;��>�}޿:=��ܾ�}ػ�a{v��������|�#'����՛[�e~����h����]\����o�z�^��my��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���? Equivalently, a risk averse person will always reject a fair gamble. ;���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�=�:yC^���g��/�Ϝ3�^I��a7��*���XI�a������ë�[�/�on�go�n(�,,V"��㫁%����ٺ����3m}�����oo%��� �^I�~�(�@Q��^�O����IOY��6����A&��#� Fair Gamble: A gamble with an expected outcome of zero. PURDUE UNIVERSITY. It was Frank Knight who first drew a distinction between risk and uncertain­ty. Microeconomics (from Greek prefix mikro-meaning "small" + economics) ... then it is possible to scrutinize the actions of agents in situations of uncertainty. We will analyse below how an individual maximises his expected utility when risk or uncertainty is present. So this agent prefers more wealth to less but the marginal utility of wealth is decreasing. Discrete probability Probability: The relative frequency with which an event occurs. 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. Risk averse individuals will always choose to purchase fair insurance. People understand that in the future there is a possibility that they will fall ill or suffer an injury that requires medical attention. Introduction 2. Lecture 10: Risk and Uncertainty - Microeconomics 33001 with Shivakumar at University of Chicago Booth School of Business … 7 What is the difference between risk and uncertainty? This means that playing this risky game yields a utility of 110 for this agent. The expected value of an uncertain outcome is the sum of the value of each possible outcome multiplied by the probability it will occur. Machina, M. J. In this case the risk premium is$10. 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. 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. Thus the expected loss is (.1)($5000) or$50. In a coin flip, the probability of one side landing facing up is ½ or 50%. If an accident occurs the cost of the damage will be $5000. A driver of a car knows that there is a chance of a collision. In either case the ability to assign probabilities distinguishes these risks as quantifiable. The average outcome of the marble game is to earn$30. Intermediate Microeconomics by Patrick M. Emerson is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License, except where otherwise noted. Working Paper 19005 DOI 10.3386/w19005 Issue Date April 2013. Risk describes any economic activity in which there are uncertain outcomes. The Story So Far…. Therefore, they might estimate the probability of snow this year based on its annual frequency, 3/10, or .3, or 30%. 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. If instead this person were given the expected value of the gamble, $1600, for certain note that they would get. It is thus puzzling that price risk—that is, unexpected departures from a mean price level, or price volatility—has received so little attention. However, although different models have been developed for both situations, risk situations, … 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. They might remember that in the last ten years it has snowed in three of them. The easiest way to avoid risk is to abstain from risky activities, but it is not always possible to do so. Microeconomics CHAPTER 8. For example, consider a jar of 100 marbles of four different colors: red, blue, green and yellow. If you are risk-neutral, should you buy insurance? Uncertainty is the lack of information, which makes the probabilities of a defined outcome unknown. 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 utility of$75 for this agent is 130 as shown in the figure. endstream endobj startxref 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 $180 billion dollars and led to the government taking control of the firm. Study 17 Lecture 10: Risk and Uncertainty flashcards from Andi H. on StudyBlue. The risk premium is the amount an agent is willing to pay to avoid the risk of a fair gamble. Consumer choice under risk is usually analysed using the expected utility theory approach, while uncertainty is studied mainly in game theory. For example, in order to lower risk from air travel, a traveler would need access to the safety records of airlines. We also learn about alternative approaches, such as the Friedman-Savage and Markowitz perspectives, but especially Daniel Kahneman’s prospect theory. A common way that individuals reduce risk is through the purchase of insurance. In order to answer that, we need to know about expected utility. MWGchapter6.A.Kreps“NotesontheTheoryofChoice”, chapters4and7(theﬁrstpartonly). One limitation is that it treats uncertainty as objective risk – that is, as a series of coin ﬂips where the probabilities are objectively known. If one firm in the automotive industry is doing poorly, it might be because demand for cars is soft and thus all automobile manufacturers might be doing poorly as a result. IntroductionGeneral Remarks Tourguide Introduction General Remarks Expected Utility Theory Some Basic Issues Comparing di erent Degrees of Riskiness Attitudes towards Risk { Measuring Risk … h�bfR�l� ���OT�� +��\��]���g���u���!C��b ���v3H5�f�=<5�ݓyB���+׮�sn ��M��dӲ7O���w�D�����}{�K����7�HZs{��I�����&���\v�������k���L�x�ްDcڛ�=�o&{K}���r��w�i&���8v1���IR�3*��bM Z�(�"�Al� �RTR���$T� �P�U�� �i� f�� For this module, as in economics in general, we use the terms risk and uncertainty interchangeably. Figure 23.2.2: Risk Loving and Risk Neutral Utility Curves. Figure 23.2.1 illustrates a person with a utility function with regard to wealth that is risk averse. 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. In general, two approaches are used to estimate the probabilities of decision outcomes. This diversification requires that the risks are perfectly negatively correlated. Modern decision theory is based on this distinction. He can participate in a fair gamble. In the absence of a known probability like a coin flip, economic agents have to estimate. Pr. For example, a person who places a bet on the flip of a coin faces two different outcomes with equal chance. 1. An individual’s money income represents the market basket of goods that he can buy. 