Economics of Uncertainty and Information assessment

Consider the Allais Paradox. Explain why it is in contrast with the assumptions of
Expected Utility Theory and describe the Common Consequence Effect.

Please answer ONE of the following TWO possible questions. Each question has three subparts – please answer all parts of the question you attempt.
Whichever question you select, you will write three short essays. It is up to you how you use
the words at your disposal, but the total word count should not exceed 2500 words. This is a
strict maximum word limit. Note that in-text referencing is included in the word count, but
the reference list at the end is not. All referencing should be in a Harvard style. Weightings
appear after each sub-part. These weightings give an indication of the appropriate number of
words to devote to each answer.

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Question 1
a) Consider the Allais Paradox. Explain why it is in contrast with the assumptions of
Expected Utility Theory and describe the Common Consequence Effect. (20%)
b) With reference to Kahneman and Tversky (1979), discuss the Certainty Effect and the
Reflection Effect. Summarize the main characteristics of the Value Function in
Prospect Theory. (50%)
c) With reference to Benartzi and Thaler (1995), establish why the Equity Premium
Puzzle has been considered a puzzle in terms of individual risk preferences. Analyze
the role of Myopic Loss Aversion in explaining the Equity Premium Puzzle. (30%)
Kahneman, D., & Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk.
Econometrica, 47(2), 263-292.
Benartzi, S., & Thaler, R. H. (1995). Myopic loss aversion and the equity premium puzzle. The
Quarterly Journal of Economics, 110(1), 73-92.

Question 2
a) Consider a market with asymmetric information among agents. Explain the difference
between pre-contractual and post-contractual opportunism, and then discuss the effect
that asymmetric information has in terms of Pareto Efficiency. (20%)
b) Consider a market for used cars where there is asymmetric information between
buyers and sellers: sellers know quality of the cars they intend to sell on the market,
but buyers do not. Discuss the supply and the demand for used cars in the presence
of asymmetric information. You should provide the condition(s) under which buyers
and sellers will trade in the market. Support your answer with appropriate equations
and/or diagrams. Define the concept of the market clearing equilibrium in the context
of a used car market under adverse selection. You should first discuss the case where
the price is equal to zero and then you should provide one example of positive trade.
(50%)
c) Explain the design of the Experimental Market proposed by Lynch et al (1986). Discuss
whether the experiment confirms the Adverse Selection model depicted by Akerlof
(1970). (30%)
Lynch, M., Miller, R. M., Plott, C. R., & Porter, R. (1986). Product quality, consumer
information, and ‘lemons’ in experimental markets. Empirical Approaches to Consumer
Protection Economics. Washington, DC: Federal Trade Commission, Bureau of Economics,
251-306.
Akerlof, G. A. (1970). The market for lemons: Quality Uncertainty and the Market Mechanism.
The Quarterly Journal of Economics, 84(3), 488-500.
Module Learning Outcomes:
On completion of this module, students will be able to:
 demonstrate systematic knowledge and understanding of and be able to formally
define main theories and models of individual decision-making and the role of
individual risk attitude in them;
 apply these theories and models to specified individual decision-making problems;
 critically appraise and compare these models by describing their main assumptions
and limitations.

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