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KWe3 Micro ch20
KWe3 Micro ch20
ECONOMICS
and
MICROECONOMICS
Paul Krugman | Robin Wells
Chapter 20
Uncertainty, Risk, and Private Information
• That risk is an important feature of the
economy, and that most people are risk-
averse
• Why diminishing marginal utility makes
people risk-averse and determines how
WHAT YOU much premium they are willing to pay to
WILL LEARN reduce risk
IN THIS • How risk can be traded, with risk-averse
people paying others to assume part of
CHAPTER their risk
• How exposure to risk can be reduced
through diversification and pooling
• How special problems are posed by
private information—situations in which
some people know things that other
people do not
The Economics of Risk Aversion
• In general, people don’t like risk and are willing to pay a price
to avoid it.
For example: insurance
• But what exactly is risk? And why don’t people like it?
• Let’s assume that there’s a 50% chance that this person will
get sick and have high medical expenses.
£115
110
More risk-averse investor
105
Risk-neutral investor
0 1 2 3 4 Quantity of policies
The Demand for Insurance
Premium of policy
180
170
0 1 2 3
Quantity of policies
The Insurance Market
Premium of
policy
£200
E
130
100
D
• The premiums the investors accepted were too small for the
true level of risk contained in the policies.
• But the biggest single problem was that many of the events
against which Lloyd’s had become a major insurer were not
independent.
Example: U.S. companies involved in a torrent of asbestos
lawsuits, many of them paid by Lloyd’s investors.
Private Information
• The result:
Companies rely on franchises despite higher costs.
Individuals are compensated with higher reward.
Companies compensated with higher sales and thus higher
licensing fees.
Part 1: http://www.youtube.com/watch?v=fTabjhrmK1I
Part 2: http://www.youtube.com/watch?v=af2ggaIiGw0
Summary
1. The expected value of a random variable is the weighted
average of all possible values, where the weight
corresponds to the probability of a given value occurring.