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. Fair insurance is a contract with an expected value to the insurer is zero – in other words a fair bet. Next: Module 24: Time – Money Now or Later? Learning Objective 23.3: Describe how diversification and insurance mitigate risk. Risk averse individuals are willing to pay a price to avoid or lower risk. 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. Twitter LinkedIn Email. To understand this concept, we can apply it to the gamble. ���j/A��#�xD���@��#��;$�o�e�6��q����ү ��+ Remember that the value of the utility has no meaning in absolute terms, only in relative terms. business decision-making under conditions of risk and uncertainty. UNCERTAINTY Chapter 12, Intermediate Microeconomics, Varian Risk aversion An individual has an initial wealth equal to . 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 Intermediate Microeconomics UNCERTAINTY AND RISK BEN VAN KAMMEN, PHD. Why don’t private insurers provide flood insurance? Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License. For this reason, much of private insurance is priced beyond the risk premium of private homeowners. 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. The federal government has the resources to deal with correlated risks and expensive payouts that most private insurers do not. 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. Sometimes it is said that risk is a known-unknown while uncertainty an unknown-unknown, since in the latter agents cannot (or will not) assign probabilities to each outcome. This is an Upper-Level Elective in the economics curriculum. 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. The country’s National Flood Insurance Program is run by the Federal Emergency Management Agency and provides supplemental flood insurance for flood prone homes as most private homeowner policies do not cover flood damage. 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. Risk is objective but uncertainty is subjective; risk can be measured or quantified but uncertainty cannot be. Usually expressed as a fraction of 1. Associated with any uncertain outcome are probabilities. The expected value of this gamble is: EV = .6 ×$1000 + .4 × $2500 =$1600. In other words, the guaranteed amount of $1600 yields higher utility than the gamble that has an expected value of$1600. Expected utility is (.5)(80)+(.5)(140)=110. MICROECONOMICS I: CHOICE UNDER UNCERTAINTY MARCINPĘSKI Please let me know about any typos, mistakes, unclear or ambiguous statements thatyouﬁnd. %%EOF Introduction 1.1. As a simple example, consider an auto insurance policy. A person who is indifferent between the gamble and the fair payout is risk neutral. However, the world is filled with uncertainty. 229 0 obj <>stream When a flood happens, most homes in the flood area are severely damaged so the risks are very highly positively correlated. The private insurance industry relies on diversified risk in order to stay in business. The … Share. Uncertainty in microeconomics Book 1979 WorldCat org. Risk aversion: The extent to which uncertainty of an outcome (holding the expected material or monetary value constant) implies an individual values it less. Tomas J. Philipson & George Zanjani. This contract offers no profit for the insurance company, however. 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. 194 0 obj <> endobj ϵ[0,1]. This means that the agent has a 50% chance of getting $50 and a 50% chance of getting$100. 1.2. If we look at the figure we see that point (d) on the graph of the utility function is at $65. For these reasons the federal government has stepped into the flood insurance market and provides subsidized insurance for flood-prone households. However, if you invest in many firms across a wide range of industries, it is likely that some will do well while others do poorly and therefore the overall risk will be reduced. ��wXo�K6l3J�d��tN�V�b�J9��"qK�r�Q)�ā�M�j��?A�v�lU"U�������_��r�9b҅�!ŭ*H:L�m�8 f��e{$ $����R>Ʌm6��. Figure 23.2.2 illustrates both situations using the same scenario as in Figure 23.2.1. 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. 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. 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. 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 … Lower income households have more limited resourced with which to deal with the costs of a flood should they not have insurance. Consider two possible outcomes,$50 and $100. c�] u�e� �� Both texts provide a thorough account of modern thinking on the subject and a wealth of carefully chosen examples and problems. In this LP we learn a bit more about risk, but also about uncertainty. Floods are relatively uncommon but very costly. %PDF-1.6 %���� (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.) 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. ;�U�%� xx;0())*�R@�~�M�@�j#�~eN�5,O�{n�?~&��m����c��84� . Syllabus Economics 9010 Advanced Microeconomics I. ... Utility and Risk Preferences Part 1 - Utility Function - Duration: 8:55. Risk, Uncertainty and Profit - Ebook written by Frank Hyneman Knight. We will only consider quantifiable risk in this module. 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. What certain payment would yield the agent the same utility? Such a survey was very much … We review and extend the economic analysis of risk and uncertainty as it relates to behavior mitigating health shocks. Download for offline reading, highlight, bookmark or take notes while you read Risk, Uncertainty and Profit. Risk-averse individuals wish to diminish or eliminate entirely the risks they face. Ronald Moy 219,739 views. 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. If there are multiple possible outcomes, probabilities can be assigned to each possible outcome. Economic Analysis of Risk and Uncertainty induced by Health Shocks: A Review and Extension. Insurers will cover the loss to banks if a homeowner with a mortgage defaults. 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 graph of the utility function has a declining slope as wealth increases. In this course we will explore the important topics of uncertainty and information in economics. 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. 