Comprehensive Study Guide: Information
& Externalities
Based on Intermediate Microeconomics by Hal R. Varian
Contents
1 Introduction 2
2 Uncertainty (Topic 5.4) 2
2.1 Expected Value vs. Expected Utility . . . . . . . . . . . . . . . . . . . . 2
2.2 Risk Attitudes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
2.3 Certainty Equivalent (CE) . . . . . . . . . . . . . . . . . . . . . . . . . . 3
3 Asset Pricing (Topic 5.5) 3
3.1 Equilibrium in Risky Assets . . . . . . . . . . . . . . . . . . . . . . . . . 3
3.2 Capital Asset Pricing Model (CAPM) . . . . . . . . . . . . . . . . . . . . 3
4 Externalities (Topic 5.2) 4
4.1 Types of Externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
4.2 Inefficiency of Competitive Equilibrium . . . . . . . . . . . . . . . . . . . 4
4.3 Solutions to Externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
4.4 Tragedy of the Commons . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
5 Public Goods (Topic 5.3) 5
5.1 The Efficiency Condition (Samuelson Rule) . . . . . . . . . . . . . . . . . 5
5.2 The Free Rider Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
5.3 Vickrey-Clarke-Groves (VCG) Mechanism . . . . . . . . . . . . . . . . . 5
6 Asymmetric Information (Topic 5.1) 6
6.1 Adverse Selection (Hidden Information) . . . . . . . . . . . . . . . . . . . 6
6.2 Signaling (Spence Model) . . . . . . . . . . . . . . . . . . . . . . . . . . 6
6.3 Moral Hazard (Hidden Action) . . . . . . . . . . . . . . . . . . . . . . . 6
1
, Intermediate Microeconomics Study Guide: Information & Externalities
1 Introduction
Standard microeconomic theory assumes perfect information and no external effects. In
this module, we relax these assumptions to study more realistic market failures:
1. Uncertainty: Agents do not know the future with certainty.
2. Externalities: Actions of one agent affect others outside the market mechanism.
3. Public Goods: Goods that are non-rival and non-excludable.
4. Asymmetric Information: When one party knows more than the other.
2 Uncertainty (Topic 5.4)
How do consumers choose between risky alternatives?
2.1 Expected Value vs. Expected Utility
P
Let a lottery have outcomes x1 , . . . , xn with probabilities π1 , . . . , πn (where πi = 1).
Expected Value (EV): The weighted average of monetary payoffs.
EV = π1 x1 + π2 x2 + · · · + πn xn
Expected Utility (EU): Rational agents maximize the weighted average of the
utility of the payoffs, not the payoffs themselves (von Neumann-Morgenstern utility).
Expected Utility Formula
EU = π1 u(x1 ) + π2 u(x2 ) + · · · + πn u(xn )
2.2 Risk Attitudes
Risk attitude is determined by the curvature of the utility function u(w) with respect to
wealth w.
1. Risk Aversion: The consumer prefers a sure amount to a lottery with the same
expected value.
• u(w) is **Concave** (u′′ < 0).
• u(E[w]) > E[u(w)] (Jensen’s Inequality).
2. Risk Neutrality: The consumer is indifferent between the lottery and its expected
value.
2
& Externalities
Based on Intermediate Microeconomics by Hal R. Varian
Contents
1 Introduction 2
2 Uncertainty (Topic 5.4) 2
2.1 Expected Value vs. Expected Utility . . . . . . . . . . . . . . . . . . . . 2
2.2 Risk Attitudes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
2.3 Certainty Equivalent (CE) . . . . . . . . . . . . . . . . . . . . . . . . . . 3
3 Asset Pricing (Topic 5.5) 3
3.1 Equilibrium in Risky Assets . . . . . . . . . . . . . . . . . . . . . . . . . 3
3.2 Capital Asset Pricing Model (CAPM) . . . . . . . . . . . . . . . . . . . . 3
4 Externalities (Topic 5.2) 4
4.1 Types of Externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
4.2 Inefficiency of Competitive Equilibrium . . . . . . . . . . . . . . . . . . . 4
4.3 Solutions to Externalities . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
4.4 Tragedy of the Commons . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
5 Public Goods (Topic 5.3) 5
5.1 The Efficiency Condition (Samuelson Rule) . . . . . . . . . . . . . . . . . 5
5.2 The Free Rider Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
5.3 Vickrey-Clarke-Groves (VCG) Mechanism . . . . . . . . . . . . . . . . . 5
6 Asymmetric Information (Topic 5.1) 6
6.1 Adverse Selection (Hidden Information) . . . . . . . . . . . . . . . . . . . 6
6.2 Signaling (Spence Model) . . . . . . . . . . . . . . . . . . . . . . . . . . 6
6.3 Moral Hazard (Hidden Action) . . . . . . . . . . . . . . . . . . . . . . . 6
1
, Intermediate Microeconomics Study Guide: Information & Externalities
1 Introduction
Standard microeconomic theory assumes perfect information and no external effects. In
this module, we relax these assumptions to study more realistic market failures:
1. Uncertainty: Agents do not know the future with certainty.
2. Externalities: Actions of one agent affect others outside the market mechanism.
3. Public Goods: Goods that are non-rival and non-excludable.
4. Asymmetric Information: When one party knows more than the other.
2 Uncertainty (Topic 5.4)
How do consumers choose between risky alternatives?
2.1 Expected Value vs. Expected Utility
P
Let a lottery have outcomes x1 , . . . , xn with probabilities π1 , . . . , πn (where πi = 1).
Expected Value (EV): The weighted average of monetary payoffs.
EV = π1 x1 + π2 x2 + · · · + πn xn
Expected Utility (EU): Rational agents maximize the weighted average of the
utility of the payoffs, not the payoffs themselves (von Neumann-Morgenstern utility).
Expected Utility Formula
EU = π1 u(x1 ) + π2 u(x2 ) + · · · + πn u(xn )
2.2 Risk Attitudes
Risk attitude is determined by the curvature of the utility function u(w) with respect to
wealth w.
1. Risk Aversion: The consumer prefers a sure amount to a lottery with the same
expected value.
• u(w) is **Concave** (u′′ < 0).
• u(E[w]) > E[u(w)] (Jensen’s Inequality).
2. Risk Neutrality: The consumer is indifferent between the lottery and its expected
value.
2
