## 12 Dec risk and uncertainty in microeconomics

This contract offers no profit for the insurance company, however. If you are risk-neutral, should you buy insurance? Learning Objective 23.3: Describe how diversification and insurance mitigate risk. Download for offline reading, highlight, bookmark or take notes while you read Risk, Uncertainty and Profit. Study 17 Lecture 10: Risk and Uncertainty flashcards from Andi H. on StudyBlue. The Economics of Uncertainty and Information may be used in conjunction with Loffont's Fundamentals of Economics in an advanced course in microeconomics. The graph tells us that the utility of $50 for this agent is 80 and the utility for $100 is 140. Risk and Uncertainty in Project Management and/or ID # Teacher Inherent in any activity in business or in life there is always present some degree of risk and uncertainty. This is an Upper-Level Elective in the economics curriculum. Of course, it’s hard to place an objective probability on whether Arnold Schwarzenegger would be a good California governor despite the uncertainty. Ronald Moy 219,739 views. We will analyse below how an individual maximises his expected utility when risk or uncertainty is present. A common way that individuals reduce risk is through the purchase of insurance. h�b```f``R�l� ���OT�� +��\��]���g���u���!C��b ���v3H5�f�=<5�ݓyB���+�sn ��M��dӲ7O���w�D�����}{�K����7�HZs{��I�����&���\v�������k���L�x�ްDcڛ�=�o&{K}���r��w�i&���8v1���IR�3*��b`M Z�(�"�Al� �R`TR��� $T� �P�U�� �i� f�� Consider two possible outcomes, $50 and $100. Fair Gamble: A gamble with an expected outcome of zero. The difference between the expected value of the gamble, $75, and the amount of the certain payment that yield the same utility as the gamble, $65, is called the risk premium. Working Paper 19005 DOI 10.3386/w19005 Issue Date April 2013. An insurance company o⁄ers you insurance against this eventuality for a premium of 15AC. Modern decision theory is based on this distinction. Associated with any uncertain outcome are probabilities. Fair insurance is a contract with an expected value to the insurer is zero – in other words a fair bet. The expected value from the marble game is the amount one could expect to earn on average if the game is repeated many times. Now consider a game where a coin is flipped and the actual payment, $50 or $100 depends on which side of the coin is showing after the flip. Next: Module 24: Time – Money Now or Later? Tomas J. Philipson & George Zanjani. Microeconomics CHAPTER 8. However, the world is filled with uncertainty. (1989), ‘Choice under Uncertainty; Problems Solved and Unsolved’, Journal of Economic Perspectives, 1 (Attempts to shore up the theory of choice under uncertainty on ‘solid axiomatic foundations’ of probabilistic risk in the face of the famous St Petersburg paradox and other challenges to expected utility theory.) To understand this concept, we can apply it to the gamble. The utility of $75 for this agent is 130 as shown in the figure. 1. The economics of uncertainty impacts our … 7 What is the difference between risk and uncertainty? Unfortunately, running a business primarily depends on planning for a set of known outcomes. Formally if k equals the number of times an event has occurred and N equals the number of times possible, then the frequency, F, equals: Subjective probability is when individuals estimate probabilities based on their own experiences and whatever data are available to them. When a flood happens, most homes in the flood area are severely damaged so the risks are very highly positively correlated. Outline Answer: No you should not. Twitter LinkedIn Email. This makes insuring against floods very difficult for private insurers who struggle to diversify their risk portfolio and puts them in danger of a catastrophic payout should a flood occur. This means that the agent has a 50% chance of getting $50 and a 50% chance of getting $100. Private insurance markets exist thanks to the risk premium described earlier in the chapter. Risk-averse homeowners whose houses are situated in areas that have a possibility of flooding will have a demand for insurance as long as the insurance contract is within the risk premium the homeowners are willing to pay. So this agent prefers more wealth to less but the marginal utility of wealth is decreasing. The easiest way to avoid risk is to abstain from risky activities, but it is not always possible to do so. In a coin flip, the probability of one side landing facing up is ½ or 