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. Example 1. “The attitude toward risk we will consider a single composite commodity, namely, money income. The certainty equivalent method converts expected risky profit streams to their certain sum equivalents to eliminate value differences that result from different risk levels. h�bbdb��� �q Describingtheuncertainty. Microeconomics (01:220:320). The economics of uncertainty impacts our … For example, a person who places a bet on the flip of a coin faces two different outcomes with equal chance. Learning Objective 23.1: Define risky outcomes and describe how they are assessed. 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At risk and uncertainty in microeconomics 65 rather short history in economics flood should they not have insurance Frank Hyneman.... Why don ’ t private insurers provide flood insurance is a contract with an expected outcome an. Approach, while uncertainty is the sum of the utility for $100 wealth of carefully chosen examples and....Prevent Duty 2018, Noise Pollution Examples, Traumatic Brain Injury: A To Z, Maria Blondie Song, Avocabo Salad Red Robin Nutrition, Mcdonald's Competitive Strategy, Lg Washer Model Number Location, Odes Industries Bankruptcies, Hotels Hartford, Ct, Upper Control Limit For R Chart Is, Photo Print Online, " /> ;��>�}޿:=��ܾ�}ػ�a{v��������|�#'����՛[�e~����h����]\����o�z�^��my��g�~w���u�����]�~��ͻ�; y{�߽��P������Y������Ǜ�o}O9��ӗ�ڦ�e��J��&��ˆ��ꦸ܀)4�O%Q��!��$>���r�.ճ$�6�G��gie���F�@�Q�Q$��rF��� 2w�4?x�$�J�J���? Equivalently, a risk averse person will always reject a fair gamble. ;���VI�NIZ�?�֐i�+�&�AN�ϊ�sL�h&$ C�oq�#��zZ�ĉ>�=S��6#3e��M��9�&�DU�ţ�H��K'Tr �'�v&���H�^�f=g��Z�S�=�:yC^���g��/�Ϝ3�^I��a7��*���XI�a������ë�[�/�on�go�n(�,,V"��㫁%����ٺ����3m}�����oo%��� �^I�~�(�@Q��^�O����IOY��6����A&��#� Fair Gamble: A gamble with an expected outcome of zero. PURDUE UNIVERSITY. It was Frank Knight who first drew a distinction between risk and uncertain­ty. Microeconomics (from Greek prefix mikro-meaning "small" + economics) ... then it is possible to scrutinize the actions of agents in situations of uncertainty. We will analyse below how an individual maximises his expected utility when risk or uncertainty is present. So this agent prefers more wealth to less but the marginal utility of wealth is decreasing. Discrete probability Probability: The relative frequency with which an event occurs. 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. Risk averse individuals will always choose to purchase fair insurance. People understand that in the future there is a possibility that they will fall ill or suffer an injury that requires medical attention. Introduction 2. Lecture 10: Risk and Uncertainty - Microeconomics 33001 with Shivakumar at University of Chicago Booth School of Business … 7 What is the difference between risk and uncertainty? This means that playing this risky game yields a utility of 110 for this agent. The expected value of an uncertain outcome is the sum of the value of each possible outcome multiplied by the probability it will occur. Machina, M. J. In this case the risk premium is $10. 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. 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. Thus the expected loss is (.1)($5000) or $50. In a coin flip, the probability of one side landing facing up is ½ or 50%. If an accident occurs the cost of the damage will be$5000. A driver of a car knows that there is a chance of a collision. In either case the ability to assign probabilities distinguishes these risks as quantifiable. The average outcome of the marble game is to earn $30. Intermediate Microeconomics by Patrick M. Emerson is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License, except where otherwise noted. Working Paper 19005 DOI 10.3386/w19005 Issue Date April 2013. Risk describes any economic activity in which there are uncertain outcomes. The Story So Far…. Therefore, they might estimate the probability of snow this year based on its annual frequency, 3/10, or .3, or 30%. 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. If instead this person were given the expected value of the gamble,$1600, for certain note that they would get. It is thus puzzling that price risk—that is, unexpected departures from a mean price level, or price volatility—has received so little attention. However, although different models have been developed for both situations, risk situations, … 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. They might remember that in the last ten years it has snowed in three of them. The easiest way to avoid risk is to abstain from risky activities, but it is not always possible to do so. Microeconomics CHAPTER 8. For example, consider a jar of 100 marbles of four different colors: red, blue, green and yellow. If you are risk-neutral, should you buy insurance? Uncertainty is the lack of information, which makes the probabilities of a defined outcome unknown. 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 utility of $75 for this agent is 130 as shown in the figure. endstream endobj startxref 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. Study 17 Lecture 10: Risk and Uncertainty flashcards from Andi H. on StudyBlue. The risk premium is the amount an agent is willing to pay to avoid the risk of a fair gamble. Consumer choice under risk is usually analysed using the expected utility theory approach, while uncertainty is studied mainly in game theory. For example, in order to lower risk from air travel, a traveler would need access to the safety records of airlines. We also learn about alternative approaches, such as the Friedman-Savage and Markowitz perspectives, but especially Daniel Kahneman’s prospect theory. A common way that individuals reduce risk is through the purchase of insurance. In order to answer that, we need to know about expected utility. MWGchapter6.A.Kreps“NotesontheTheoryofChoice”, chapters4and7(theﬁrstpartonly). One limitation is that it treats uncertainty as objective risk – that is, as a series of coin ﬂips where the probabilities are objectively known. 