11- uncertainty Flashcards
what are typical examples of uncertainty in economic systems?
tomorrowโs prices
future wealth
future availability of commodities (e.g., oil, water supplies)
present and future actions of other people
what are rational responses to uncertainty?
buying insurance (health, life, auto)
a portfolio of contingent consumption goods (diversification: buy stocks of sunglass and umbrella companies simultaneously)
what do individuals aim to maximise when their is uncertainty?
they aim to maximise the expected utility of optimal consumption that could afford in different scenarios or :
E(U)= ๐_1 ๐ข(๐_1 )+๐_2 ๐ข(๐_2 )+โฆ+๐_๐ ๐ข(๐_๐) for a case of n different states
what is risk aversion mathematically?
when the utility of the expectation is prefered to expected utility
what is risk loving?
when the expected utility is preffered to utility of the expectation
what is risk neutrality?
when the expected utility is equal to the utility of the expectation
what does risk averse agent utility against consumption curve look like?
it begins steep and positive but then flattens out
what does the risk loving agent utility against consumption curve look like?
it begins flat and then gets steeper as consumption increases
what does the risk neutral agents utility against consumption curve look like
they will have a constant gradient as consumption increases
how can we measure the exact degree of risk aversion?
by considering how much concave the utility function is. more concave the greater the degree of risk aversion.
what is the arrow-pratt measure of absolute risk aversion?
r= - [uโโ(c)/uโ(c)]
what is the formula for the arrow pratt measure of relative risk aversion?
p= -[uโโ(c)/uโ(c)]*c
what is constant absolute risk aversion (CARA)?
the degree of risk aversion does not change with income
what is the certainty equivalent income (CE)?
the consumers certainty equivalent income (CE) is the perfectly safe income that would make him exactly as well off as if he participated in gambling
if the consumer is risk neutral what is the certainty equivalent relative to the expected pay off?
if the consumer is risk neutral, then the certainty equivalent equals expected payoff.
if the consumer is risk loving, what is the certainty equivalent relative to the expected pay off?
if the consumer is risk loving then the certainty equivalent is above the expected pay off ie the consumer is ready to pay more to participate in the gamble
if the consumer is risk averse, then what is the certainty equivalent relative to the expected payoff?
if the consumer is risk averse, then the certainty equivalent is below the expected payoff ie the consumer is ready to pay some money to not participate in the gamble
what is the risk premium?
A risk premium shows the amount of additional return that an agent requires to choose a gamble (risky investment) over safe investment.
what is the formula for the risk premium?
risk premium = expected payoff - certainty equivalent
what is the relationship between risk aversion and risk premium?
there is a positive relationship between the risk aversion and risk premium, ie the greater risk aversion is associated with a higher risk premium
what is the relationship between uncertainty and risk premium?
there is a postive relationship between uncertainty and risk premium, ie higher level of uncertainty is associated with higher risk premium
What would be the minimum insurance premium that an insurance company will ask for?
The minimum insurance premium is โActuarially fair premiumโ which yields zero profit for the insurance seller and also equals the โexpected lossโ of the buyer.
what type of market does the actuarilly fair premium ensured?
it is insure if the insurance market is perfectly competitive
what is the actuarially fair premium rate equal to?
it is equal to the probability of the accident
if the insurance premium rate is actuarially fair what would the risk averse consumer insurance type be?
he would go for the full cover
