1 x *'(W ) R ]Rf ( R )dR E{U "[W x *(W ) R ][1 x *'(W ) R ]R}

E{U "[W x * R]R} E{U "[W x * R]R 2 x *'(W )} 0

E[U "(W xR) R]
x * '(W )
E[U "(W xR) R 2 ]

Since the denominator is negative, sign{x *'(W )} sign{E[U "(W xR) R]}

88

(4)

89
When absolute risk aversion is decreasing, we have
U "(W xR) U "(W )

U '(W xR)
U '(W )
U "(W xR) U "(W )

U '(W xR)
U '(W )

for R 0

(5)

for R 0

(6)

Multiply (5) by U '(W xR) R

[0

R 0]

Multiply (6) by U '(W xR) R

[0

R 0]

U "(W xR ) R

U "(W )
U '(W xR ) R
U '(W )

Taking expectation on both sides E{U "(W xR) R}

(4) x * '(W )

U "(W )
E{U '(W xR) R} 0
U '(W )

by FOC

E[U "(W xR ) R ]
0
E[U "(W xR ) R 2 ]

If absolute risk aversion is decreasing in wealth, a rise in wealth will raise the amount of
investment in risky assets.

89

90
Numerical example:
First order condition of the asset allocation problem: E[U '(W xR) R] 0
Let

i)
ii)

1
U (W ) W W 2 U '(W ) W
2
1
f ( R)
for a R b (uniform distribution)
ba
b

E[U '(W xR) R] 0 U '(W xR) Rf ( R)dR 0

a
b

[ (W xR)]R(
a

1
)dR 0
ba

[( W ) R xR 2 ]dR 0

ba a
b

R2
R3
[( W )
x ] 0
2
3 a
b2
b3
a2
a3
[( W ) x ] [( W ) x ] 0
2
3
2
3
( W ) 2

(b a 2 ) (b3 a 3 ) x 0
2
3
( W ) 2
(b a 2 )
3( W )(b a)(b a) 3( W )(b a )
2
x*

0
3
2 (b a)(b 2 ab a 2 ) 2 (b 2 ab a 2 )
3
(b a )
3
x *
3 (b a )
3(b a )

0
2
2
W 2 (b ab a ) 2(b 2 ab a 2 )
Higher wealth leads to a smaller x !!

U"

U'
W W
U "
as W
absolute risk aversion is increasing in W
U'

Note that

90

if W is not too large

91
Example:

Allocation among different assets

Two assets: e1 and e2

W : inital wealth
x : the portion of wealth allocated to e1

max E{U [Wxe1 W (1 x)e2 ]}

x

FOC:

dEU
dU
E{ } E{U '[Wxe1 W (1 x)e2 ](We1 We2 )} E{U '[Wxe1 W (1 x)e2 ](e1 e2 )} 0
dx
dx

1
Let U (W ) aW bW 2 [U '(W ) a bW ]
2

quadratic utility function

E{[a b[Wxe1 W (1 x)e2 ](e1 e2 )} 0

E{ae1 ae2 bWxe1 bWxe1e2 bW (1 x)e1e2 bW (1 x )e2 } 0
2

aE (e1 ) aE (e2 ) bWxE (e1 ) bWxE (e1e2 ) bW (1 x) E (e1e2 ) bW (1 x) E (e2 ) 0

2

aE (e1 ) aE (e2 ) bWxE (e1 ) bWxE (e1e2 ) bWE (e1e2 ) bWxE (e1e2 ) bWE (e2 ) bWxE (e2 ) 0
2

aE (e1 ) aE (e2 ) bWE (e1e2 ) bWE (e2 ) x[bWE (e1 ) bWE (e1e2 ) bWE (e1e2 ) bWE (e2 )]
2

aE (e1 ) aE (e2 ) bWE (e1e2 ) bWE (e2 )

2
2
bWE (e1 ) 2bWE (e1e2 ) bWE (e2 )
2

Note that
E (e1 ) : mean of e1
E (e2 ) : mean of e2
E (e1 ) var(e1 ) [ E (e1 )]2 var(e1 ) E[e1 E (e1 )]2 E{e1 2e1 E (e1 ) [ E (e1 )]2 }
2

E (e1 ) 2[ E (e1 )]2 [ E (e1 )]2 =E (e1 ) [ E (e1 )]2

2

E (e2 ) var(e2 ) [ E (e2 )]2

2

E (e1e2 ) cov(e1 , e2 ) E (e1 ) E (e2 ) cov(e1 , e2 ) E[(e1 E (e1 ))(e2 E (e2 ))]
aE (e1 ) aE (e2 ) bWE (e1e2 ) bWE (e2 )
2
2
bWE (e1 ) 2bWE (e1e2 ) bWE (e2 )
2

aE (e1 ) aE (e2 ) bW [cov(e1 , e2 ) E (e1 ) E (e2 )] bW {var(e2 ) [ E (e2 )]2 }

bW {var(e1 ) [ E (e1 )]2 } 2bW [cov(e1 , e2 ) E (e1 ) E (e2 )] BW {var(e2 ) [ E (e2 )]2 }

