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RISK AND UNCERTAINTY

Why do people try to shed economic risks?What institutions in a market economy help individuals pool risks or spread them to the broader community? Why do markets fail to provide insurance in some circumstances? We turn now to these issues. Whenever you drive a car, own a house, store corn, make an investment, or work on a risky job. you are risking life, limb, or fortune. How do pie behave in the face of risks?We generally find that people want to avoid uncertainties about their income and consumption. When we desire to avoid risk and uncertainty. we are “risk-averse.” A person is when the displeasure from losing a given amount of income is greater than the pleasure from gaining the same amount of income.

For example, suppose that we are offered a risky coin flip in which’ we will win S1000 if the coin comes up heads and lose S1000 if the coin comes up tails. This bet has an expect value of 0 (equal to a probability of 1/2 times \$1000 and a probability of 1/2 times – \$1000). A bet which has a zero expected value is called a fair bet. If we turn down all fair bets, we are risk-averse. In terms of the utility concept that we analyzed in Chapter 5, risk aversion is the same as diminishing marginal utility of income. Being risk-averse implies that the gain in utility achieved by getting an extra amount of income is less than the loss in utility from losing the same amount of income. For a fair bet (such as flipping a coin for \$10(0), the expected dollar value is zero.

But in terms of utility. the ~ted utility value is negative because the utility you stand to win is less than the utility you stand 10 lose. We can use Figure 11-2 to illustrate the concept. of risk aversion. Say that situation (b) is the position, in which you have equal amounts Of  assumption in states 1 and 2, consuming 2 units in both states. A “risk lover” comes to you and says. ·Let’s flip «coin for 1 unit.” The risk lover is in effect offering you the chance .to move to situation (d), where you would have 3 units of consumption if the coin came up heads and 1 unit if tails. By careful calculation, you see that if you refuse the bet and stay in situation (b), the expected value of utility is 7 utils (= Ijy X 7 utils + Ijy X 7 utils).

Whereas if you accept the bet, & he expected value of utility is 61 (- In X 9 utils + 1/2 X 4 utils), This example shows that if you are risk-averse, with diminishing marginal utility, you will amid actions that increase uncertainty without some expectation of gain. . Say that I am a corn fainer. While J dearly must contend with the natural hazards of fanning, I do not also want to bear corn-price risks.  the expected value of the corn price is \$4 per bushel. where this expectation arises from two equally likely you comes with prices of \$~ and 55 per bushel. Unless I can shed the price risk, I an, forced into a lottery where I must sell my 10,()()().bush crop for either S30.000 or S50,OOO depending upon the flip of the corn-price coin. But by the principle of risk aversion and diminishing marginal. utility.

I would prefer a sure thing. That is. I would prefer to hedge my price risk by selling my corn for the expected-value price of \$4, yielding a total of \$40.000. “”by? Because the prospect of losing S10,ooo is more painful than the prospect of . gaining SIO,ooo is pleasant. If my income is cut to \$30.000, I will have to cut back on important spending, such as college tuition or a new roof. On the other hand, the extra S 10,000 might be less critical, going toward luxuries like a winter vacation or a new, conditioned lawn ~r. People are generally risk-averse, preferring a sure thing to uncertain levels of consumption: people refer outcomes with less uncertainty and the same average values. For this reason, activities that reduce the uncertainties of consumption lead to it’ comments in economic welfare.

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