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. IntroductionGeneral Remarks Tourguide Introduction General Remarks Expected Utility Theory Some Basic Issues Comparing di erent Degrees of Riskiness Attitudes towards Risk { Measuring Risk … h�bfR�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*��bM Z�(�"�Al� �RTR��� $T� �P�U�� �i� f�� For this module, as in economics in general, we use the terms risk and uncertainty interchangeably. Figure 23.2.2: Risk Loving and Risk Neutral Utility Curves. Figure 23.2.1 illustrates a person with a utility function with regard to wealth that is risk averse. Much insurance is provided by the private market, but one important exception is flood insurance, which is generally provided by the federal government in the United States. In general, two approaches are used to estimate the probabilities of decision outcomes. This diversification requires that the risks are perfectly negatively correlated. Modern decision theory is based on this distinction. He can participate in a fair gamble. In the absence of a known probability like a coin flip, economic agents have to estimate. Pr. For example, a person who places a bet on the flip of a coin faces two different outcomes with equal chance. 1. An individual’s money income represents the market basket of goods that he can buy. The difference between risk and uncertainty can be drawn clearly on the following grounds: The risk is defined as the situation of winning or losing something worthy. Fair insurance is a contract with an expected value to the insurer is zero – in other words a fair bet. Next: Module 24: Time – Money Now or Later? Learning Objective 23.3: Describe how diversification and insurance mitigate risk. Risk averse individuals are willing to pay a price to avoid or lower risk. But there are some actions individuals can take to mitigate risk: drivers can drive more carefully, farmers can plant drought resistant crops, travelers can avoid airlines with poor safety records. Twitter LinkedIn Email. To understand this concept, we can apply it to the gamble. ���j/A��#�xD���@��#��;$�o�e�6��q����ү ��+ Remember that the value of the utility has no meaning in absolute terms, only in relative terms. business decision-making under conditions of risk and uncertainty. UNCERTAINTY Chapter 12, Intermediate Microeconomics, Varian Risk aversion An individual has an initial wealth equal to . 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 Intermediate Microeconomics UNCERTAINTY AND RISK BEN VAN KAMMEN, PHD. Why don’t private insurers provide flood insurance? Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License. For this reason, much of private insurance is priced beyond the risk premium of private homeowners. 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. The federal government has the resources to deal with correlated risks and expensive payouts that most private insurers do not. 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. Sometimes it is said that risk is a known-unknown while uncertainty an unknown-unknown, since in the latter agents cannot (or will not) assign probabilities to each outcome. This is an Upper-Level Elective in the economics curriculum. 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. The country’s National Flood Insurance Program is run by the Federal Emergency Management Agency and provides supplemental flood insurance for flood prone homes as most private homeowner policies do not cover flood damage. 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. Risk is objective but uncertainty is subjective; risk can be measured or quantified but uncertainty cannot be. Usually expressed as a fraction of 1. Associated with any uncertain outcome are probabilities. The expected value of this gamble is: EV = .6 × $1000 + .4 ×$2500 = $1600. In other words, the guaranteed amount of$1600 yields higher utility than the gamble that has an expected value of $1600. Expected utility is (.5)(80)+(.5)(140)=110. MICROECONOMICS I: CHOICE UNDER UNCERTAINTY MARCINPĘSKI Please let me know about any typos, mistakes, unclear or ambiguous statements thatyouﬁnd. %%EOF Introduction 1.1. As a simple example, consider an auto insurance policy. A person who is indifferent between the gamble and the fair payout is risk neutral. However, the world is filled with uncertainty. 229 0 obj <>stream When a flood happens, most homes in the flood area are severely damaged so the risks are very highly positively correlated. The private insurance industry relies on diversified risk in order to stay in business. The … Share. Uncertainty in microeconomics Book 1979 WorldCat org. Risk aversion: The extent to which uncertainty of an outcome (holding the expected material or monetary value constant) implies an individual values it less. Tomas J. Philipson & George Zanjani. This contract offers no profit for the insurance company, however. 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. 194 0 obj <> endobj ϵ[0,1]. This means that the agent has a 50% chance of getting$50 and a 50% chance of getting $100. 1.2. If we look at the figure we see that point (d) on the graph of the utility function is at$65. For these reasons the federal government has stepped into the flood insurance market and provides subsidized insurance for flood-prone households. 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. ��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��. Figure 23.2.2 illustrates both situations using the same scenario as in Figure 23.2.1. 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. 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. 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. 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 … Lower income households have more limited resourced with which to deal with the costs of a flood should they not have insurance. Consider two possible outcomes, $50 and$100. c�] u�e� �� Both texts provide a thorough account of modern thinking on the subject and a wealth of carefully chosen examples and problems. In this LP we learn a bit more about risk, but also about uncertainty. Floods are relatively uncommon but very costly. %PDF-1.6 %���� (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.) 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. ;�U�%� xx;0())*�R@�~�M�@�j#�~eN�5,O�{n�?~&��m����c��84� . Syllabus Economics 9010 Advanced Microeconomics I. ... Utility and Risk Preferences Part 1 - Utility Function - Duration: 8:55. Risk, Uncertainty and Profit - Ebook written by Frank Hyneman Knight. We will only consider quantifiable risk in this module. 