91

92
Mean-Variance Analysis and Portfolio Selection
Traditionally the investors are assumed to care about only the mean and variance of his income.
This is true only under the following situations.
i)

The utility function is quadratic

U ( M ) a bM cM 2

b, c 0

E[U ( M )] a bE ( M ) cE ( M 2 ) a bE ( M ) c{[ E ( M )]2 var( M )}

Counter-example:
If U ( M ) a bM cM 2 dM 3

b, c, d 0

then E[U ( M )] a bE (M ) cE (M ) dE (M 3 ) a bE (M ) c{[ E (M )]2 var(M )} dE (M 3 )

2

i.e. the investor will care more than the mean and variance of the risky asset

Drawbacks of having a quadratic utility function:

1)
When M is very large, marginal utility 0 .
2)
If there is only 1 risky asset and one safe one, the investor will hold less of the risky asset when
he becomes richer.
[In the real world, the rich tends to hold riskier and higher yielding portfolios than the poor.]
Proof:
Suppose there are 2 assets each costing $1 per unit and the income yielded by each (per unit) is as
follows ($): Asset A:
M A for sure
Asset B:

M B with mean M B and variance var(M B )

The individual has wealth $W and spends x on the risky asset and W x on the safe asset.
Individual's problem:
max E{U [(W x)M A xM B ]}
x

Assume a quadratic utility function, we have

E[U ( M )] a bE ( M ) cE ( M 2 ) a bE ( M ) c{[ E ( M )]2 var( M )}

Given that M (W x) M A xM B E (M ) (W x)M A xM B and var(M ) x 2 var(M B )

92

93

max E{U [(W x)M A xM B ]} a b[(W x)M A xM B ] c[(W x)M A xM B ]2 cx 2 var(M B )

x

a b(W x)M A bxM B c[(W x)M A xM B ]2 cx 2 var(M B )

FOC:

dEU
bM A bM B 2c[(W x) M A xM B ]( M A M B ) 2cx var( M B ) 0
dx
Since each unit of the 2 assets costs $1 each and B is risky, hence M B M A 0 .
dEU
b( M B M A ) 2c[(W x) M A xM B ]( M B M A ) 2cx var( M B ) 0
dx
b( M B M A ) 2cWM A ( M B M A ) 2cxM A ( M B M A ) 2 xcM B ( M B M A ) 2cx var( M B ) 0
x

ii)

2cWM A ( M B M A ) b( M B M A )
2c{M A ( M B M A ) M B ( M B M A ) var( M B )}

2cM A ( M B M A )
M A (M B M A )
dx

0
dW 2c{M A ( M B M A ) M B ( M B M A ) var( M B )}
( M B M A ) 2 var( M B )

Each security in the portfolio has a normal distribution

Suppose the ith security N ( i , i 2 ) and cov( X i , X j ) ij
n

Let ai be the number of shares of security i, then

ai X i
i 1

N ( ai i , ai a j ij )
i 1

Hence an investor only needs to know the mean and variance of the portfolio!!

93

94
Proposition: Mutual Fund Separation Theorem
If there is a riskless asset and conditions i) and/or ii) are satisfied and all investors have the same
subjective probability distributions, then investors will differ in the amount of wealth they hold in risky
assets, but they will not differ in the fraction of that risky wealth devoted to each particular risky asset.
Proof:
Suppose there are only 2 available securities x and z . Each is perfectly divisible, and 1 unit of each will
cost the investor all his wealth. Assume X N (X , X2 )
Z N (Z , Z2 )

[We can expect the market to ensure that the riskier security has a higher mean return.]
Now suppose the investor puts half his wealth into each ( x and z ).
1
1
X Z
2
2
x
z
x z
x
z
x z
1
1
1 1
2 Var (
) Var ( ) Var ( ) Var ( ) 2Cov( , ) ( ) 2 X2 ( ) 2 Z2 2( )( ) XZ
2
2 2
2
2
2 2
2
2
2 2

Provided x and z are not perfectly and positively correlated, we have XZ XZ 1

X Z
1
1
1 1
1
1
1 1
1
1
2 ( ) 2 X2 ( ) 2 Z2 2( )( ) XZ ( ) 2 X2 ( ) 2 Z2 2( )( ) X Z ( X Z ) 2
2
2
2 2
2
2
2 2
2
2
1
1
X Z
2
2

1
2

(Z X )
mean-variance frontier: 2 assets

1
2

X Z
2

The above exercise shows that the mean-variance frontier is a concave curve.

94

95

mean-variance frontier

Now suppose there is a riskless asset R yielding an income OR for sure if all the investors wealth is
invested in that asset.
Now, let the investor combines the riskless asset R with a risky asset. Clearly, any risky asset along the
line RS will be dominated by the line RP . (same , lower ; same , higher )
Together with the ICs, the optimal asset allocation is determined. Notice that no matter where the ICs
are, the point P is in the same position, i.e. the portfolio of risky assets remains the same.
This person will put less money in
the risk-free asset.
Z

This person
will put
more money
in the riskfree asset.