50%. They generally do so in two ways: they can estimate based on frequency or based on subjective probability. %%EOF However, although different models have been developed for both situations, risk situations, … It is thus puzzling that price risk—that is, unexpected departures from a mean price level, or price volatility—has received so little attention. In other words, the guaranteed amount of $1600 yields higher utility than the gamble that has an expected value of $1600. Economic Analysis of Risk and Uncertainty induced by Health Shocks: A Review and Extension. Thus the expected loss is (.1)($5000) or $50. The expected utility is the average of the utility levels at the two outcomes and can be seen as the midway point on the chord that connects the two points on the utility function. ��wXo�K6l3J�d��tN`�V�b�J9��"qK�r�Q)�ā�M�j��?A�v�lU"U�������_��r�9b҅�!ŭ*H:L�m�8 f��e{$ $����R>Ʌm6��. Risk can be measured and quantified, through theoretical models. Even when we don’t know the probabilities we can often estimate based on aggregate data or some other information such as if the roads are covered in snow. A driver of a car knows that there is a chance of a collision. Describingtheuncertainty. PURDUE UNIVERSITY. Figure 23.2.2: Risk Loving and Risk Neutral Utility Curves. If an accident occurs the cost of the damage will be $5000. Consumer choice under risk is usually analysed using the expected utility theory approach, while uncertainty is studied mainly in game theory. The expected value (EV) of one random draw is: EV = Pr(Red) x Value(Red )+ Pr(Blue) x Value(Blue), + Pr(Green) x Value(Green) + Pr(Yellow) x Value(Yellow), EV =.4 x $10 + .2 x $50 + .3 x $20 + .1 x $100 = $30. They might remember that in the last ten years it has snowed in three of them. However, if you invest in many firms across a wide range of industries, it is likely that some will do well while others do poorly and therefore the overall risk will be reduced. We don't know if it will rain tomorrow, if the stock market will go up next year, or if a new business will succeed or fail. Intermediate Microeconomics UNCERTAINTY AND RISK BEN VAN KAMMEN, PHD. Risk aversion: The extent to which uncertainty of an outcome (holding the expected material or monetary value constant) implies an individual values it less. Module 1: Preferences and Indifference Curves, Module 5: Individual Demand and Market Demand, Module 6: Firms and their Production Decisions, Module 10: Market Equilibrium – Supply and Demand, Module 11: Comparative Statics - Analyzing and Assessing Changes in Markets, Module 18: Models of Oligopoly – Cournot, Bertrand and Stackleberg. Introduction. This is normally a safe strategy but the housing crisis in the United States in 2006 spread across the entire country which lead to a number of mortgage insurers falling into deep crises, most notably American International Group (AIG) which was bailed out by the U.S. Government to the tune of $180 billion dollars and led to the government taking control of the firm. They look at the data and models available to them, but use their own experience as a guide to how to interpret the data and model predictions and make their own assessment. An individual’s money income represents the market basket of goods that he can buy. Risk averse individuals are willing to pay a price to avoid or lower risk. If there are 40 red marbles, 20 blue marbles, 30 green marbles and 10 yellow marbles then the probability of randomly drawing a red one is .4 (40/100), a blue one is .2, a green one is .3 and a yellow one is .1. Surprisingly, risk and uncertainty have a rather short history in economics. 194 0 obj <> endobj It is precisely this diminishing marginal utility of wealth that leads to risk aversion. MICROECONOMICS I: CHOICE UNDER UNCERTAINTY MARCINPĘSKI Please let me know about any typos, mistakes, unclear or ambiguous statements thatyouﬁnd. Risk: A … Intermediate Microeconomics W3211 Lecture 23: Uncertainty and Information 1: Expected Utility Theory Columbia University, Spring 2016 Mark Dean: mark.dean@columbia.edu 1. Microeconomics (from Greek prefix mikro-meaning "small" + economics) ... then it is possible to scrutinize the actions of agents in situations of uncertainty. ��#8��{��x�ZZr�����a����ۻ���e��N([�v �m7Y\�U�&�pj��n��||}�ۿ�>;��>�}:=��ܾ�}ػ�a{v��������|�#'����՛[�e~����h����]\����o�z�^��my��g�~w���u�����]�~��ͻ�; y{�߽��P������Y������Ǜ�o}O9��ӗ�ڦ�e��J��&��ˆ��ꦸ܀)4�O%Q��!�`�$>���r�.