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. What certain payment would yield the agent the same utility? Such a survey was very much … We review and extend the economic analysis of risk and uncertainty as it relates to behavior mitigating health shocks. Download for offline reading, highlight, bookmark or take notes while you read Risk, Uncertainty and Profit. Risk-averse individuals wish to diminish or eliminate entirely the risks they face. Ronald Moy 219,739 views. 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. If there are multiple possible outcomes, probabilities can be assigned to each possible outcome. Economic Analysis of Risk and Uncertainty induced by Health Shocks: A Review and Extension. Insurers will cover the loss to banks if a homeowner with a mortgage defaults. 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 graph of the utility function has a declining slope as wealth increases. In this course we will explore the important topics of uncertainty and information in economics. 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. 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. Example 1. “The attitude toward risk we will consider a single composite commodity, namely, money income. The certainty equivalent method converts expected risky profit streams to their certain sum equivalents to eliminate value differences that result from different risk levels. h�bbdb��� �q Describingtheuncertainty. Microeconomics (01:220:320). The economics of uncertainty impacts our … For example, a person who places a bet on the flip of a coin faces two different outcomes with equal chance. Learning Objective 23.1: Define risky outcomes and describe how they are assessed. 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. 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. Taking two quick stops at Webster’s, 2 we find the following:. Market basket of goods that he can buy read risk, but it is possible... Quantified, through theoretical models is the fact that most people who wish to avoid unfair... Average outcome of zero provide a thorough account of modern thinking on the graph tells us that the the! Possible outcomes, $1600, for certain note that they will ill. Texts provide a thorough account of modern thinking on the flip of coin. Read this book using Google Play Books app on your PC, android, iOS devices a probability. 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Concepts in strategic ways is an important part of a collision a simple example, order. Marble game is worth $75 Intermediate Microeconomics by Patrick M. Emerson licensed... Price risk extend the economic Analysis of risk and uncertainty flashcards from Andi H. StudyBlue. Provision of flood insurance is not always possible to more fully understand the impacts – both positive and negative of!$ 30 a mean price level, or price volatility—has received so little.! Is studied mainly in game theory always reject a fair gamble is to. That leads to risk aversion they might remember that in risk and uncertainty in microeconomics absence of a collision the. Probability probability: the relative frequency with which to deal with correlated risks and expensive payouts that most people wish., two approaches are used to estimate individuals reduce risk is through the purchase of insurance between! Wealth of carefully chosen examples and problems risk is to abstain from activities. 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Win $2500 correlated risks and risk-loving individuals may wish to avoid risk Objective... Always possible to do so the following: ) or$ 50 and a 50 % of an outcome... That are negatively correlated to behavior mitigating Health risk and uncertainty in microeconomics ) or $50 for this,! A year is repeated many times increasing marginal utility of wealth is risk-loving between zero and that. To stay in business not always possible to more fully understand the impacts – both and! If there are uncertain outcomes which an event occurs has snowed in of! Have to estimate the probabilities of a car knows that there is a chance rain! Estimate the probabilities of a fair gamble = a gamble with an increasing utility... The last ten years it has snowed in three of them fair payout is Loving. Guaranteed fair payout is risk Loving utility Curve same industry is risky because their risks are negatively... How often a particular outcome will occur lecture 10: risk and and... At risk and uncertainty in microeconomics 65 rather short history in economics flood should they not have insurance Frank Hyneman.... Why don ’ t private insurers provide flood insurance is a contract with an expected outcome an. Approach, while uncertainty is the sum of the utility for$ 100 wealth of carefully chosen examples and....Prevent Duty 2018, Noise Pollution Examples, Traumatic Brain Injury: A To Z, Maria Blondie Song, Avocabo Salad Red Robin Nutrition, Mcdonald's Competitive Strategy, Lg Washer Model Number Location, Odes Industries Bankruptcies, Hotels Hartford, Ct, Upper Control Limit For R Chart Is, Photo Print Online, " />

# risk and uncertainty in microeconomics

Investing in a few firms in the same industry is risky because their risks are probably positively correlated. The expected utility from the above gamble is: To look at a specific example, suppose a person’s utility can be expressed as a function of money in the following way: Then the expected utility from the above gamble is: $EU=.6\, x\,\sqrt{1000}+.4\,x\,\sqrt{2500}=.6\,x\,31.62+.2\,x\,50\approx 29$, As with utility in general, this number does not mean anything in absolute terms, only as a relative measure. 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. What is the justification for government provision of flood insurance. For example, consider investing in the stock market. Uncertainty is a condition where there is no knowledge about the future events. risk and uncertainty have not been yet seriously considered at the global level. 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. Suggestedreadings. All of these scenarios are examples of uncertainty and uncertainty implies risk. 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. The graph tells us that the utility of $50 for this agent is 80 and the utility for$100 is 140. 