Up to now consumers have been assumed to be entirely aware of their incomes and personal preferences, and suppliers fully informed as to the technology and costs of production. Although assuming complete certainty is not realistic, most of the results obtained so far – for example, that demand curves are negatively sloped – hold even when people are less than perfectly informed. Nevertheless, uncertainty is often crucial. Without uncertainty there would be no insurance industry, no need for consultants, no litigation, no advertising, no reason to engage in scientific research.

Another crucial aspect of uncertainty is that some market participants are likely to be better informed than others. A jeweler usually knows a lot more about the quality of a diamond offered for sale than do potential buyers. This chapter introduces the tools necessary to deal with imperfect information and with unbalanced distributions of knowledge.

DECISIONS UNDER UNCERTAINTY

Expected Gain versus Expected Utility

Suppose an airline must decide whether to send off a flight from Los Angeles to Chicago, despite being unsure about the weather at O'Hare Airport in Chicago by the time the flight arrives. The plane already has 100 people aboard. If the flight is dispatched and O'Hare is open, suppose the airline will gain $40,000. If the airline holds the flight until the weather clears, the disruption in the schedule will make its gain smaller, say only $20,000.