E
X
E
mean-variance frontier
R

Among the money

these 2 individuals put
in the risky assets, the
ratio of asset X and
asset Z will be the
same.

95

96
Increasing Risk (Rothschild and Stiglitz)
Question:

What is a random variable Y more variable, riskier, more uncertain than another
random variable X ?

4 possible answers:
1.

Y is equal to X plus noise

YX Z
d

E (Z | X ) 0 for all X

has the distribution as

p 1.
with probability p , p 1 where b

Suppose X is a lottery which pays off ai with probability pi ,

Then Y is a lottery ticket which pays off bi

is either a sure

payoff of ai or a lottery ticket which has an expected value equals to ai .

Note that X and Y have the same mean.

2.

Every risk-averse individual prefers X to Y ( X and Y have the same mean)

EU ( X ) EU (Y )
i.e.

3.

concave U

U ( X ) f ( X )dX U (Y ) g (Y )dY

Y has more weight in the tails than X

f(x)

s(x)
mean preserving spread (MPS

g(x)=f(x)+s(x)

96

97
4.

Y has a greater variance than X

Var (Y ) Var ( X ),

Definition:

E ( X ) E (Y )

A partial ordering p on a set is a binary, transitive, reflexive and anti-symmetric relation

if A p B and B p A A B .

Definition of a :

X is less risky than Y if Y X Z

d

Definition of I :

F I G iff G F Si where Si is MPS .

Definition of U :

F U G iff for any bounded concave function, U ( X )dF ( X ) U ( X )dG( X )

i 1

Theorem:

a , I , U are partial orderings .

Theorem:

F I G

Theorem:

V is a complete ordering but it is not equivalent to the other 3.

Definition:

A relation P is a binary relation.

Definition:

A relation P is transitive if A P B and B P C A P C .

Definition:

A relation P is reflective if A P A .

Definition:

A relation P is antisymmetric if A P B and B P A A B .

Definition:
relation.

A partial ordering P on a set is a binary, transitive, reflexive and antisymmetric

Definition:

A complete ordering P on a set is a partial ordering where given any

F a G

F U G

A and B, either A P B or B P A .

97

98
Effect of increasing risk on the optimal solution
max EU ( X , ) U ( X , )dF ( X )

X : uncertainty

FOC:

dEU d U ( X , )dF ( X )
dU ( X , )

dF ( X ) U ( X , )dF ( X ) EU ( X , ) 0
d
d
d
Let * be the unique soltution to the FOC .
Assume that in the neighborhood of * , U is montonic decreasing in .
Proposition: If U ( X , ) is a concave function of X , an increase in riskiness will decrease * .
Proof:
a)
b)

Risk EU ( X , ) (because U is a concave function)

In order to restore the FOC, then has to be lowered as U is montonic decreasing in .

Proposition: If U ( X , ) is a convex function of X , an increase in riskiness will increase * .

98

99
Example:

Savings and uncertainty

Initial wealth: W0
Each $ saved today yields the random return e .

max E[U (C1 ) (1 )U (C2 )] U [(1 s)W0 ] (1 ) EU (sW0 e)

s

: discount rate

FOC:
dEU
W0U '[(1 s )W0 ] (1 ) E[U '( sW0 e)eW0 ]
ds
W0U '[(1 s)W0 ] (1 ) E[U '( sW0 e)e]W0 0

U '[(1 s)W0 ] (1 ) E[U '( sW0 e)e]

b
Let U (C ) aC C 2 U '(C ) a bC
2
U '[(1 s)W0 ] (1 ) E[U '( sW0 e)e]
a b[(1 s)W0 ] (1 ) E{[a b( sW0 e)]e}

a b[(1 s)W0 ] (1 )[aE(e) bsW0 E(e2 )]

a bW0 bsW0 (1 )aE (e) (1 )bW0 E (e 2 ) s
a bW0 (1 )aE (e) [(1 )bW0 E (e 2 ) bW0 ]s
s

a bW0 (1 )aE (e)

[(1 )bW0 E (e 2 ) bW0 ]

U ( X , )

risk E (e2 ) s

U ( sW0e)
s

The above result is not general.

U ( X , )

X e; s

U '( sW0 e)W0e

Whether risk s or depends on whether eU '(sW0 e) is a concave function or a convex function

in e .
Note:
eU '( sW0 e) is a concave function in e
i)

d 2 [eU '( sW0e)] d [U '( sW0e) eU "( sW0e)( sW0 )]

de2
de
2
U "( sW0e) sW0 e( sW0 ) U '''( sW0e) U "( sW0e) sW0
sW0 [2U "( sW0 e) esW0U '''( sW0 e)]

ii)

sW0 [2U "(C ) CU '''(C )] 0

eU '( sW0 e) is a convex function [2U "(C ) CU '''(C )] 0

99

(1)
(2)

100
iii)
iv)

A non-positive third derivative is sufficient for increasing risk leading to decrease savings.
U "C
Arrow-Pratt concept of relative risk aversion: R
U'
U '(U " CU ''') U " CU "
R'
(U ') 2
1
U " CU "
R ' [(U " CU ''')
]
U'
U'
1
CU "
1
R ' [U "(1
) CU '''] [U "(1 R) CU ''']
U'
U'
U'
sign( R ') sign{ [U "(1 R) CU ''']}
If R is non-increasing (R ' 0) and R 1 (2) holds .

