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Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Managerial Economics & Business
Strategy
Chapter 12
The Economics of
Information
12-2
Overview
I. The Mean and the Variance
II. Uncertainty and Consumer Behavior
III. Uncertainty and the Firm
IV. Uncertainty and the Market
V. Auctions
12-3
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.
12-4
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:
s2 = q1 (x1- E[x])2 + q2 (x2- E[x])2 +…+qn(xn- E[x])2
! Standard Deviation
– The square root of the variance.
! High variances (standard deviations) are associated
with higher degrees of risk
12-5
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.
12-6
Examples of How Risk Aversion
Influences Decisions
! Product quality
– Informative advertising
– Free samples
– Guarantees
! Chain stores
! Insurance
Price Uncertainty and
Consumer Search
! Suppose consumers face numerous stores selling
identical products, but charge different prices.
! The consumer wants to purchase the product at the
lowest possible price, but also incurs a cost, c, to acquire
price information.
