Summary in haiku form
Or feed the parking meter?
Expected value.
Summary in one paragraph
Optimizing individuals also have to makes choices about uncertainty, e.g., whether to buy insurance or whether to go gambling. An important concept is expected value, which can be thought of as the average outcome of a risky situation. If you want to get formal about it, the Law of Large Numbers says that repeating a bet a large number of times is likely to produce an average outcome close to the expected value; this explains why casinos and insurance companies are not necessarily risky businesses. Expected value calculations also demonstrate the problem of adverse selection: when buyers and sellers don’t both have the same information—for example, consumers who know more about their health than insurance companies—the resulting information asymmetry can lead to an outcome where individual optimization does not lead to good outcomes for the group as a whole.
Notes on specific pages
Page 40: “Optimizing individuals can have one of three different attitudes about risk.”
We’ll return to the topic in Chapter 16, but Daniel Kahneman shared the 2002 Nobel Prize (with Vernon Smith) “for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty.” (Basically, Kahneman and co-author Amos Tversky—who would almost have shared the prize had he lived long enough—showed that people don’t really act like optimizing individuals, e.g., they treat small losses as “more important” than small gains.)
Page 41: “Why is he winning so much? He owns the casino!”
A fun read here is “Casinos have great night” (The Onion, May 28, 2003).
Page 47: James Tobin and the theory of optimal investments
Jim Tobin won the 1981 Nobel Prize “for his analysis of financial markets and their relations to expenditure decisions, employment, production and prices.” The jokes about “Congratulations, you win the Nobel Prize” started with a true story recounted as follows in his 2002 NY Times obituary: After he won the Nobel Prize, reporters asked him to explain the portfolio theory. When he tried to do so, one journalist interrupted, ”Oh, no, please explain it in lay language.” So he described the theory of diversification by saying: ”You know, don’t put your eggs in one basket.” Headline writers around the world the next day created some version of ”Economist Wins Nobel for Saying, ‘Don’t Put Eggs in One Basket.’ ”
Page 49: George Akerlof and adverse selection
George Akerlof shared the 2001 Nobel Prize (with Michael Spence and Joseph Stiglitz) “for their analyses of markets with asymmetric information.” Akerlof’s Nobel-prize-winning ideas about adverse selection were rejected by three journals before finally being published in the Quarterly Journal of Economics. Read more about this and other terrific rejection stories in “How are the mighty fallen: Rejected classic articles by leading economists” (Joshua S. Gans and George B. Shepherd, Journal of Economic Perspectives 8:165-179, 1994).
Page 52: “It does help explain why economists spend so much time debating health care policy.”
Some interesting articles on health care policy include this short-and-sweet article on the “public option” by Victor Fuchs, often called the father of health economics, and a longer article, “Rethinking Social Insurance“, which is actually Martin Feldstein’s presidential address to the American Economic Association in January 2005. (Feldstein was thought to be one of the three top candidates to take over leadership of the Federal Reserve when Alan Greenspan retired. Ben Bernanke was the lucky winner; Felstein was arguably an even luckier loser, and so was Glenn Hubbard, whose students at CBS—Columbia Business School—made this terrific consolation-prize video.) There are of course a million other articles you can find by economists and others.
