IN CONTEXT Focus Decision making KEY THIN Daniel Elisberg (1931~) FORE 1921 US economist Frank Knight explains that bbe quantified and uncertainty” cannot. ns of a US mathematician ‘J. Savage tries to show how probabilities can be assigned to unknown future events. AFTER From 1970s chavioral experiments to study behavior un conditions of ur 1989 Michael Smit oses a "taxonomy" of tisk, 2007 Nassim Nicholas ‘Taleb's The Black Swan problem of rare, unforeseen events, ainty PEOPLE DON’T CARE ABOUT PROBABILITY WHEN THEY CHOOSE PARADOXES IN DECISION MAKING y the 18605 mainstcam | expecd sed on ther beiesabe BB irsistcetsttn | intact tates ae understanding peopl ion _| with the highest expecte making. Human beings are ratio But this sot of id calculating individuals, When | challenged by results sugg) confonte with differont options | that, ev xd an uncertain future, probability to ing to the theary. One of th their cho to boost (the am se chal portant, nt of satisfaction they People shy away from these ambiguities and Economists often assume that people aro rational decision makers People don't care about. probability ‘when they choose. by different rules, ‘and that hen they face will decide on the probabilities of each likely But some possible futu people nave a compl unknown, probability See also: £ A probabil Payers wer (p61) in Aversion Elisberg de demonstr make ate given som there! However, a future oliofs about sd utility, One of the challenges g paradox, a these ios and rent -95 « Bohaviosa] economies 268-69 R ECONOMICS 249 A probability experiment offered a choice of bots Atunt Ply 1 old thete were 20 red bal it n unspecific yollow Drawing a ved bal ‘in $100, Most players opt ng on an idea or ed by John Ma nally ynard Keynes Aversion to ambiguity Ellsberg described a thought experiment in was offered if a ball of a particular color was drawn from an imaginary uum (se@ above), The bets macle by the experiment’s participants ated that people tend to make a reasoned choice when some information from the degree of probability, and horefore risk, can be assessed However, their behavior changes if a future outcome seems ambiguous, and this is the paradox hat departs from expected utility theory. People prefer to know more about the uncertainties they face, than less. In the words of et US Defense Secretary Donald Rumsfeld (1982-), people prefer the "known unknowns” to the "unknown unknowns.” Th outcome of the experiment has been reproduced in several real experiments since Elisberg published his paper. It hhas become known as “ambiguity aversion,” and sometimes Knightian uncertainty" after the US economist Frank Knight (p 163). In seeking to know more about ple may act inconsistently with previous, ‘unknown unknowns, more logical choices, and put questions of probability aside when making their choice. Know the unknowns Ellsberg's paradox has proved ‘controversial, Some economi claim that it can safely be contained within conventional theory, and that experimental conditions do net properly reproduce people's behavior shen faced with reallife ambiguity. However, the financial Crisis of 2008 has provoked fresh interest in the problem ‘of ambiguity. Poople want to know more about the unknown, ‘unquantifiable risks that expected uuubty theory cannot account for. = thoice olfere ivan urn, together drawn, or $100 ifa black or yell ould win $100; a lack would fora bet on the rec $100 ita rod or Daniel Ellsherg Born in 1931, Daniel Ellsherg studied economics at Harvard University, and joined the US Marine Corps in 1954. In 1959, he became an analyst for the White House, He received his PhD in 1962, in which he first presented his paradox. Ellsberg, then working with top security clearance, became disillusioned with the Vietnam War. In 1971, he leaked top socret reports dotailing the Pentagon's belief that the war could not be won, before handing himself over to the authorities. His trial collapsed when it was revealed that White House agents had used illegal wiretaps of his house. Key works 1961 Risk, Ambiguity, and the Savage Axioms 2001 Risk, Ambiguity, and Decisiona oe ma e 228 IN CONTEXT Focus ‘Markets and firms KEY THINKER George Akerlof (1940-) BEFORE, 1558 English financier Sir Thomas Gresham advises that ‘bad money drives out good 1944 John von Neumann and Oskar Morgenstern publish the first attempt to analyze strategic behavior in omic situations. IS economist Michae Spence explains how people signal their