Economics of Uncertainty and Information

This chapter gives a non-technical overview of the main topics in the economics of uncertainty and information. We begin by distinguishing between uncertainty and risk and defining possible attitudes to risk. We then focus on risk-aversion and examine its role in insurance markets. The next topic is asymmetric information, that is, situations where two parties to a potential transaction do not have the same information; in particular, one of the two parties has valuable information that is not available to the other party. Three important phenomena that arise in situations of asymmetric information are adverse selection, signaling and screening. Each of these topics is analyzed in detail with the help of simple examples. We then turn to the issue of optimal risk-sharing in contracts between two parties, called Principal and Agent, when the outcome of the contractual relationship depends on external states that are not under the control of either party.