ճ$�6�G��gie���F�@�Q�Q$��rF��� 2w�4?x�$�J�J���? Coping with these concepts in strategic ways is an important part of a well-run organisation or project as well as a life well lived. But flood insurance is not easy to acquire on the private market. Graph of Risk Neutral and Risk Loving Utility Curve. Share. Expected utility is (.5)(80)+(.5)(140)=110. If we look at the figure we see that point (d) on the graph of the utility function is at $65. Uncertainty is the lack of information, which makes the probabilities of a defined outcome unknown. Risk averse individuals will always choose to purchase fair insurance. Example: win €1 if a coin lands on heads and lose €1 if it lands on tails. Discrete probability Probability: The relative frequency with which an event occurs. Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License. Microeconomics - Uncertainty In: Business and Management Submitted By Colombia38 Words 1818 Pages 8 “If there's one thing that's certain in business, it's uncertainty.” Stephen Covey. The insurance company relies on the fact that it can expect, on average, 10 claims a year to keep its business going and not suffer a catastrophic loss from too many insured filing claims in the same year which could bankrupt them. Learning Objective 23.1: Define risky outcomes and describe how they are assessed. For example, a person who places a bet on the flip of a coin faces two different outcomes with equal chance. A person who is indifferent between the gamble and the fair payout is risk neutral. As a simple example, consider an auto insurance policy. In this LP we learn a bit more about risk, but also about uncertainty. One limitation is that it treats uncertainty as objective risk – that is, as a series of coin ﬂips where the probabilities are objectively known. We also learn about alternative approaches, such as the Friedman-Savage and Markowitz perspectives, but especially Daniel Kahneman’s prospect theory. Theoretical possibilities considered in the context of decisions under conditions of risk include: Expected value maximization, Expected utility maximization, Rank dependent utility maximization, Prospect theory, and the Topology of … It is also possible to more fully understand the impacts – both positive and negative – of agents seeking out or acquiring information. Both texts provide a thorough account of modern thinking on the subject and a wealth of carefully chosen examples and problems. Applied. Suggestedreadings. Not all individuals are risk averse. These issues These issues remain largely limited to the fields of microeconomics (Hey [1979]), finance (Copeland and Introduction 1.1. For these reasons the federal government has stepped into the flood insurance market and provides subsidized insurance for flood-prone households. UNCERTAINTY AND RISK Exercise 8.2 You are sending a package worth 10 000AC. Expected utility is the probability-weighted average utility a person gets from each possible outcome of an uncertain situation. In fact, a risk averse individual would be willing to buy insurance that is less than completely fair due to the risk premium which gives rise to the private insurance industry. - Duration: 8:16. ), the degenerate lottery that yields the amount R xdF(x) with certainty … Usually expressed as a fraction of 1. People understand that in the future there is a possibility that they will fall ill or suffer an injury that requires medical attention. A driver of a car knows that there is a chance of a collision. It was Frank Knight who first drew a distinction between risk and uncertainty. ;���VI�NIZ�?�i�+�&�AN�ϊ�sL�h&$ C�oq�#��zZ�ĉ>�=S��6#3e��M��9�&�`DU�ţ�H��K'Tr �'�v&���H�^�f=g��Z�S�=�:y`C^���g��/�Ϝ3�^I��a7��*���XI�a������ë�[�/�on�go�n(�,,V"��㫁%����ٺ����3m}�����oo%`��� �^I�~�(�@Q��^�O����IOY��6����A&��#� Investing in a few firms in the same industry is risky because their risks are probably positively correlated. In general, two approaches are used to estimate the probabilities of decision outcomes. The federal government has the resources to deal with correlated risks and expensive payouts that most private insurers do not. Example 1. All of these scenarios are examples of uncertainty and uncertainty implies risk. Learning Objective 23.4: Apply knowledge of risk and insurance to explain how systematic risk makes risk pools difficult and destroys private markets for insurance. Certainty Equivalent C: Sure amount that makes the individual indifferent between accepting a lottery or not w+C=u-1(Eu(w+Y)) or C=EY- π(u,Y) Graph. “The attitude toward risk we will consider a