Example of insurance - reducing risk, Microeconomics

The Value of Title Insurance While Buying a House

*  A Scenario:

- Price of house is $200,000

- 5% chance that seller does not own house

*  Risk neutral buyer would pay:

  Risk averse buyer would pay quite less

*  By reducing the risk factor, title insurance increases the value of house by an amount much greater than premium.

*  Value of Complete Information 

- The difference between expected value of choice with complete information and expected value when information is incomplete.

*  Assume that a store manager must decide how many fall suits to order:

- 100 suits cost $180 per suit

- 50 suits cost $200per suit

- The price of suits is $300

* Assume that a store manager must determine how many fall suits to order:

- Unsold suits can be returned for ½ cost.

- The probability of selling each quantity is 50 percent.

With the incomplete information:

- Risk Neutral: Buy 100 suits

- Risk Averse: Buy 50 suits

*  The expected value with the complete information is $8,500.

- 8,500 = .5(5,000) + .5(12,000)

* The expected value with the uncertainty is $6,750.

 The value of complete information is $1,750.

*  An Example

- Per capita packed milk consumption over years has fallen

- The milk producers which is engaged in market research to develop new sales strategies to encourage consumption of packed milk.

*  Findings

- Packed milk demand is seasonal with greatest demand in summer

- Ep is negative and small

- EI is positive and large

* Milk advertising increases sales most in summer.

*  Allocating advertising based on this information in Karachi increased sales by Rs. 400,000 and profits by 9 percent.

*  The cost of the information was low relatively, while value was substantial.

Posted Date: 10/10/2012 9:04:09 AM | Location : United States

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