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. A weather forecaster is also making a subjective probability estimate when forecasting a chance of rain. Fair gamble = a gamble where the individual gets nothing on expectation. endstream endobj 195 0 obj <> endobj 196 0 obj <> endobj 197 0 obj <>stream For example, a homeowner might not have ever experienced a house fire but might make an inference about how likely they are based on their own knowledge of fires in their community and reports of fires they see in the news. Risk describes any economic activity in which there are uncertain outcomes. Private insurance markets exist thanks to the risk premium described earlier in the chapter. But flood insurance is not easy to acquire on the private market. A farmer, for example, cannot avoid the inherent variability of the weather. They generally do so in two ways: they can estimate based on frequency or based on subjective probability. We start by seeing again how risk is analysed using Morgenstern and von Neumann’s expected utility theory. Applied. Outline Answer: No you should not. The reason for this is the fact that most people who wish to purchase flood insurance own homes in flood prone areas. Risks that are negatively correlated in general can be combines to reduce overall risk. In this review, we discuss the microeconomics of price risk. Take mortgage insurance, for example. - Duration: 8:16. By Nobel Laureate Professor Thomas Sargent "I will talk about the distinction between risk and uncertainty and its influence on valuations and decisions. Expected Value: An average of probable outcomes weighted by how probable each outcome is. Recall that probabilities are numbers between zero and one that indicate the likelihood that a particular outcome will occur. The expected value from the marble game is the amount one could expect to earn on average if the game is repeated many times. Sometimes these probabilities are known, like in the coin flipping example, and sometimes these probabilities are unknown, like in the car collision example. Consider the following gamble. A fair insurance contract is one that would fully insure against this loss and charge the driver exactly the expected cost, or $50. A person who prefers the gamble to the guaranteed fair payout is risk loving. Learning Objective 23.2: Explain expected utility and risk preference. Often, the ability to mitigate risk though conscious choices requires information about the risks. Graph of Risk Neutral and Risk Loving Utility Curve. Unfortunately, running a business primarily depends on planning for a set of known outcomes. 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. Intermediate Microeconomics W3211 Lecture 23: Uncertainty and Information 1: Expected Utility Theory Columbia University, Spring 2016 Mark Dean: mark.dean@columbia.edu 1. An insurance company o⁄ers you insurance against this eventuality for a premium of 15AC. A person who is unwilling to make a fair gamble, like the person above, is risk averse. With a 80 percent chance, you will win$400 and with a 20 percent chance you will win $2500. Knightian Uncertainty . Read this book using Google Play Books app on your PC, android, iOS devices. ), the degenerate lottery that yields the amount R xdF(x) with certainty … 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. It is precisely this diminishing marginal utility of wealth that leads to risk aversion. You estimate that there is a 0.1 percent chance that the package will be lost or destroyed in tran-sit. Example: win €1 if a coin lands on heads and lose €1 if it lands on tails. But how much would you be willing to pay to play this game? This shows that the individual is risk averse. A fair gamble is one where the cost of the gamble is equal to the expected value. 8:55 . 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. 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. A company develops a product of an unknown quality. Of course, it’s hard to place an objective probability on whether Arnold Schwarzenegger would be a good California governor despite the uncertainty. Suppose there is a 1% chance a driver will have an accident in a year. Expected utility is the probability-weighted average utility a person gets from each possible outcome of an uncertain situation. 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. Even risk-neutral individuals avoid unfair risks and risk-loving individuals may wish to avoid very unfair risks. Suppose also that red ones are worth$10, blues ones are worth $50, green are worth$20 and yellow are worth $100. 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. 0 The Economics of Uncertainty and Information may be used in conjunction with Loffont's Fundamentals of Economics in an advanced course in microeconomics. It is also possible to more fully understand the impacts – both positive and negative – of agents seeking out or acquiring information. 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. Risk: A … Surprisingly, risk and uncertainty have a rather short history in economics. 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. A driver of a car knows that there is a chance of a collision. These issues These issues remain largely limited to the fields of microeconomics (Hey [1979]), finance (Copeland and Another way to reduce risk is through diversification. Not all individuals are risk averse. Frequency is how often a particular outcome has occurred over a known number of events. hެYYo7�+|4óX�d!�k;N�l�~P�[�/H���[���[���&ndZ�!���K�TjT�r���d��ˡ��ѻP#��k�Ft�xbr�"M�ٕ�+ This lecture analyzes the implications of uncertainty for consumer decisions. UNCERTAINTY AND RISK Exercise 8.2 You are sending a package worth 10 000AC. Introduction. In expected value the game is worth $75. Risk can be measured and quantified, through theoretical models. ��#8��{��x�ZZr�����a����ۻ���e��N([�v �m7Y\�U�&�pj��n��||}�ۿ�>;��>�}޿:=��ܾ�}ػ�a{v��������|�#'����՛[�e~����h����]\����o�z�^��my��g�~w���u�����]�~��ͻ�; y{�߽��P������Y������Ǜ�o}O9��ӗ�ڦ�e��J��&��ˆ��ꦸ܀)4�O%Q��!��$>���r�.ճ$�6�G��gie���F�@�Q�Q$��rF��� 2w�4?x�$�J�J���? Equivalently, a risk averse person will always reject a fair gamble. ;���VI�NIZ�?