R ' 0 U "(1 R ) CU "' 0

Since U " 0 (risk averse), R 1 0 U "(1 R ) CU "' 2U " CU "'

If R is non-decreasing ( R ' 0 ) and R 1 (1) holds .

R ' 0 U "(1 R ) CU "' 0
Since U " 0 (risk averse), R 1 0 U "(1 R ) CU "' 2U " CU "'

Example:

U (W ) (1 a)W 1a
U '(W ) (1 a) W
2

(a 0, a 1)

U "(W ) a(1 a) 2 W a 1

U "C
[a(1 a) 2 W a 1 ]W

a constant relative risk aversion

U'
(1 a) 2 W a

If a 1 (R 1)

risk savings .

If a 1 ( R 1)

risk savings .

100

101
Bayesian Economics
Varian, Hal (1986): Retail Pricing and Clearance Sales, American Economic Review, March, pp.1432.
One-period model
Assume a risk-neutral firm which will encounter 1 and only 1 buyer whose reservation price is V .
Prior knowledge about V : f (V ) density function, F (V ) distribution function

max P[1 F ( P)] (0) F ( P)

The consumer will buy the

good only if P V !!

Probability that the

reservation price is P

F (V )
Probability that the reservation
price is P

1
F ( P1 )

FOC: P[ F '( P)] [1 F ( P)] Pf ( P) [1 F ( P)] 0

1 F ( P)
P
f ( P)

f (V )

P1

Example:
Let

1
f (V )
0
V
F (V )
1

0 V 1

uniform distribution on [0,1]

otherwise
0 V 1
1V

FOC: P(1) (1 P) 0 1 2 P 0 P*
Expected profit

1
2

1
1 1
(1 )
2
2 4

101

102
Two-period model
Assume if the good is not sold during the period, the seller faces another buyer during the second period
who is identical to the one he met during the first period.
The firm now has 2 chances to sell the good.
Failing to sell the good in period 1 at price P1 provides the seller information about the reservation price
V of the consumer. In this case, this implies that V P1 . It is because if V P1 , the good would have
been sold.
Prior distribution:

1
f (V )
0

0 V 1

uniform distribution on [0,1]

otherwise

Posterior distribution:
g (sold|V ) f (V )
f (V | sold)
g (sold|z ) f ( z )dz

f (V | unsold)

P( A | B)

P( B | A) P( A)
P( B | A) P( A) P( B | AC ) P( AC )

g (unsold|V ) f (V )

g (unsold|z ) f ( z )dz

1
g (sold|V )
0
0
g (unsold|V )
1

for P1 V
P1 : price charged in period 1

for P1 V
for P1 V
for P1 V

f (V )
1
(1) f (V )

f (V | sold) P (1) f ( z )dz 1 F ( P1 ) 1 P1

1

f (V | unsold) (1) f (V ) f (V ) 1
P1 (1) f ( z )dz F ( P1 ) P1
0
or
F (V ) F ( P1 ) V P1

1 P1
F (V | sold) 1 F ( P1 )
0

F (V | unsold) F (V ) V
F (P ) = P

1
1

for P1 V
for V P1

for P1 V
for V P1

for P1 V
for V P1
for P1 V
for V P1

102

U (0,1)

103
The choice of P1 affects the problem in 2 ways:
1.
It affects the probability of a sale in period 1.
2.
It determines what the firm can infer from no sale. For example, if P1 1 , then the fact that the
good was not sold in the first period is uninformative, because the firm was certain that V 1 at
the outset.
Similarly, P1 0 is certain to result in a sale during the first period so that there is no learning
resulted.

max P1[1 F ( P1 )] F ( P1 )[1 F2 ( P2 )]P2

P1 , P2

probability
that the good
is sold in
period 1

(1)

probability that
the good is not
sold in period 1

probability that the good is sold

in period 2

It is instructive to think of this as a dynamic programming and to consider the firms optimal strategy in
period 2, given that the good is not sold in period 1 at the price P1 .

103

104
Firms problem in period 2
max P2 [1 F2 ( P2 )]

Note that the firm will face this

problem only when the good is not
sold in period 1!

