Managerial economics Business strategy Chapter 12 The Economics of information Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 Managerial Economics & Business Strategy Chapter 12 The Economics of Information
Overview The mean and the variance I. Uncertainty and consumer behavior I. Uncertainty and the firm I. Uncertainty and the market V Auctions Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 Overview I. The Mean and the Variance II. Uncertainty and Consumer Behavior III. Uncertainty and the Firm IV. Uncertainty and the Market V. Auctions
The mean The expected value or average of a random variable Computed as the sum of the probabilities that different outcomes will occur multiplied by the resulting payoffs Ex/=q1x1+q2x2+….+qn where xi is payoff i, qi is the probability that payoff i occurs, and q1+ g2 The mean provides information about the average value of a random variable but yields no information about the degree of risk associated with the random variable Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 The Mean • The expected value or average of a random variable • Computed as the sum of the probabilities that different outcomes will occur multiplied by the resulting payoffs: E[x] = q1 x1 + q2 x2 +…+qn xn , where xi is payoff i, qi is the probability that payoff i occurs, and q1 + q2 +…+qn = 1. • The mean provides information about the average value of a random variable but yields no information about the degree of risk associated with the random variable
The variance standard Deviation ariance A measure of risk. The sum of the probabilities that different outcomes will occur multiplied by the squared deviations from the mean of the random variable q1(x1-E[x])2+q2(x2E[X])2+.+qn(xnE[x Standard deviation The square root of the variance Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 The Variance & Standard Deviation Variance • A measure of risk. • The sum of the probabilities that different outcomes will occur multiplied by the squared deviations from the mean of the random variable. s 2 = q1 (x1 - E[x])2 + q2 (x2 - E[x])2 +…+qn (xn - E[x])2 Standard Deviation • The square root of the variance
Uncertainty and Consumer Behavior Risk Aversion Risk Averse: An individual who prefers a sure amount of SM to a risky prospect with an expected value, ex, of SM Risk loving: An individual who prefers a risky prospect with an expected value, E[x], of SM to a sure amount of $M. Risk Neutral. an individual who is indifferent between a risky prospect where E[x]=$M and a sure amount of $M Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 Uncertainty and Consumer Behavior Risk Aversion Risk Averse: An individual who prefers a sure amount of $M to a risky prospect with an expected value, E[x], of $M. Risk Loving: An individual who prefers a risky prospect with an expected value, E[x], of $M to a sure amount of $M. Risk Neutral: An individual who is indifferent between a risky prospect where E[x] = $M and a sure amount of $M
Examples of How risk Aversion influences decisions Product quality a Informative advertising ■ Free samples Guarantees Chain stores Insurance Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 Examples of How Risk Aversion Influences Decisions • Product quality Informative advertising Free samples Guarantees • Chain stores • Insurance
Consumer search The optimal Search strategy. EB Reservation Price 0 Accept R Reject Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 Consumer Search The Optimal Search Strategy. c c EB Reservation Price Accept R Reject $ P 0
Consumer search An increase in search costs EB raises the reservation price. 0 RR Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 Consumer Search c c EB R $ P 0 An increase in search costs raises the reservation price. R* c* c*
Uncertainty and the firm · Risk Aversion Are managers risk averse or risk neutral? Diversification -Dont put all your eggs in one basket Profit maximization a When demand is uncertain, expected profits are maximized at the point where expected marginal revenue equals marginal cost: E[MR]=MC Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 Uncertainty and the Firm • Risk Aversion Are managers risk averse or risk neutral? • Diversification “Don’t put all your eggs in one basket” • Profit Maximization When demand is uncertain, expected profits are maximized at the point where expected marginal revenue equals marginal cost: E[MR] = MC
Asymmetric Information Situation that exists when some people have better information than others Example: Insider trading Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 Asymmetric Information • Situation that exists when some people have better information than others. • Example: Insider trading
