Class note:
In economics, there are always uncertainties involved. These uncertainties include:
Cost
Price
Demand
Quality
Return/revenue
Uncertainty = risk
How do you reduce risk?
How can you reduce the income uncertainty or risk?
Imposing minimum wage.
Job protection.
How can you reduce the uncertainty about quality?
Imposing certainty standard.
Getting more information on the product
Warranty
What if you are trading internationally, what is the risk you face?
Exchange rate – depending on the exchange rates, firms can gain or lose revenue or profit.
Any type of insurance reduces risk and uncertainty.
Diversifying the portfolio can reduce the risk
Investing on something that has a characteristic of counter cyclical goods
Knowing a good that has high demand when the economy is in recession.
Realizing cyclical goods (both pro and con)
We will always choose the option that will give highest utility.
To do this, we have to be able to measure the risk.
Probability: likelihood that a given outcome will occur.
Have both subjective and objective sides.
Objective: probability of state of nature may be its relative frequency if and when the risky decision is repeated a large number of times
Subjective: simply be the gut feeling of the person making the risky decision.
All probabilities add up to one (1)
Payoff: the financial reward in each state of nature (to the person who takes risky decision)
It is the value you get after a decision.
Probability distribution: the full list of all possible payoffs and the probability of each payoff.
X-axis: the possible outcomes.
Has a certain number.
Y-axis: the probability.
You will always choose one that gives highest utility.
Expected value: the average outcome you observe. if the graph has symmetry on a certain point, that point is the expected value.
Formula: sum of (payoff and its probability)
Risk in economics: the probability of going down and probability of going above the average.
The further you move away from the mean (or further you move away from deviation), you have higher risk.
Variance: a measure of riskiness (uncertainty)
Higher the variance, higher the risk.
Another popular measure of the riskiness is standard deviation.
Standard deviation = square root of variance.
Variance is the sum of (probability * (outcome – expected value)^2)
Graph with bigger range = higher variance, thus higher risk
Graph with smaller range = less variance, thus less risk.
Different preferences toward risk:
Risk averse
Condition of preferring a certain income to a risky income with the same expected value
Your marginal utility of income is falling.
The curve is increasing in a decreasing rate.
You are afraid of losing the income more than adding more on the utility.
Risk neutral
Condition of being indifferent between a certain income and an uncertain income with the same expected value.
Your marginal utility of income is constant.
Constant slope
Risk loving
Condition of preferring a risky income to a certain income with the same expected value.
You love to gamble, although