P2

f 2 ( P2 ) f ( P2 )
F (P )

if P1 P2
if P1 P2

if P1 P2
1

F2 ( P2 ) F ( P2 )
if P1 P2
F (P )

1
FOC:
P2 [ F2 '( P2 )] [1 F2 ( P2 )] P2 f 2 ( P2 ) [1 F2 ( P2 )] 0
P2

f ( P2 )
F ( P2 )
1
0
F ( P1 )
F ( P1 )

P2 [1

F ( P2 ) F ( P1 ) F ( P1 ) F ( P2 )
]

F ( P1 ) f ( P2 )
f ( P2 )

Since P2 0 F ( P1 ) F ( P2 ) 0 P1 P2
If V

U (0,1) P2

a clearance sale is being held

P1 P2
P
2 P2 P1 P2 1
1
2

Note:
1.
For any given P1 , if the good is not sold during the first period, then the seller can rule out the
probability that V P1 .
2.
The distribution that the seller uses in period 2 is U (0, P1 ) , so the second periods problem is
equivalent to the one facing a firm with only 1 period to sell and a prior distribution of uniform
P
distribution. The solution to that problem is to select P2 1 .
2

104

105

P2

P1
(1)
2

max P1[1 F ( P1 )] F ( P1 )[1 F2 ( P2 )]P2

P1 , P2

(1)

P1
P1
F 2 P

P
P2
3P 2

max P1 [1 F ( P1 )] F ( P1 ) 1 1 P1 (1 P1 ) P1 1 2 1 P1 (1 P1 ) 1 P1 1
P1
F ( P1 ) 2
4
4

P1 2

FOC:
P 1
d
3
2
1 P1 0 P1
P2 1
dP1
2
3
2 3
2
Expected profit
3
Results:
1.
Price falls over time.
2.
Expected profit is higher.

Deficiencies of the above analysis: 2 important factors are not included.

1.

The number of customers who come into the store during the first period.
Intuitively, if only a few customers arrive during the first period, the firm should be less certain
about its influence than if a large number of customers examine the good and reject it at price P1 .

2.

Heterogeneity among consumers may be important.

If some consumers are willing to pay V , while others will pay an amount below the firms
reservation price, then the problem is more complicated.
The good might not be sold not because the price was too high, but because that periods
customers were all of wrong type.

105

106
The Risk-Bearing Premium
Suppose there are only 2 states of the world, s 1, 2 . In the state-claim space, the axes indicate
amounts of the contingent income claims C1 and C2 .
In a simplified 2-state world,

EU U q1U (C1 ) q2U (C2 )

where q1 q2 1

qi is the probability that state i happens

For a given level of U , this equation describes an entire set of C1 and C2 combinations that are equally
preferred, so this is the equation of an indifference curve.

C2

certainty

MRS slope of IC

line

(C1 , C 2 )

dC2
dC1

U constant

q1U '(C1 )
q2U '(C2 )

dMRS
d ln MRS
) sign(
)
dC1
dC1
d ln MRS d [ln q1 ln U '(C1 ) ln q2 ln U '(C2 )

dC1
dC1

sign(

LL line

(C1 , C2 )

45

U "(C1 ) U "(C2 ) dC2

U '(C1 ) U '(C2 ) dC1

U "(C1 ) U "(C2 ) q1U '(C1 )

0
U '(C1 ) U '(C2 ) q2U '(C2 )

if U " 0

C1
the certainty line connects all the points such that C1 C2
For any indifference curve, as it crosses the certainty line, it has slope

q1
as C1 C2 .
q2

A risk-adverse individual will prefer an income with certainty

The dashed line (LL line) through the point (C1 , C2 ) shows all the (C1 , C2 ) having the same expected
income as the point (C1 , C2 ) : q1C1 q2C2 q1C1 q2C2 c
q
Along the dashed line, the maximum utility is at the point (C1 , C 2 ) as the slope of the dashed line is 1
q2

which is the same as the indifference curve at the point (C1 , C 2 ) .

Thus the certainty of having income c is preferred to any other (C1 , C2 ) combination whose
mathematical expectation is c .
106

107
Contingent Claim Markets
Suppose an individual is a price-taker in a market where contingent income claims (C1 , C2 ) --each of
which offers income if and only if the corresponding state obtains -- can be exchanged in accordance
with the price ratio P1 P2 . The budget line NN goes through the endowment point (C1 , C2 ) .
The equation for the budget line NN: PC
1 1 P2C2 PC
1 1 P2C2
Expected utility is maximized at the point C * . At C * ,

C2

q1U '(C1 ) P1
.
q2U '(C2 ) P2

certainty line

NN line (slope=

P1

P2

(C , C )
1

C*
45

C1
The quantities of state-claims income held are such that
ratio of the probability-weighted marginal utilities ratio of the state-claim prices
In a S states situation, we have

q U '(Cn )
q1U '(C1 ) q2U '(C2 )

... n
P1
P2
Pn

Assuming an interior solution, at the individual's risk-bearing optimum the expected (probabilityweighted) marginal utility per dollar of income will be equal in each and every state.

107

108
Remark:
1. Starting from a certainty position, a risk-averse individual would never accept any gamble at fair
odds.

C2

certainty
line
( C1 *, C2 * )

LL line

45

(C1 , C2 )

C1
2.