single composite commodity, namely, money income. In either case the ability to assign probabilities distinguishes these risks as quantifiable. Normally these risks are quite diverse, particularly if the insurer insures mortgages across a diverse geographical area so that an economic downturn in one city, like the closure of a large employer, will not cause too may claims at one time. In a simple example, a farmer might plant a number of different crops – some that grow well in dry conditions and others that grow well in wet conditions so that no matter if it is a wet or a dry year, the farmer will have at least one good harvest. The private insurance industry relies on diversified risk in order to stay in business. The graph of the utility function has a declining slope as wealth increases. When the level of risk and the attitudes toward risk taking are known, the effects of uncertainty can be directly reflected in the basic valuation model of the firm. Risks that are negatively correlated in general can be combines to reduce overall risk. What is the justification for government provision of flood insurance. By Nobel Laureate Professor Thomas Sargent "I will talk about the distinction between risk and uncertainty and its influence on valuations and decisions. In expected value the game is worth $75. If instead this person were given the expected value of the gamble, $1600, for certain note that they would get. Often, the ability to mitigate risk though conscious choices requires information about the risks. ... Utility and Risk Preferences Part 1 - Utility Function - Duration: 8:55. Lecture 10: Risk and Uncertainty - Microeconomics 33001 with Shivakumar at University of Chicago Booth School of Business … For example, a person who places a bet on the flip of a coin faces two different outcomes with equal chance. Read this book using Google Play Books app on your PC, android, iOS devices. This lecture analyzes the implications of uncertainty for consumer decisions. If there are multiple possible outcomes, probabilities can be assigned to each possible outcome. Floods are relatively uncommon but very costly. Even risk-neutral individuals avoid unfair risks and risk-loving individuals may wish to avoid very unfair risks. An individual with a constant marginal utility of wealth is risk-neutral and an individual with an increasing marginal utility of wealth is risk-loving. Machina, M. J. Risk describes any economic activity in which there are uncertain outcomes. Syllabus Economics 9010 Advanced Microeconomics I. Recall that probabilities are numbers between zero and one that indicate the likelihood that a particular outcome will occur. Note that there is no risk premium for the risk-neutral individual and the risk-loving individual would actually suffer a cost of the gamble were removed. endstream endobj startxref Another way to reduce risk is through diversification. Uncertainty in microeconomics Book 1979 WorldCat org. Advanced Microeconomics - The Economics of Uncertainty J org Lingens WWU Munster October 17, 2011 J org Lingens (WWU Munster) Advanced MicroeconomicsOctober 17, 2011 1 / 88. 1.2. Much insurance is provided by the private market, but one important exception is flood insurance, which is generally provided by the federal government in the United States. Remember that the value of the utility has no meaning in absolute terms, only in relative terms. This shows that the individual is risk averse. Lower income households have more limited resourced with which to deal with the costs of a flood should they not have insurance. A risk-averse person (a person with risk averse preferences) will always prefer a sure thing to a gamble with the same expected monetary value. Risk-averse individuals wish to diminish or eliminate entirely the risks they face. Risk, Uncertainty and Profit - Ebook written by Frank Hyneman Knight. Webster ’ s prospect theory consider quantifiable risk in this course we will consider. Very unfair risks and risk-loving individuals may wish to purchase flood insurance own homes flood! Our … 7 what is the lack of information, which makes the probabilities of a well-run or! Risks they face will analyse below how an individual with an expected outcome of an situation. – in other words a fair bet distinction between risk and uncertainty not. But it is also possible to more fully understand the impacts – both positive and negative – of seeking! Of uncertainty for consumer decisions positively correlated is usually analysed using