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. Figure 23.2.2 illustrates both situations using the same scenario as in Figure 23.2.1. The graph of the utility function has a declining slope as wealth increases. A person who is indifferent between the gamble and the fair payout is risk neutral. The graph tells us that the utility of $50 for this agent is 80 and the utility for $100 is 140. ϵ[0,1]. Next: Module 24: Time – Money Now or Later? Associated with any uncertain outcome are probabilities. The Geneva Papers on Risk and Insurance , 13 (No 46, January 1988), 96-99 Uncertainty in Macroeconomics and the Microeconomics of Uncertainty* by Henri Loubergé** Professor von Furstenberg's lecture on "Uncertainty in Macroeconomics" [1988] has presented a very comprehensive survey of the problems raised in current macroeconomic research. “The attitude toward risk we will consider a single composite commodity, namely, money income. As a simple example, consider an auto insurance policy. Expected utility is (.5)(80)+(.5)(140)=110. Risk can be measured and quantified, through theoretical models. He can participate in a fair gamble. Intermediate Microeconomics by Patrick M. Emerson is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License, except where otherwise noted. Fair insurance is a contract with an expected value to the insurer is zero – in other words a fair bet. %%EOF hެYYo7�+|4óX�d!�k;N�l�~P�[�/H���[���[���&ndZ�!���K�TjT�r���d��ˡ��ѻP#��k�Ft�xbr�"M�ٕ�+ Learning Objective 23.2: Explain expected utility and risk preference. Investing in a few firms in the same industry is risky because their risks are probably positively correlated. The … Similarly, economists have studied behavior in the face of risk and uncertainty for at least a century, and risk and uncertainty are without a doubt a feature of economic life. - Duration: 8:16. To understand this concept, we can apply it to the gamble. Describingtheuncertainty. 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. MICROECONOMICS I: CHOICE UNDER UNCERTAINTY MARCINPĘSKI Please let me know about any typos, mistakes, unclear or ambiguous statements thatyoufind. Knightian Uncertainty . It is precisely this diminishing marginal utility of wealth that leads to risk aversion. ��#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�$�J�J���? It is thus puzzling that price risk—that is, unexpected departures from a mean price level, or price volatility—has received so little attention. Uncertainty is a condition where there is no knowledge about the future events. In a simple example, a farmer might plant a number of different crops – some that grow well in dry conditions and others that grow well in wet conditions so that no matter if it is a wet or a dry year, the farmer will have at least one good harvest. The formal incorporation of risk and uncertainty into economic theory was only accomplished in 1944, when John von Neumann and Oskar Morgenstern published their Theory of Games and Economic Behavior - although the exceptional effort of Frank P. Ramsey (1926) must be mentioned as an antecedent. A weather forecaster is also making a subjective probability estimate when forecasting a chance of rain. Pr. People understand that in the future there is a possibility that they will fall ill or suffer an injury that requires medical attention. ���j/A��#�xD���@��#��;$�o�e`�6��q����ү ��+ MWGchapter6.A.Kreps“NotesontheTheoryofChoice”, chapters4and7(thefirstpartonly). Uncertainty is the lack of information, which makes the probabilities of a defined outcome unknown. Study 17 Lecture 10: Risk and Uncertainty flashcards from Andi H. on StudyBlue. Remember that the value of the utility has no meaning in absolute terms, only in relative terms. 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. For these reasons the federal government has stepped into the flood insurance market and provides subsidized insurance for flood-prone households. If we look at the figure we see that point (d) on the graph of the utility function is at $65. The expected value of this gamble is: EV = .6 × $1000 + .4 × $2500 = $1600. h�bbd```b``��� �q ;�U�%� xx;0())*�R@�~�M�@�j#�~eN�5,O�{n�?~&��m����c��84� . In a coin flip, the probability of one side landing facing up is ½ or 50%. A fair insurance contract is one that would fully insure against this loss and charge the driver exactly the expected cost, or $50. Often, the ability to mitigate risk though conscious choices requires information about the risks. PURDUE UNIVERSITY. What is the justification for government provision of flood insurance. Example: win €1 if a coin lands on heads and lose €1 if it lands on tails. The Story So Far…. Even risk-neutral individuals avoid unfair risks and risk-loving individuals may wish to avoid very unfair risks. The reason for this is the fact that most people who wish to purchase flood insurance own homes in flood prone areas. 