If his initial endowment were not a certainty position, when offered the opportunity to transact at
a price ratio corresponding to fair odds he would want to "insure" by moving to a certainty
position-as indicated by the solution C along the fair market line LL.

C2

certainty
line

(C1 , C 2 )
LL line

(C1 , C2 )

45

C1
Thus an individual with an uncertain endowment might accept a "gamble" in the form of a risky contract
offering contingent income in one state in exchange for income in another. But he would accept only
very particular risky contracts, those that offset the riskiness of his endowed gamble.

108

109
3.

If the market price did not represent fair odds, as in the case of market line NN, whether or not
he starts from a certainty endowment the individual would accept some risk; his tangency
optimum would lie off the 45 line at a point like C * in the direction of the favorable odds.

C2

certainty line

NN line (slope=

P1

P2
(C , C )
1

C*
45

C1
C2

certainty
line

is on the certainty line

NN line is flatter than LL line
NN line

C*

45

(C1 , C2 )

C1
C2

certainty
line

C*

is on the certainty line

NN line is steeper than LL line

NN line

45

(C1 , C2 )

C1

109

110
Wealth effect
increasing
tolerance for
absolute risk

C2

decreasing tolerance
for absolute risk
In E3, all the points are closer to the
45 line than does C * . The
individual reduces his absolute
consumption risk.

D
B
45 certainty line

C **

E1

In E1 and E2, his "tolerance" for

absolute risk must be increasing with
wealth.

E2
E3

C*

A solution along the dividing line

C * B would represent constant
tolerance for absolute risk.
C

C'

market
lines

C1

110

111
Insurance Market
(Rothschild, Michael and Joseph Stiglitz: Equilibrium in Competitive Insurance Markets: An Essay on
the Economics of Imperfect Information)
Consider an individual who will have an income of W if he is lucky enough to avoid accident. In the
event an accident occurs, his income will be only W L . The individual can insure himself against this
accident by paying to an insurance company a premium 1 , in return he will be paid 2 if an accident
occurs. Without insurance his income in the 2 states, "accident", "no accident", was (W , W L) ; with
insurance it is now (W 1 , W L 2 ) , where 2 2 1 .
The vector (1 ,2 ) completely describes the insurance contract.

Demand for insurance contracts

V (q,W1 ,W2 ) (1 q)U (W1 ) qU (W2 )

q : probability of an accident

W1 : his income if there is no accident

W2 : his income if there is accident
A contract is worth V (q, ) V (q, W 1 , W L 2 ) .
From all the contracts the individual is offered, he chooses the one that maximizes V (q, ) . Since he
always has the option of buying no insurance, an individual will purchase a contract only if
V (q, ) V (q, 0) V (q, W , W L) .
We assume that persons are identical in all respects except their probability of having an accident and
that they are risk-averse.

Supply of Insurance Contracts

We assume that companies are risk-neutral, that they are concerned with expected profits, so that
contract when sold to an individual who has a probability of incurring an accident of q , is worth
(q, ) (1 q)1 q 2 1 q(1 2 )
Any contract with non-negative expected profit will be offered.

Definition of Equilibrium
Equilibrium in a competitive insurance market is a set of contracts such that, when customers choose
contracts to maximize expected utility,
(i)
no contract in the equilibrium set makes negative expected profits; and
(ii)
there is no contract outside the equilibrium set that, if offered, will make a non-negative profit.

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Equilibrium with identical customers

W2
45

*
E

W1
The point (W1 , W2 ) is the typical customers uninsured state. Purchasing the insurance policy
( , ) moves the individual from to the point (W , W ) .
1

Free entry and perfect competition will ensure that policies bought in competitive equilibrium make zero
expected profits, so that if is purchased, (q, ) (1 q)1 q 2 0 .
The set of all policies that break even is illustrated by the line E in the Figure, which is the fair-odds
line. The equilibrium policy * maximizes the individuals expected utility and just breaks even.

* satisfies the 2 conditions of equilibrium:

(i)
(ii)

it breaks even;
selling any contract preferred to it will bring insurance companies expected loss.

Since customers are risk-averse, the point * is located at the intersection of the 45 (representing
equal income in both states of nature) and the fair-odds line.
In equilibrium each customer buys complete insurance at actuarial odds.
[slope of IC slope of E line

U '(W )(1 q) 1 q
]

U '(W )q
q

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Imperfect Information: Equilibrium with two classes of customers
This market can have only 2 kinds of equilibria:
i)
pooling equilibria in which both groups buy the same contract, and
ii)
separating equilibria in which different types purchase different contracts.
Claim:

There cannot be a pooling equilibrium

Suppose is a pooling equilibrium.

