11- uncertainty

Question 1

what are typical examples of uncertainty in economic systems?

Answer 1

tomorrow’s prices
future wealth
future availability of commodities (e.g., oil, water supplies)
present and future actions of other people

Question 2

what are rational responses to uncertainty?

Answer 2

buying insurance (health, life, auto)
a portfolio of contingent consumption goods (diversification: buy stocks of sunglass and umbrella companies simultaneously)

Question 3

what do individuals aim to maximise when their is uncertainty?

Answer 3

they aim to maximise the expected utility of optimal consumption that could afford in different scenarios or :
E(U)= 𝜋_1 𝑢(𝑐_1 )+𝜋_2 𝑢(𝑐_2 )+…+𝜋_𝑛 𝑢(𝑐_𝑛) for a case of n different states

Question 4

what is risk aversion mathematically?

Answer 4

when the utility of the expectation is prefered to expected utility

Question 5

what is risk loving?

Answer 5

when the expected utility is preffered to utility of the expectation

Question 6

what is risk neutrality?

Answer 6

when the expected utility is equal to the utility of the expectation

Question 7

what does risk averse agent utility against consumption curve look like?

Answer 7

it begins steep and positive but then flattens out

Question 8

what does the risk loving agent utility against consumption curve look like?

Answer 8

it begins flat and then gets steeper as consumption increases

Question 9

what does the risk neutral agents utility against consumption curve look like

Answer 9

they will have a constant gradient as consumption increases

Question 10

how can we measure the exact degree of risk aversion?

Answer 10

by considering how much concave the utility function is. more concave the greater the degree of risk aversion.

Question 11

what is the arrow-pratt measure of absolute risk aversion?

Answer 11

r= - [u’‘(c)/u’(c)]

Question 12

what is the formula for the arrow pratt measure of relative risk aversion?

Answer 12

p= -[u’‘(c)/u’(c)]*c

Question 13

what is constant absolute risk aversion (CARA)?

Answer 13

the degree of risk aversion does not change with income

Question 14

what is the certainty equivalent income (CE)?

Answer 14

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

Question 15

if the consumer is risk neutral what is the certainty equivalent relative to the expected pay off?

Answer 15

if the consumer is risk neutral, then the certainty equivalent equals expected payoff.

Question 16

if the consumer is risk loving, what is the certainty equivalent relative to the expected pay off?

Answer 16

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

Question 17

if the consumer is risk averse, then what is the certainty equivalent relative to the expected payoff?

Answer 17

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

Question 18

what is the risk premium?

Answer 18

A risk premium shows the amount of additional return that an agent requires to choose a gamble (risky investment) over safe investment.

Question 19

what is the formula for the risk premium?

Answer 19

risk premium = expected payoff - certainty equivalent

Question 20

what is the relationship between risk aversion and risk premium?

Answer 20

there is a positive relationship between the risk aversion and risk premium, ie the greater risk aversion is associated with a higher risk premium

Question 21

what is the relationship between uncertainty and risk premium?

Answer 21

there is a postive relationship between uncertainty and risk premium, ie higher level of uncertainty is associated with higher risk premium

Question 22

What would be the minimum insurance premium that an insurance company will ask for?

Answer 22

The minimum insurance premium is ‘Actuarially fair premium’ which yields zero profit for the insurance seller and also equals the ‘expected loss’ of the buyer.

Question 23

what type of market does the actuarilly fair premium ensured?

Answer 23

it is insure if the insurance market is perfectly competitive

Question 24

what is the actuarially fair premium rate equal to?

Answer 24

it is equal to the probability of the accident

Question 25

if the insurance premium rate is actuarially fair what would the risk averse consumer insurance type be?

Answer 25

he would go for the full cover