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. The Economics of Uncertainty and Information may be used in conjunction with Loffont's Fundamentals of Economics in an advanced course in microeconomics. Microeconomics (from Greek prefix mikro-meaning "small" + economics) ... then it is possible to scrutinize the actions of agents in situations of uncertainty. In this course we will explore the important topics of uncertainty and information in economics. Both texts provide a thorough account of modern thinking on the subject and a wealth of carefully chosen examples and problems. ... Utility and Risk Preferences Part 1 - Utility Function - Duration: 8:55. 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. UNCERTAINTY Chapter 12, Intermediate Microeconomics, Varian Risk aversion An individual has an initial wealth equal to . Learning Objective 23.1: Define risky outcomes and describe how they are assessed. Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License. 1. However, although different models have been developed for both situations, risk situations, … 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. By Nobel Laureate Professor Thomas Sargent "I will talk about the distinction between risk and uncertainty and its influence on valuations and decisions. The economics of uncertainty impacts our … IntroductionGeneral Remarks Tourguide Introduction General Remarks Expected Utility Theory Some Basic Issues Comparing di erent Degrees of Riskiness Attitudes towards Risk { Measuring Risk … In expected value the game is worth $75. However, the world is filled with uncertainty. 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. If an insurer has 1000 clients, each with a 1% risk of needing to make a claim, it is necessary that the 1% risk is not too positively correlated to avoid situations in which too many insured make claims in thee same year. endstream endobj 195 0 obj <> endobj 196 0 obj <> endobj 197 0 obj <>stream If one firm in the automotive industry is doing poorly, it might be because demand for cars is soft and thus all automobile manufacturers might be doing poorly as a result. The federal government has the resources to deal with correlated risks and expensive payouts that most private insurers do not. A fair gamble is one where the cost of the gamble is equal to the expected value. Introduction. University of Chicago economist Frank Knight wrote about the difference between one kind of uncertainty and another in his stock-market-oriented economics text Risk, Uncertainty and Profit. These issues These issues remain largely limited to the fields of microeconomics (Hey [1979]), finance (Copeland and Not all individuals are risk averse. In other words, the guaranteed amount of $1600 yields higher utility than the gamble that has an expected value of $1600. The risk premium is the amount an agent is willing to pay to avoid the risk of a fair gamble. 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. An individual’s money income represents the market basket of goods that he can buy. Modern decision theory is based on this distinction. This means that the agent has a 50% chance of getting $50 and a 50% chance of getting $100. For example, a person who lives in an area that only rarely gets snow in the winter might wonder what the chances are that there will be snow this winter. For this reason, much of private insurance is priced beyond the risk premium of private homeowners. When a flood happens, most homes in the flood area are severely damaged so the risks are very highly positively correlated. So this agent prefers more wealth to less but the marginal utility of wealth is decreasing. Working Paper 19005 DOI 10.3386/w19005 Issue Date April 2013. 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. Discrete probability Probability: The relative frequency with which an event occurs. We start by seeing again how risk is analysed using Morgenstern and von Neumann’s expected utility theory. Economic Analysis of Risk and Uncertainty induced by Health Shocks: A Review and Extension. If you are risk-neutral, should you buy insurance? Read this book using Google Play Books app on your PC, android, iOS devices. We will only consider quantifiable risk in this module. Risk is objective but uncertainty is subjective; risk can be measured or quantified but uncertainty cannot be. One limitation is that it treats uncertainty as objective risk – that is, as a series of coin flips where the probabilities are objectively known. Share. Learning Objective 23.3: Describe how diversification and insurance mitigate risk. 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. If an accident occurs the cost of the damage will be $5000. This contract offers no profit for the insurance company, however. 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. 206 0 obj <>/Filter/FlateDecode/ID[<18350D743DFD7B468F1DFCC6E35CE378><522AB398DAF72C46B2FCF003F03F2E0B>]/Index[194 36]/Info 193 0 R/Length 81/Prev 270382/Root 195 0 R/Size 230/Type/XRef/W[1 3 1]>>stream The utility of $75 for this agent is 130 as shown in the figure. In the absence of a known probability like a coin flip, economic agents have to estimate. Risk-averse individuals wish to diminish or eliminate entirely the risks they face. Introduction 2. 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. 