Suppose that the market consists of 2 kinds of customers:
low-risk individuals with accident probability q L , and
high-risk individuals with accident probability q H q L .
The fraction of high-risk customers is , so that the
average accident probability: q q H (1 )q L .
Consider ( p , ) .
If ( p, ) 0 , then firms offering lose money, contradicting the definition of equilibrium.
If ( p, ) 0 , then there is a contract that offers slightly more consumption in each state of nature,
which still will make a profit when all individuals buy it. All will prefer this contract to , so cannot
be an equilibrium.

W2
45

( p, ) 0

( p, ) 0

: initial endowment of all consumers

W1

Thus, ( p, ) 0 and lies on the market odd line E .

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114

W2
45

W1
@ : slope of U H

(1 q H )U '(W1 )
q H U '(W2 )

and slope of U L

(1 q L )U '(W1 )
q LU '(W2 )

qL 1 qH
slope of U L
L
H
1 q q
From the diagram, we can see that there is a contract , close to , such that
slope of U H

for the low risk type, , and

ii) for the high risk type, .
Since is close to , it makes a profit when the less risky buy it, ( p L , ) ( p L , ) ( p, ) 0
i)

The existence of contradicts the second part of the definition of equilibrium, hence cannot be an
equilibrium.

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Separating Equilibrium
If there is an equilibrium, each type must purchase a separate contract.

1 qL
The low-risk contract lies on line L (with slope
) and the high-risk contract on line H (with
qL
slope

1 qH
). The contract on H most preferred by high-risk customers give complete insurance.
qH
W2

W1
This is H in the diagram; it must be part of any equilibrium.
Low-risk customers, would, of all contracts on L , most prefer contract which, like H , provides
complete insurance.
However, offers more consumption in each state than H , and high-risk types will prefer it to H .
If and H are marketed, both high- and low-risk types will purchase .
The nature of imperfect information in this model is that insurance companies are unable to
distinguish among their customers.
All who demand must be sold . Profits will be negative; ( H , ) is not an equilibrium set of
contracts.

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W2

UL
H

W1
An equilibrium contract for low-risk types must not be more attractive to high-risk types than H , it
must be on the indifference curve U H . Of all such contracts, the one that low-risk type most prefer is
L , the contract at the intersection of L and U H . This establishes that the set ( H , L ) is the only
possible equilibrium for a market with low- and high-risk customers.

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However, ( H , L ) may not be an equilibrium.

W2
L

E
H

.
U

W1
Consider the contract . It lies above U L , the low-risk indifference curve through L and also above
U H . If is offered, both low- and high-risk types will purchase it in preference to either H and L .
If it makes a profit when both groups buy it, will upset the potential equilibrium of ( H , L ) . 's
profitability depends on the composition of the market.
If there are sufficiently many high-risk people so that E represents market odds, then will lose
money.
If market odds are given by E ' (as they will be if there are relatively few high-risk insurance
customers), then will make a profit. Since ( H , L ) is the only possible equilibrium, in this case the
competitive insurance market will have no equilibrium.

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Asymmetric information
Example:

immigration

Asymmetric information has been used by some economists to explain why most of the Taiwanese
students stay in the United States after graduation. They argued that the employers in USA have more
information in evaluating the students true productivity while the Taiwanese employers cannot do so.
Thus, each student remaining in USA will receive wage rate equals to his value of marginal product
(productivity), However, all the returning students only receive a wage rate equals to the average
productivity of all returning students as the Taiwanese employers cannot differentiate the students
productivity and only know their average productivity.
For illustration, suppose there are 2 students A and B with productivity 1.0 and 2.0 respectively, they
will receive wage rate WUSA 1.0 and WUSB 2.0 respectively if they stay at USA. If both of them return,

PA PB
1.5 .
2
Furthermore, we assume that there are different coefficients k for different groups of students such that
they will be indifferent between working in USA for a wage rate W and returning to Taiwan for a wage
rate kW . For example, if k A 0.8 , then if A is offered a wage WT 0.8WUS 0.8PA , he will return to
Taiwan. [Note that for k 1, we may say that the student prefers to work in Taiwan, because if the
student is offered the same wage rate, he will prefer to return to Taiwan. For k 1 , we may say that he
prefers to work in USA. For k 1 , he is indifferent.]
they will receive identical wage rate equals their average productivity, that is WT

Given group of students with different productivity, we are interested in determining the number of
students staying in the USA and returning to Taiwan and the wage rate they receive. Equilibrium in the
market is defined as 2 sets of students, one set of them return to Taiwan and the other set stay in USA.
For those whose return, WT kWUS .
For those whose stay, WT kWUS .

