6. Intermediate Microeconomics
Up until now, our analysis of consumers and firms alike has assumed that both have perfect knowledge of the future. However, the world is filled with uncertainty. 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. This lecture analyzes the implications of uncertainty for consumer decisions.
The economics of uncertainty investigates how uncertainty and risk affect the allocation of scarce resources, especially in financial markets and in the provision of insurance. Central to this study is the difference between uncertainty (not knowing which of several possible outcomes might occur) and risk (assigning probabilities to different possible outcomes).
People have different preferences about risk. Some prefer to avoid risk (risk aversion), others are indifferent (risk neutrality), while others enjoy risk (risk loving). Risk aversion in particular is a driving force behind the provision of insurance. Those who dislike risk are willing to pay to avoid it.
Risk and uncertainty are important to financial markets, as well. The exchange of financial instruments, such as stocks and bonds, are based on uncertainty of the future, tempered with attempts to quantify the risk of different possibilities.
Uncertainty and Risk:
A cornerstone of the economic analysis of uncertainty is the difference between uncertainty and risk. While closely related concepts that are occasionally (and erroneously) used interchangeably, uncertainty and risk have important differences.
Uncertainty: Uncertainty is the observation that the future is not known. You don't know what might happen tomorrow. You might step in a puddle of mud on the way to class. Or you might anger an intelligent extraterrestrial life form that retaliates by destroying all life on the planet. You just never know.
Risk: Risk is assigning quantitative probabilities to alternative future outcomes. While it is possible that you could either step in a mud puddle or your could cause total destruction of the planet, both are not equally likely outcomes. Risk is the process of assigning probabilities to these alternatives (for example, 99.999999999% chance of mud puddle stepping versus 0.000000001% chance of total planet destruction).
While anything is possible (which is the essence of uncertainty) everything is not equally probable (which is the essence of risk). Many who participate in the financial markets and in the insurance industry spend a great deal of time and effort trying to transform uncertainty into risk. This can be accomplished with simple historical extrapolation. If, for example, every winter 5 people out of 100 contract the flu, then the projected risk of this outcome is 5%. In actuality, more sophisticated analysis is frequently used. That is, the risk of flu contraction might be evaluated based on lifestyle, weather conditions, medical treatment, and other factors.
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