8:55 . 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. 7 What is the difference between risk and uncertainty? 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. Floods are relatively uncommon but very costly. If instead this person were given the expected value of the gamble, $1600, for certain note that they would get. Suppose there is a 1% chance a driver will have an accident in a year. In either case the ability to assign probabilities distinguishes these risks as quantifiable. The easiest way to avoid risk is to abstain from risky activities, but it is not always possible to do so. ;���VI�NIZ�?�֐i�+�&�AN�ϊ�sL�h&$ 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&��#� This means that playing this risky game yields a utility of 110 for this agent. 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. But flood insurance is not easy to acquire on the private market. Risk describes any economic activity in which there are uncertain outcomes. Surprisingly, risk and uncertainty have a rather short history in economics. They generally do so in two ways: they can estimate based on frequency or based on subjective probability. All of these scenarios are examples of uncertainty and uncertainty implies risk. endstream endobj startxref Therefore, they might estimate the probability of snow this year based on its annual frequency, 3/10, or .3, or 30%. In this case the risk premium is $10. For example, in order to lower risk from air travel, a traveler would need access to the safety records of airlines. With a 80 percent chance, you will win $400 and with a 20 percent chance you will win $2500. The difference between risk and uncertainty can be drawn clearly on the following grounds: The risk is defined as the situation of winning or losing something worthy. 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. 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. Lecture 10: Risk and Uncertainty - Microeconomics 33001 with Shivakumar at University of Chicago Booth School of Business … In this LP we learn a bit more about risk, but also about uncertainty. The private insurance industry relies on diversified risk in order to stay in business. An insurance company o⁄ers you insurance against this eventuality for a premium of 15AC. Consider two possible outcomes, $50 and $100. You estimate that there is a 0.1 percent chance that the package will be lost or destroyed in tran-sit. Usually expressed as a fraction of 1. It is also possible to more fully understand the impacts – both positive and negative – of agents seeking out or acquiring information. But there are some actions individuals can take to mitigate risk: drivers can drive more carefully, farmers can plant drought resistant crops, travelers can avoid airlines with poor safety records. Fair gamble = a gamble where the individual gets nothing on expectation. ), the degenerate lottery that yields the amount R xdF(x) with certainty … UNCERTAINTY AND RISK Exercise 8.2 You are sending a package worth 10 000AC. Such a survey was very much … business decision-making under conditions of risk and uncertainty. This is exacerbated by the fact that it is common that homeowners in flood probe areas are disproportionately low-income households because flood prone land is generally cheaper than land in higher areas. Microeconomics CHAPTER 8. Definition (Risk Premium π): Maximal amount of money that an individual is willing to pay to escape a pure risk u(w-π(u,X))= Eu(w+X) with EX=0. Consider the following gamble. A company develops a product of an unknown quality. (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.) If there are multiple possible outcomes, probabilities can be assigned to each possible outcome. Graph of Risk Neutral and Risk Loving Utility Curve. Microeconomics (01:220:320). Of course, it’s hard to place an objective probability on whether Arnold Schwarzenegger would be a good California governor despite the uncertainty. Example 1. Applied. 194 0 obj <> endobj Unfortunately, running a business primarily depends on planning for a set of known outcomes. For example, consider investing in the stock market. 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. A driver of a car knows that there is a chance of a collision. Risk describes any economic activity in which there are uncertain outcomes. For example, a person who places a bet on the flip of a coin faces two different outcomes with equal chance. 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. This is an Upper-Level Elective in the economics curriculum. %PDF-1.6 %���� For this module, as in economics in general, we use the terms risk and uncertainty interchangeably. Outline Answer: No you should not. We review and extend the economic analysis of risk and uncertainty as it relates to behavior mitigating health shocks. The expected value of an uncertain outcome is the sum of the value of each possible outcome multiplied by the probability it will occur. Private insurance markets exist thanks to the risk premium described earlier in the chapter. 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