A. ECONOMICS OF RISK AND UNCERTAINTY

,Our analysis of markets presumed that were known for certain and that each fin could predict how other firms would behave. In reality, business life is teeming with risk and’ uncertainty. Let’s see how risk clouds the picture if you are in the oil business and decide to drill a well. To be you might plan on coats of $100 million for the well, but this is just a guess because you don’t know how deep you need to drill to find oil, or whether your equipment will break down and need to be replaced, or h long your crew will need to be on the job.

In addition, you ‘cannot know about the revenues from the well because of price and output  uncertainty. Price uncertainty comes because oil prices fluctuate widely~they have been as low as $10 a ‘barrel and as high as $88 a barrel over the last 20 years. Output uncertainty is undoubtedly the major ,worry, for your well may be dry, or it may yield too little to be worth operating, or it may be a lucrative.

These problems are not confined to the oil business. Virtually all firms find that output prices will fluctuate from month to month; input prices of labor, land, machines, and fuel are often highly volatile; the behavior of competitors cannot be forecast in advance. The essence of business is to invest now in order to make profits in the future, in effect putting fortunes up as hostage to future uncertainties.

Economic life is a risky business.  Modern economics has developed useful tools to incorporate uncertainty into the analysis of business and household behavior and of financial markets. This section examines the role of markets in spreading risks and time, presents the theory of individual behavior under uncertainty, and provides the essential theory underlying insurance markets, These topics are but. a brief glimpse into the fascinating world of risk and economic life.

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