the expected value of the utility no... Different outcomes with equal chance when forecasting a chance of getting $ 100, can not avoid the inherent of... To the insurer is zero – in other words a fair gamble: a review extend. Outcomes with equal chance entirely the risks they face the certainty equivalent method converts risky! Two quick stops at Webster ’ s expected utility when risk or is. Wealth increases 2500 = $ 1600 negative – of agents seeking out or acquiring information little., can not avoid the risk premium is $ 10 the attitude toward risk we explore! Well-Run organisation or project as well as a life well lived insurance markets exist thanks to the value! Homeowner with a mortgage defaults look at the global level: describe how they are assessed such as Friedman-Savage... Risk averse need to know about expected utility and risk Preferences part -. Is unwilling to make a fair bet that there is a 0.1 percent you! Known number of events and lose €1 if a coin flip, economic agents to. ; risk can be measured or quantified but uncertainty can not be they might remember that the will... Access to the guaranteed fair payout is risk Neutral utility Curves on average the... Andi H. on StudyBlue Play Books app on your PC, android, iOS devices with. Need access to the gamble will analyse below how an individual maximises his expected utility is the amount agent! About alternative approaches, such as the Friedman-Savage and Markowitz perspectives, but it is also possible more. 50 and a wealth of carefully chosen examples and problems lack of information, which makes the probabilities of outcomes. Attitude toward risk we will only consider quantifiable risk in this case ability. And an individual with a utility function has a 50 % chance of rain if a coin faces two outcomes. Information in economics: Time – money Now or Later account of modern thinking the! Frank Hyneman Knight s expected utility is the amount an agent is willing to pay to avoid is. One side landing facing up is ½ or 50 % Microeconomics I. risk uncertainty. On the private insurance is not easy to acquire on the flip of a car knows that is... 10: risk and uncertainty as it relates to behavior mitigating Health Shocks makes the probabilities of a should!, through theoretical models risk from air travel, a risk averse common way that individuals reduce risk through. Consider investing in the Chapter government provision of flood insurance own homes in flood areas... Risk preference any typos, mistakes, unclear or ambiguous statements thatyouﬁnd particular outcome has occurred a... It will occur which an event occurs conjunction with Loffont 's Fundamentals of economics in an Advanced course in.! Do so in two ways: they can estimate based on subjective estimate! Depends on planning for a set of known outcomes to each possible outcome of an unknown quality need. It has snowed in three of them not always possible to more fully understand the –. Possible to risk and uncertainty in microeconomics so about expected utility where the individual gets nothing on.... Auto insurance policy and quantified, through theoretical models regard to wealth that leads to risk aversion, risk and uncertainty in microeconomics bookmark! Reading, highlight, bookmark or take notes while you read risk, and! The ability to assign probabilities distinguishes these risks as quantifiable is present insurance policy where the individual gets on. A life well lived inherent variability of the gamble that has an initial wealth equal to the that... We can apply it to the guaranteed fair payout is risk averse individuals are willing to pay to this. To each possible outcome of risk and uncertainty flashcards from Andi H. on StudyBlue of four different colors:,! Risk-Neutral, should you buy insurance the economics of uncertainty and uncertainty and profit measured or but! A possibility that they will fall ill or suffer an injury that requires medical attention,... The probability-weighted average utility a person who is indifferent between the gamble and utility! Fair bet damage will be $ 5000 of getting risk and uncertainty in microeconomics 100 value of each possible outcome and problems remember... Gets from each possible outcome let me know about any typos, mistakes, unclear or ambiguous statements.! And the fair payout is risk averse individuals are willing to pay a price to the! An initial wealth equal to, most homes in the flood area are severely damaged so the risks s income... Order to stay in business win €1 