Information, Risk, and Uncertainty in Economics

By Peake, Charles F. | National Forum, Winter 2000 | Go to article overview

Information, Risk, and Uncertainty in Economics


Peake, Charles F., National Forum


The classical theory of perfectly competitive markets, originated in Adam Smith's Wealth of Nations, dominated economics in the middle of this century, and is prominently featured in most principles of economics texts today. Smith's idea is that, if left to pursue their own self-interests, people follow an "invisible hand" to promote society's well being. The mid-century version was the "second welfare theorem": competitive markets establish optimum social welfare provided there is an appropriate initial distribution of wealth. This theory assumes that rational decision-makers have available full and free information and incorporate it into their decisions.

Since mid-century, the classical information assumption has given way to the economics of uncertainty. A fruitful line of analysis that brought Nobel prizes to Harry Markowitz and William Sharpe explains optimum portfolio diversification by asset owners who face uncertainty. Others, such as Nobel laureate Herbert Simon, introduced a concept of rationality that links decision-making under uncertainty to the availability of information and to decision-makers' limited ability to process this information. A third focal area, asymmetric information, led to 1996 Nobel prizes for James Mirrlees and William Vickery.

ASYMMETRIC INFORMATION

George Akerlof's classic paper on "lemons" in the used-car market (Quarterly Journal of Economics, 1970) reflects the old adage "let the buyer beware." Akerlof deals with the type of uncertainty in which the information available to people differs; that is, it is asymmetric. The seller of a used car has more information about the car than the buyer does; the seller knows from experience whether the car is a dysfunctional "lemon" or an excellent running "plum." Expecting that a car may be a lemon, potential buyers will not pay the high price of a plum. Sellers of lemons have no incentive to inform buyers of their true value, and so the market treats all cars as if they were lemons. Because owners of plums are unwilling to sell at this lower price, buyers' expectations of lemons cause only lemons to be sold. Sellers of plums may offer incentives such as warranties or money-back guarantees to convince buyers that their cars are plums.

RISK AND UNCERTAINTY: MORAL HAZARD AND ADVERSE SELECTION

At about this same time, Mirrless (Review of Economic Studies, 1971; Economic Journal, 1997) developed the concepts of private information, moral hazard, and adverse selection more fully. Private information is possessed by one decision-maker, but it is costly or impossible for the other party to obtain. The implications of asymmetric private information are usefully explained in terms of insurance. Uncertainty presents individuals with a variety of risks that may create financial disaster: expensive health problems, loss of home to fire, automobile accidents, or natural disasters. The basic principle of insurance is to spread risks over a large number of people so that costs of the relatively few who experience large losses are shared by the many who do not. Risk-averse individuals are willing to pay for insurance that includes a reasonable profit for the insurers.

Moral hazard, where one party to a contract has an incentive to change behavior after an agreement is reached, characterizes insurance. In automobile insurance, for example, information on how carefully and defensively the insured person drives is private information. Once the contract is entered, the insured no longer faces the prospect of financial loss and thus has less incentive to continue to drive carefully. This lack of incentive raises the potential costs to the insurer, who is unable to monitor the insured to determine whether or not the person is driving safely.

Adverse selection occurs when people use private information to their advantage and the other party's disadvantage. Those who have a serious illness or a high risk of becoming ill are more likely to buy health insurance. …

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