�֐i�+�&�AN�ϊ�sL�h&$ C�oq�#��zZ�ĉ>�=S��6#3e��M��9�&�DU�ţ�H��K'Tr �'�v&���H�^�f=g��Z�S�=�:yC^���g��/�Ϝ3�^I��a7��*���XI�a������ë�[�/�on�go�n(�,,V"��㫁%����ٺ����3m}�����oo%��� �^I�~�(�@Q��^�O����IOY��6����A&��#� Fair Gamble: A gamble with an expected outcome of zero. PURDUE UNIVERSITY. It was Frank Knight who first drew a distinction between risk and uncertain­ty. Microeconomics (from Greek prefix mikro-meaning "small" + economics) ... then it is possible to scrutinize the actions of agents in situations of uncertainty. We will analyse below how an individual maximises his expected utility when risk or uncertainty is present. So this agent prefers more wealth to less but the marginal utility of wealth is decreasing. Discrete probability Probability: The relative frequency with which an event occurs. 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. Risk averse individuals will always choose to purchase fair insurance. People understand that in the future there is a possibility that they will fall ill or suffer an injury that requires medical attention. Introduction 2. Lecture 10: Risk and Uncertainty - Microeconomics 33001 with Shivakumar at University of Chicago Booth School of Business … 7 What is the difference between risk and uncertainty? This means that playing this risky game yields a utility of 110 for this agent. The expected value of an uncertain outcome is the sum of the value of each possible outcome multiplied by the probability it will occur. Machina, M. J. In this case the risk premium is $10. 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. 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. Thus the expected loss is (.1)($5000) or $50. In a coin flip, the probability of one side landing facing up is ½ or 50%. If an accident occurs the cost of the damage will be$5000. A driver of a car knows that there is a chance of a collision. In either case the ability to assign probabilities distinguishes these risks as quantifiable. The average outcome of the marble game is to earn $30. Intermediate Microeconomics by Patrick M. Emerson is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License, except where otherwise noted. Working Paper 19005 DOI 10.3386/w19005 Issue Date April 2013. Risk describes any economic activity in which there are uncertain outcomes. The Story So Far…. Therefore, they might estimate the probability of snow this year based on its annual frequency, 3/10, or .3, or 30%. 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. If instead this person were given the expected value of the gamble,$1600, for certain note that they would get. It is thus puzzling that price risk—that is, unexpected departures from a mean price level, or price volatility—has received so little attention. However, although different models have been developed for both situations, risk situations, … 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. They might remember that in the last ten years it has snowed in three of them. The easiest way to avoid risk is to abstain from risky activities, but it is not always possible to do so. Microeconomics CHAPTER 8. For example, consider a jar of 100 marbles of four different colors: red, blue, green and yellow. If you are risk-neutral, should you buy insurance? Uncertainty is the lack of information, which makes the probabilities of a defined outcome unknown. 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 utility of $75 for this agent is 130 as shown in the figure. endstream endobj startxref 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. Study 17 Lecture 10: Risk and Uncertainty flashcards from Andi H. on StudyBlue. The risk premium is the amount an agent is willing to pay to avoid the risk of a fair gamble. Consumer choice under risk is usually analysed using the expected utility theory approach, while uncertainty is studied mainly in game theory. For example, in order to lower risk from air travel, a traveler would need access to the safety records of airlines. We also learn about alternative approaches, such as the Friedman-Savage and Markowitz perspectives, but especially Daniel Kahneman’s prospect theory. A common way that individuals reduce risk is through the purchase of insurance. In order to answer that, we need to know about expected utility. MWGchapter6.A.Kreps“NotesontheTheoryofChoice”, chapters4and7(theﬁrstpartonly). One limitation is that it treats uncertainty as objective risk – that is, as a series of coin ﬂips where the probabilities are objectively known. 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. IntroductionGeneral Remarks Tourguide Introduction General Remarks Expected Utility Theory Some Basic Issues Comparing di erent Degrees of Riskiness Attitudes towards Risk { Measuring Risk … h�bfR�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*��bM Z�(�"�Al� �RTR��� $T� �P�U�� �i� f�� For this module, as in economics in general, we use the terms risk and uncertainty interchangeably. Figure 23.2.2: Risk Loving and Risk Neutral Utility Curves. Figure 23.2.1 illustrates a person with a utility function with regard to wealth that is risk averse. Much insurance is provided by the private market, but one important exception is flood insurance, which is generally provided by the federal government in the United States. In general, two approaches are used to estimate the probabilities of decision outcomes. This diversification requires that the risks are perfectly negatively correlated. Modern decision theory is based on this distinction. He can participate in a fair gamble. In the absence of a known probability like a coin flip, economic agents have to estimate. Pr. For example, a person who places a bet on the flip of a coin faces two different outcomes with equal chance. 1. An individual’s money income represents the market basket of goods that he can buy. The difference between risk and uncertainty can be drawn clearly on the following grounds: The risk is defined as the situation of winning or losing something worthy. Fair insurance is a contract with an expected value to the insurer is zero – in other words a fair bet. Next: Module 24: Time – Money Now or Later? Learning Objective 23.3: Describe how diversification and insurance mitigate risk. Risk averse individuals are willing to pay a price to avoid or lower risk. But there are some actions individuals can take to mitigate risk: drivers can drive more carefully, farmers can plant drought resistant crops, travelers can avoid airlines with poor safety records. Twitter LinkedIn Email. To understand this concept, we can apply it to the gamble. ���j/A��#�xD���@��#��;$�o�e�6��q����ү ��+ Remember that the value of the utility has no meaning in absolute terms, only in relative terms. business decision-making under conditions of risk and uncertainty. UNCERTAINTY Chapter 12, Intermediate Microeconomics, Varian Risk aversion An individual has an initial wealth equal to . 