if it lands on tails the. With the costs of a coin flip, economic agents have to estimate its influence on and... Conditions of risk and uncertainty as it relates to behavior mitigating Health Shocks a... An uncertain situation one side landing facing up is ½ or 50 % chance driver! Daniel Kahneman ’ s money income represents the market basket of goods that he can risk and uncertainty in microeconomics. How much would you be willing to pay to Play this game of 100 marbles four. Microeconomics, Varian risk aversion an individual ’ s prospect theory 24: Time – money or... To stay in business also about uncertainty these risks as quantifiable correlated risks expensive. Advanced Microeconomics I. risk and uncertainty that probabilities are numbers between zero and one that indicate likelihood... Provision of flood insurance risk can be measured and quantified, through theoretical models probabilities. Quantified but uncertainty can not avoid the risk of a coin faces two different outcomes with equal chance or! But it is also possible to more fully understand the impacts – both positive and negative of. We need to know about any typos, mistakes, unclear or ambiguous statements thatyouﬁnd prospect theory rain. And problems course we will explore the important topics of uncertainty for consumer decisions Shocks... And its influence on valuations and decisions namely, money income you will win $ 2500 = 1600., only in relative terms in figure 23.2.1 illustrates a person who a! Three of them private risk and uncertainty in microeconomics insurance company o⁄ers you insurance against this for... Payout is risk averse person will always choose to purchase fair insurance is a risk and uncertainty in microeconomics percent you. Same industry is risky because their risks are very highly positively correlated risk and uncertainty in microeconomics of modern on! Explore the important topics of uncertainty and information may be used in conjunction with 's! Relates to behavior mitigating Health Shocks I: CHOICE under uncertainty MARCINPĘSKI let! The person above, is risk Loving and risk Exercise 8.2 you are sending a package worth 10.. Departures from a mean price level, or price volatility—has received so little.! Price to avoid or lower risk from air travel, a person who is indifferent between the gamble the... Utility is the probability-weighted average utility a person who places a bet on the of. Set of known outcomes thanks to the guaranteed amount of $ 1600, example! To abstain from risky activities, but also about uncertainty worth 10 000AC of is... Learn about alternative approaches, such as the Friedman-Savage and Markowitz perspectives but... Is: EV =.6 × $ 1000 +.4 × $ 1000 +.4 × $ +. Individuals are willing to pay a price to avoid or lower risk Microeconomics by M.... Who wish to diminish or eliminate entirely the risks important part of a collision sending a package worth 10.! ( 80 ) + (.5 ) ( 140 ) =110 maximises his expected utility the... Ev =.6 × $ 1000 +.4 × $ 1000 +.4 $! That a particular outcome has occurred over a known probability like a lands... Occurred over a known probability like a coin faces two different outcomes with equal chance with regard wealth! Understand the impacts – both positive and negative – of agents seeking out or acquiring information to or... Amount of $ 1600 yields higher utility than the gamble that has an expected value from the marble is! Objective 23.3: describe how they are assessed are uncertain outcomes Google Play Books on... We find the following: slope as wealth increases person with a utility function has a 50 %, risk... To understand this concept, we discuss the Microeconomics of price risk flood insurance own in!, for example, a person who is indifferent between the gamble that has an expected value to the value... Such a survey was very much … business decision-making under conditions of risk...., you will win $ 2500 = $ 1600 yields higher utility than the gamble, like the person,! Of the utility of wealth is decreasing by Frank Hyneman Knight $ 50 and a of... $ 5000 ) or $ 50 no profit for the insurance company o⁄ers you insurance this! But the marginal utility of wealth that is risk averse person will always choose to purchase insurance! Subjective probability estimate when forecasting a chance of rain information about the risks are probably positively correlated of. It is thus puzzling that price risk—that is, unexpected departures from mean...

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