The Analytics of Uncertainty and Information

510 Pages·2013·4.08 MB·English

by  Bikchandani S.

more information - www.cambridge.org/9780521834087

THEANALYTICSOFUNCERTAINTY
ANDINFORMATION
SECONDEDITION
Therehasbeenexplosiveprogressintheeconomictheoryofuncertaintyand
information in the past few decades. This subject is now taught not only in
departmentsofeconomicsbutalsoinprofessionalschoolsandprogramsori-
entedtowardbusiness,governmentandadministration,andpublicpolicy.This
bookattemptstounifythesubjectmatterinasimple,accessiblemanner.PartI
of the book focuses on the economics of uncertainty; Part II examines the
economicsofinformation.
This revised and updated second edition places a greater focus on game
theory.Newtopicsincludeposted-pricemarkets,mechanismdesign,common-
valueauctions,andtheone-shotdeviationprincipleforrepeatedgames.
SushilBikhchandaniisaprofessorintheAndersonSchoolofManagementat
theUniversityofCalifornia,LosAngeles.Hisinterestsincludeauctions,market
institutions,herdbehavior,andinformationeconomics.ProfessorBikhchan-
danihaspublishedinnumerousacademicjournals,includingTheoreticalEco-
nomics, Operations Research, Journal of Economic Theory, Journal of Political
Economy,andEconometrica.
JackHirshleifer(August26,1925–July26,2005)wasanAmericaneconomist
andlongtimeprofessorattheUniversityofCalifornia,LosAngeles.Hetaught
attheUniversityofChicagofrom1955to1960,andthereafteratUCLAuntil
2001. Professor Hirshleifer was well known for his work on uncertainty and
informationineconomics,theeconomicanalysisofconflict,andbioeconomics.
His undergraduate textbook, Price Theory and Applications, went into seven
editions.A1958articlebyHirshleiferbeganthetriumphantcomebackofIrving
Fisher’stheoryofcapitalandinterest,nowdeemedcanonical.
John G. Riley is Distinguished Professor of Economics at the University of
California,LosAngeles.AFellowoftheEconometricSociety,hisresearchhas
appeared in eminent journals such as theAmerican Economic Review, Econo-
metrica,JournalofPoliticalEconomy,QuarterlyJournalofEconomics,Reviewof
Economic Studies, Journal of Economic Theory, and the RAND Journal of Eco-
nomics.ProfessorRileyistheauthorofEssentialMicroeconomics(Cambridge
UniversityPress,2012)andco-author,withthelateJackHirshleifer,ofthefirst
editionofTheAnalyticsofUncertaintyandInformation(CambridgeUniversity
Press,1992).

CAMBRIDGESURVEYSOFECONOMICLITERATURE
SeriesEditor
ProfessorFrankWolak,StanfordUniversity
SeriesAdvisor
ProfessorJohnPencavel,StanfordUniversity
The literature of economics is rapidly expanding, and within just a few years, many
subjectshavechangedinrecognition.Perceivingthestateofknowledgeinfast-developing
subjectsisdifficultforstudentsandtimeconsumingforprofessionaleconomists.This
seriesofbooksisintendedtohelpwiththisproblem.Eachbookgivesaclearstructure
toandbalancedoverviewofthetopicandiswrittenatanintelligiblelevelforthesenior
undergraduate.Theywillbeusefulforteachingaswellasprovideamature,yetcompact,
presentationofthesubjectforeconomistswishingtoupdatetheirknowledgeoutside
theirownspecialties.
OtherTitlesintheSeries
SanfordV.BergandJohnTschirhart,NaturalMonopolyRegulation:
PrinciplesandPractice
MarkBlaug,TheMethodologyofEconomics:OrHowEconomistsExplain
(SecondEdition)
EdwinBurmeister,CapitalTheoryandDynamics
RichardE.Caves,MultinationalEnterpriseandEconomicAnalysis
(ThirdEdition)
RobertClarkandJosephSpengler,TheEconomicsofIndividualandPopulationAging
ThrainnEggertsson,EconomicBehaviorandInstitutions
RobertFerberandWernerZ.Hirsch,SocialExperimentationandEconomicPolicy
AnthonyC.Fisher,ResourceandEnvironmentalEconomics
JamesW.Friedman,OligopolyTheory
HelmutFrisch,TheoriesofInflation
PeterIsard,ExchangeRateEconomics
MortonI.KamienandNancyL.Schwartz,MarketStructureandInnovation
MarkKilingsworth,LaborSupply
AnneO.Krueger,ExchangeRateDetermination
DennisC.Mueller,PublicChoice
ToddSandlerandKeithHartley,TheEconomicsofDefense
StevenM.Sheffrin,RationalExpectations(SecondEdition)
JohnB.ShovenandJohnWhalley,ApplyingGeneralEquilibrium
E.RoyWeintraub,Microfoundations:TheCompatibilityofMicroeconomics
andMacroeconomics

