Information, Uncertainty and Risk
Information, Uncertainty
& Risk.
Economic decisions are made before outcomes are known and often with unequal information. Learn to evaluate risky prospects and recognise when hidden information or hidden action distorts markets.
Observe
Separate known odds from unknown futures.
A decision can be rational
without producing a good outcome.
A farmer may choose the crop with the highest expected return and still suffer from an unusual drought. Economic reasoning evaluates the quality of the decision using information available beforehand—not only the realised outcome afterward.
Risk permits meaningful probabilities. Fundamental uncertainty concerns outcomes or probabilities that cannot be reliably specified.
Think
Weight outcomes by probabilities.
Expected value summarises
a probability distribution.
Expected monetary value is the probability-weighted average payoff over repeated decisions. It does not guarantee the outcome of a single choice. Risk-averse people may prefer a certain amount below expected value because utility rises at a diminishing rate with wealth.
Compare expected values
Chooses the prospect with the highest expected monetary payoff.
Values stability
May pay a risk premium to replace uncertain loss with a certain insurance premium.
Analyse
Change probability and payoff.
Evaluate an investment
before the outcome is known.
A regional innovation project yields €160,000 if successful and loses €40,000 if unsuccessful. Change its probability of success and compare expected value with a certain alternative paying €55,000.
Decision-under-risk laboratory
INTERACTIVE EXPECTED VALUE
Risky innovation project
Certain project
The conventional investment produces a known net payoff.
The risky project has a slightly higher expected payoff, but much greater dispersion.
Apply
Diagnose hidden information and action.
Information problems arise
before and after agreement.
Adverse selection occurs before a transaction when one side knows more about its type or quality. Moral hazard occurs afterward when protected or unobserved behaviour changes. Institutions respond through signalling, screening, monitoring and incentive-compatible contracts.
Adverse selection
High-risk buyers know more about their risk than insurers, potentially driving low-risk buyers away.
Moral hazard
Insurance may reduce the incentive to prevent loss when behaviour cannot be perfectly observed.
Signalling
An informed party credibly communicates quality.
Screening
The uninformed party offers choices that reveal information.
Incentives
Deductibles, monitoring and contracts share consequences.
Decide
Identify the information problem.
What happens after
insurance coverage begins?
After receiving full bicycle-theft insurance, an owner becomes less careful about locking the bicycle because the insurer cannot observe every precaution.
MODULE 10 · CHECKPOINT
You can now reason
before certainty arrives.
Probabilities discipline decisions under risk, while information economics reveals how hidden types and actions reshape markets, contracts and public policy.