skills, to potential employers, 1976 US economists Michael Rothschild and Joseph Stiglitz publish Equilibrium in Competitive Insurance Markets, a study of the problem of “cherry picking ‘when insurance companies ‘compete for customers MOST CARS = TRADED WILL z BE LEMONS MARKET UNCERTAINTY The buyer ofa econd-hand car has less information about its ‘quality than th salle Sollers with good ears therefore withdraw their cats from the market, The matket begins til US economist George ‘Akerlof started studying prices and markets in the 1960s, most economists believed that markets would allow everyone willing to sell goods at a certain price to make deals with anyone who wanted to buy goods at that price, Akerlof demonstrated that ses this is not true. This inequahity of information creates uncertainty the buyer, by! who becomes reluctant | Gre to pay a high price for obs ny car on the market. higl most cars traded will be inferior— lemons, His key work, The Market for Lemons (1970), explains how uncertainty caused by lim: information can cau: fail, Akatlof st llers have different amounts nformation, and these differences, mmetries, can have matkets to ed that buyers sstrous consequences for the forkings of markets./ aty ets to ats of he ‘See also: Free matt 210-13 » Signaling and screening 281 economics 54-61 » Market inf CONTEMPORARY ECONOMI (09 = Matkets and social outcomes Asymmetric information ‘The buyer of a second-hand car has less information about i quality than the seller who already owns the car. The seller will have been able to ass ther the car is worse than an average similar car—whether, itis a lemon’—an item with defects. Any buyor that ends up with a lemon feels cheated, The existence of undetectable lemons in the market creates uncertainty in the mind of the buyer extends to concerns about the quality of all the second-hand cars on sale. This uncertainty wo drop the price ing to offer for any car secquence prices drop theory is a moder sion of an idea first sugge by English financior Sir Gresham (1519-79). Gresham observed that when caine of higher and lower silver cot ulation, peop! eofa higher silver content, meaning would try te hold on tot George Akerlof that "bad money drives good ‘money out of circulation.” In the same way sellets with better than-average cars to sell will | withdraw them from the market, | because it is impossible for them to get a fair price from a buyer ‘sho isunablo to tll whether that | car is a lemon or not. This meat that “most cars traded willbe | lemons.” In theory this could lead the market A car dealer can rechice a buyer's not occur at any price, even if ele when selling a ear by offeringy there are traders willing to quatantees. In many cases buy and sell | snarkets adjust to account or asymmetric infotrwation, Adverse selection Another market in which lemons affect trade is the insurance Unable to identify them ace market. In medical insurance, _| ‘This is known as “adverse for instance, the buyers of policies | selection,” and the potential for know more about the state of their | adverse selection means that hoalth than the insurance companies end up often find themsolves doing with, on average, much greater business with people they would risks than ar rathor avoid: the least healthy premiums. has resulted people. As insurance premiums | in the withdrawal of medical se for older age groups, a greater | insurance policies for people proportion of “lemons” buy over a certain age in some areas, w policies, but firms are still lors, So insurets cavored by the Born in Connecticut in 1940, George Akeriof grew up in an ‘academic family. At school he became interested in the social sciences, including history and economics. His father's irregular employment patterns fostered hi interest in Keynesian economics. 1978, he taught at the London School of Economics before returning to Berkeley as professor. He was awarded the | Nobel Prize for Economics in | 2001, alongside Michael Spence and Joseph Stiglita, Akeriof went onto study foran | Key works economics degree at Yale, then | —————________ gained a PhD from MIT | 1970 The Market for Lemons (Massachusetts Institute of 1988 Fairness and Technology) in 1966. Shortly after | Unemployment (with Janet joining Berkeley as an associate | Yellen) professor, Akerlof spent a yearin | 2009 Animal Spirits: How India, where he explored the Human Psychology Drives the probloms ofunemployment. in | Economy (with Robert J. Shiller)