The Analytics of Uncertainty
and Information
Second Edition
SUSHIL BIKHCHANDANI
UniversityofCalifornia,LosAngeles
JACK HIRSHLEIFER
JOHN G. RILEY
UniversityofCalifornia,LosAngeles
32AvenueoftheAmericas,NewYork,NY10013-2473,USA
CambridgeUniversityPressispartoftheUniversityofCambridge.
ItfurtherstheUniversity’smissionbydisseminatingknowledgeinthepursuitof
education,learning,andresearchatthehighestinternationallevelsofexcellence.
www.cambridge.org
Informationonthistitle:www.cambridge.org/9780521541961
(cid:2)C SushilBikhchandani,JackHirshleifer,andJohnG.Riley1992,2013
Thispublicationisincopyright.Subjecttostatutoryexception
andtotheprovisionsofrelevantcollectivelicensingagreements,
noreproductionofanypartmaytakeplacewithoutthewritten
permissionofCambridgeUniversityPress.
Firstpublished1992
Secondedition2013
PrintedintheUnitedStatesofAmerica
AcatalogrecordforthispublicationisavailablefromtheBritishLibrary.
LibraryofCongressCataloginginPublicationData
Bikhchandani,Sushil.
Theanalyticsofuncertaintyandinformation/SushilBikhchandani,UniversityofCalifornia–
LosAngeles,JackHirshleifer,JohnG.Riley,UniversityofCalifornia,LosAngeles.–
SecondEdition.
pagescm
Includesbibliographicalreferencesandindex.
ISBN978-0-521-83408-7(hardcovers)–ISBN978-0-521-54196-1(pbk.)
1.Uncertainty. 2.Equilibrium(Economics) 3.Decisionmaking. 4.Informationtheory
ineconomics. I.Hirshleifer,Jack. II.Riley,JohnG. III.Title.
HB615.H568 2013
339.5–dc23 2013005525
ISBN978-0-521-83408-7Hardback
ISBN978-0-521-54196-1Paperback
CambridgeUniversityPresshasnoresponsibilityforthepersistenceoraccuracyofURLsfor
externalorthird-partyInternetWebsitesreferredtointhispublicationanddoesnotguarantee
thatanycontentonsuchWebsitesis,orwillremain,accurateorappropriate.
Contents
Acknowledgments pagexi
InMemoriam xiii
Introduction:TheEconomicsofUncertaintyandInformation 1
PARTI
1 ElementsofDecisionunderUncertainty 7
1.1 TheMenuofActs 9
1.2 TheProbabilityDistribution 9
1.2.1 RiskversusUncertainty 10
1.2.2 “Hard”versus“Soft”Probabilities 11
1.3 TheUtilityFunction 13
1.4 TheExpected-UtilityRule 13
1.4.1 AnInformalPresentation 16
1.4.2 TheIndependenceAxiom 22
1.5 RiskAversion 26
1.6 UtilityParadoxesandRationality 35
1.6.1 ProbabilityMatching 35
1.6.2 FramingtheQuestion 36
1.6.3 AllaisParadox 38
1.6.4 EllsbergParadox 41
2 RiskBearing:TheOptimumoftheIndividual 46
2.1 TheRisk-BearingOptimum:BasicAnalysis 47
2.1.1 Contingent-ClaimsMarkets 49
2.1.2 RegimesofAssetMarkets–Completeand
Incomplete 51
2.1.3 ProductiveOpportunities 58
vii
viii Contents
2.2 ChoosingCombinationsofMeanandStandardDeviation
ofIncome 62
2.2.1 μ,σ,Preferences 62
2.2.2 OpportunitySetandRisk-BearingOptimum 66
2.3 State-DependentUtility 77
2.3.1 AnApplication:The“ValueofLife” 80
3 ComparativeStaticsoftheRisk-BearingOptimum 86
3.1 MeasuresofRiskAversion 86
3.2 EndowmentandPriceEffects 95
3.2.1 CompleteMarkets 95
3.2.2 IncompleteMarkets 98
3.3 ChangesintheDistributionofAssetPayoffs 103
3.4 StochasticDominance 108
3.4.1 ComparisonofDifferentConsumptionProspects 108
∗
3.4.2 RespondingtoIncreasedRisk 116
4 MarketEquilibriumunderUncertainty 123
4.1 MarketEquilibriuminPureExchange 123
4.1.1 ApplicationtoShareCropping 127
4.1.2 ApplicationtoInsurance 130
4.2 ProductionandExchange 137
4.2.1 EquilibriumwithProduction:CompleteMarkets 137
∗
4.2.2 StockMarketEquilibrium 145
∗
4.2.3 MonopolyPowerinAssetMarkets 150
4.3 TheCapitalAssetPricingModel 156
PARTII
5 InformationandInformationalDecisions 169
5.1 Information–SomeConceptualDistinctions 169
5.2 InformationalDecisionAnalysis 172
5.2.1 TheUseofEvidencetoReviseBeliefs 172
5.2.2 RevisionofOptimalActionandtheWorthof
Information 181
5.2.3 MoreInformativeversusLessInformativeMessage
Services∗ 189
∗ Starred sections represent more difficult or specialized materials that can be omitted
withoutsignificantlossofcontinuity.