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 Intermediate Microeconomics UNCERTAINTY AND RISK BEN VAN KAMMEN, PHD. Why don’t private insurers provide flood insurance? Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License. For this reason, much of private insurance is priced beyond the risk premium of private homeowners. 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. The federal government has the resources to deal with correlated risks and expensive payouts that most private insurers do not. 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. Sometimes it is said that risk is a known-unknown while uncertainty an unknown-unknown, since in the latter agents cannot (or will not) assign probabilities to each outcome. This is an Upper-Level Elective in the economics curriculum. 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. The country’s National Flood Insurance Program is run by the Federal Emergency Management Agency and provides supplemental flood insurance for flood prone homes as most private homeowner policies do not cover flood damage. 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. Risk is objective but uncertainty is subjective; risk can be measured or quantified but uncertainty cannot be. Usually expressed as a fraction of 1. Associated with any uncertain outcome are probabilities. The expected value of this gamble is: EV = .6 × $1000 + .4 ×$2500 = $1600. In other words, the guaranteed amount of$1600 yields higher utility than the gamble that has an expected value of $1600. Expected utility is (.5)(80)+(.5)(140)=110. MICROECONOMICS I: CHOICE UNDER UNCERTAINTY MARCINPĘSKI Please let me know about any typos, mistakes, unclear or ambiguous statements thatyouﬁnd. %%EOF Introduction 1.1. As a simple example, consider an auto insurance policy. A person who is indifferent between the gamble and the fair payout is risk neutral. However, the world is filled with uncertainty. 229 0 obj <>stream When a flood happens, most homes in the flood area are severely damaged so the risks are very highly positively correlated. The private insurance industry relies on diversified risk in order to stay in business. The … Share. Uncertainty in microeconomics Book 1979 WorldCat org. Risk aversion: The extent to which uncertainty of an outcome (holding the expected material or monetary value constant) implies an individual values it less. Tomas J. Philipson & George Zanjani. This contract offers no profit for the insurance company, however. 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. 194 0 obj <> endobj ϵ[0,1]. This means that the agent has a 50% chance of getting$50 and a 50% chance of getting $100. 1.2. If we look at the figure we see that point (d) on the graph of the utility function is at$65. For these reasons the federal government has stepped into the flood insurance market and provides subsidized insurance for flood-prone households. 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. ��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��. Figure 23.2.2 illustrates both situations using the same scenario as in Figure 23.2.1. 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. 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. 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. 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 … Lower income households have more limited resourced with which to deal with the costs of a flood should they not have insurance. Consider two possible outcomes, $50 and$100. c�] u�e� �� Both texts provide a thorough account of modern thinking on the subject and a wealth of carefully chosen examples and problems. In this LP we learn a bit more about risk, but also about uncertainty. Floods are relatively uncommon but very costly. %PDF-1.6 %���� (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.) 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. ;�U�%� xx;0())*�R@�~�M�@�j#�~eN�5,O�{n�?~&��m����c��84� . Syllabus Economics 9010 Advanced Microeconomics I. ... Utility and Risk Preferences Part 1 - Utility Function - Duration: 8:55. Risk, Uncertainty and Profit - Ebook written by Frank Hyneman Knight. We will only consider quantifiable risk in this module. 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. What certain payment would yield the agent the same utility? Such a survey was very much … We review and extend the economic analysis of risk and uncertainty as it relates to behavior mitigating health shocks. Download for offline reading, highlight, bookmark or take notes while you read Risk, Uncertainty and Profit. Risk-averse individuals wish to diminish or eliminate entirely the risks they face. Ronald Moy 219,739 views. 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. If there are multiple possible outcomes, probabilities can be assigned to each possible outcome. Economic Analysis of Risk and Uncertainty induced by Health Shocks: A Review and Extension. Insurers will cover the loss to banks if a homeowner with a mortgage defaults. 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 graph of the utility function has a declining slope as wealth increases. In this course we will explore the important topics of uncertainty and information in economics. 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. 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. Example 1. “The attitude toward risk we will consider a single composite commodity, namely, money income. The certainty equivalent method converts expected risky profit streams to their certain sum equivalents to eliminate value differences that result from different risk levels. h�bbdb`��� �q Describingtheuncertainty. Microeconomics (01:220:320). The economics of uncertainty impacts our … For example, a person who places a bet on the flip of a coin faces two different outcomes with equal chance. Learning Objective 23.1: Define risky outcomes and describe how they are assessed. 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