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Question:
Let there be 3 types of Taiwanese students (with equal number) in the USA.
Type A with productivity 2.0 and k A 0.7 .
Type B with productivity 1.5 and kB 1.1 .
Type C with productivity 1.0 and kC 0.6 .
Type

Productivity

A
B
C

2.0
1.5
1.0

The rules:

if

WUS
2.0
1.5
1.0

WT kWUS

return

WT kWUS

stay in US

k
0.7
1.1
0.6

kWUS
1.4
1.65
0.6

WT average wage (productivity) of returning students

i)
ii)
iii)
iv)
v)
vi)
vii)
viii)

2.0 1.5 1.0

1.5 A, C return; B stays (inconsistent)
3
2 1
1.5 A, C retun; B stays (consistent) equilibrium
A, C return; B stays WT
2
2 1.5
1.75 all return (inconsistent)
A, B return; C stays WT
2
1.5 1
1.25 C returns; A, B stay (inconsistent)
B, C return; A stays WT
2
A returns; B, C stay WT 2 all return (inconsistent)
B returns; A, C stay WT 1.5 A, C return; B stays (inconsistent)
C returns; A, B stay WT 1.0 C returns; A, B stay (consistent) equilibrium
A, B, C stay WT 0 (but if A returns, he will get 2 kWUS ) (not an equilibrium)
A, B, C return WT

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Akerlof, George (1970): The Market for Lemons: Quality Uncertainty and The Market Mechanism,
Quarterly Journal of Economics, pp. 488-500.
The automobile market:
Observation: The large price difference between new cars and those which have just left the
showroom.
Bad cars drive out the good because they sell at the same price as good cars.
In a more continuous case with different grades of goods, it is quite possible to have the bad
driving out the not-so-bad driving out the medium driving out the not-so-good driving out the
good in such a sequence of events that no market exists at all.
The insurance market
Observation: People over 65 have great difficulty in buying medical insurance.
Question:

Why doesnt the price to match the risk?

[Group insurance, which is the most common form of medical insurance in the United States, picks out
the healthy, for general adequate health is a pre-condition for employment.]
The employment of minorities
The Lemons Principle casts light on the employment of minorities. Employers may refuse to hire
members of minority groups for certain of jobs. The decision may not reflect irrationality or prejudice
but profit maximization. For race may serve as a good statistic for the applicants social background,
quality of schooling, and general capabilities.
Spence, Michael (1973): Job Market Signaling, Quarterly Journal of Economics, pp.355-374.

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Unproductive Screening
Suppose there are 2 groups of people, geniuses (G of them) and idiots (I of them).
Productivity of geniuses PG
Productivity of idiots PI

( PG PI )

Assume that the only way employers can differentiate between G and I is on the basis of external
characteristics visible before the contract of employment is made.
If the employees see no differentiable characteristics, they will pay each group the same wage, so that
G
I
W PG
PI
P
everyone is paid
GI
GI
Let's assume that the geniuses can differentiate themselves by acquiring a signal, such as
education.
Separating equilibrium:
conditions:

only the geniuses get education and the idiots get no education

PG PI CI cost of education for the idiots

PG PI CG cost of education for the geniuses

Note that although it is privately desirable for the geniuses to get education, it is socially
undesirable.

Pooling equilibrium:
Suppose no one gets education initially.
If PG P CG , then no one will get education.

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The Principal-Agent Problem
The principal-agent problem exists in almost every social structure where some units are
regarded as managers and some units as supervised agents.
Examples:
1.
Parents, not knowing whether their kids prepare their homework or not, wish to reward the kids
for good grades.
2.
A landlord leasing his or her land to a tenant has no way of knowing whether yield is a product
of the tenants working hard or not, when weather has a large impact on the crops, but, he or she
may wish to provide the tenant with a sufficient incentive to cultivate the land.
3.
A plaintiff, expecting to win a large sum of money, would like to encourage his hired attorney to
work hard before a court appearance.
4.
A school, not observing what teachers actually do in class, may wish to reward the teachers
according to the achievements of the students.
5.
A government, not observing the efforts of its workers, would like to compensate its workers
according to public polls on some aspects of the government bureaucracy.
A simple model of restaurant owner versus waiters:
Consider a model of firms consisting of 2 groups: a restaurant owner (the principal) and waiters (the
agent).
Questions:
i)
Even if the restaurant owner can ensure that the employee has the skills, how can the restaurant
owner be sure that the waiters will indeed make the effort to work hard and be nice to the
customers?
ii)
What are the incentives for the waiters to work hard and be nice to the customers?
iii)
Although the boss can monitor the waiters' effort, monitoring is costly to the restaurant owner
and may or may not compensate for the extra output generated by monitoring.
iv)
Given that the revenue is collected by the restaurant owner, the waiters may not have the
incentive to work hard.
The timing of the interaction between the owner and the waiter is as follows:
1.
The owner designs the terms of the contract, which specifies the payments the waiter will
receive, depending on the observed revenue of the restaurant.
2.
The owner offers the contract to the waiter, and the waiter decides whether to accept the contract
and start working or to choose some other work.
3.
If the waiter accept the contract, then he goes to work and decides how much effort to exert in
this work.
4.
The restaurant's revenue is observed, and the owner pays the waiter as promised in the contract.
Remark:
This commonly used setup implies that the owner is in control of the bargaining in the sense that she
makes a take-it-or-leave-it offer to the waiter. The waiter then can either accept the terms or reject them
but is unable to bargain over the terms of the contract.

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