Econ quiz#4

Explain the "lemons principle"

--There are two types of cars: good ones and lemons, but we can't tell which is which
--Good cars are worth more to the their owners than lemons are worth to theirs
--More lemons will find their way into the used car market
--the price of used cars will start to fall, eventually causing the market to collapse which will cause
--good car owners will not sell their cars
--trouble free cars usually don't find their way into the used car market
--cars offered for sale are usually of lower quality than cars not offered

Expected Value

a weighted average of all its possible outcomes, where the weights are the respective probabilities;

how much you can expect to lose or win

Risk Averse

Risk averse: convex shaped utillity function, that has a diminishing marginal utility of wealth
-would always refuse a fair gamble
--the more wealth a consumer has the smaller the increase in utilty caused by a 1 unit increase in his wealth
-- EV > CEV

Risk Neutral

--constant marginal utility of wealth
--indifferent between accepting or refusing a fair gamble
--linear utility function
-- EV = CEV

Risk Seeking

increasing marginal utility of wealth
--utility function is concave in total wealth; slope increase with total wealth
-- EV < CEV
--the richer you are the more risk seeking you tend to be

Certainty Expected Value

the sum of money for which an individual would be indifferent between receiving that sum and taking the gamble

Risk Pooling

the idea that risk is spread among a larger group of people participating
If we can make the group large enough, the rate of payouts will be average
ex. insurance companies; joint ownership

Reservation price for insurance

the most one would be willing to pay for insurance.
EU (certain payment) = EU (loss)

Adverse selection

the process by which "undersirable" members of a population of buyers or sellers are more likely to participate in a voluntary exchange

those with a higher expected value of claims would choose to insure before a less "risky" class

ex. insurance (medical): people will buy insurance if they know they have health problems

moral hazard

people will tend to engage in behavior that is more risky due to the presence of insurance than you would if you had to bear the risk alone

ex. financial bailouts; car insurance;

Why does insurance have a negative expected value?

The purchaser is just tring to cover the cost of an accident happening. They don't buy insurance with the intention to make profit. At best they will break even, which doesn't always happen

Expected Utility

the expected value of use or utility over all possible outcomes