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5.risk Uncertainty
5.risk Uncertainty
How economics can help understand, analyze, and cope with limited information
Land Use
Habitat conservation plan calls for acquisition of 100 acres of land in coastal area. Cost uncertain. Maybe $1,000,000 (30% chance), maybe $3,000,000 (70% chance). NPV of benefits are $2,000,000 (for sure!). Good idea? Proposal to add 10 km2 to the CIMR at cost (reduced harvest) of $2 million (NPV); ecological benefits uncertain: $4 million with probability 0.7; $0 with probability 0.3
Marine Reserves
What is risk?
Should be accounted for in social projects (and regulations) and private decisions.
Think of there being different states of nature that can emerge, and we are uncertain about which we will end up with. We want to develop a way to describe risk quantitatively by evaluating the probability of all possible outcomes.
Bus: $2 (certain) Bike: .5(8) - .5(0) = $4 (risky) If she is risk neutral, she takes her bike ($4 > $2) If she is a risk lover, she takes her bike If she is sufficiently risk averse, she may bus Bus: $2 Bike: .2(8) + .8(0) = $1.60 (risky) If she is risk neutral, she rides the bus ($2 > 1.60)
U(15)
.5*U(10) + .5*U(20)
10 15 20
Generally speaking, most people risk averse. Diversification can reduce risk. Since govt can pool risk across all taxpayers, there is an argument that society is essentially risk neutral. Most economic analyses assume risk neutrality. Note: may get unequal distribution of costs and benefits.
Or
S ViPi
New air quality regulations in Santa Barbara County will reduce ground level ozone.
2 states of nature
Cost = $1011
Overall evaluation
Expected cost if control = $1011 Expected cost if no control =
By this analysis, should control even though high loss is low probability event.
Value of Information
The real question is not: Should we engage in control or not? The question is: Should we act now or postpone the decision until later? So there is a value to knowing whether the high damage state of nature will occur. We can calculate that valuethis is Value of information
Sensitivity Analysis
A method for determining how sensitive your model results are to parameter values.
7E+11 6E+11 5E+11 4E+11 3E+11 2E+11 1E+11 0 0 0.01 0.02 0.03 0.04 0.05 0.06 Discount rate (r)
6.00E+11
4.00E+11
2.00E+11
Choose distributions for parameters. Let computer draw values from distns Plot results
Managing Risk
Risk is a problem of its own Several tools available to reduce risk
Insurance Liability
Probability of loss: 0.001; Loss=$100,000 Expected annual loss: $100 No insurance Most years: no loss; some years $100,000 loss 1000 houses pool $100 each/yr ($100,000/yr) Most yearsone loss Sometimes no losses, sometimes 2-3 losses Much less variability in annual losses Fire is amenable to risk pooling Risks uncorrelated Earthquake insurance in Cal NOT amenable to risk pooling
Most years no loss; some years enormous loss
Loss must be amenable to risk pooling There must be a clear loss Loss must be in well-defined period of time Frequency of loss must allow a premium calculation Moral hazard must not be severe (eg, hazardous waste insurance causes folks to be sloppy) Adverse selection must not be severe (eg, only high risk folks take out insurance)
Some regs apply to nature of tankers Other protection achieved through liability