Coping with risk in economic life

Chapter 15 Coping with risk in economic life David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith 15.1 Individual attitudes towards risk  A risk neutral person – is only interested in whether the odds will yield a profit on average  A risk-averse person – will refuse a fair gamble  i.e. one which on average will make exactly zero monetary profit  A risk-lover – will bet even when a strict mathematical calculation reveals that the odds are unfavourable 15.2 Risk and insurance  Risk-pooling – works by aggregating independent risks to make the aggregate more certain  Risk-sharing – works by reducing the stake  By pooling and sharing risks, insurance allows individuals to deal with many risks at affordable premiums. 15.3 Moral hazard and adverse selection  Moral hazard – is the exploiting of inside information to take advantage of the other party to a contract  e.g. if you take less care of your property because you know it is insured  Adverse selection – occurs when individuals use their inside information to accept or reject a contract, so that those who accept are not an average sample of the population  e.g. smokers taking out life insurance 15.4 Portfolio selection  The risk-averse consumer prefers a higher average return on a portfolio of assets – but dislikes risk.  Diversification – is a strategy of reducing risk by risk-pooling across several assets whose individual returns behave differently from one another.  Beta – is a measurement of the extent to which a particular share's return moves with the return on the whole stock market 15.5 Efficient asset markets  The theory of efficient markets – says that the stock market is a sensitive processor of information – quickly responding to new information to adjust share prices correctly  An efficient asset market already incorporates existing information properly in asset prices. 15.6 More on risk  A spot market – deals in contracts for immediate delivery and payment  A forward market – deals in contracts made today for delivery of goods at a specified future date at a price agreed today  Hedging – the use of forward markets to shift risk on to somebody else.  A speculator – temporarily holds an asset in the hope of making a capital gain. 15.7 Chapter 16 Introduction to welfare economics David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith 16.9 Welfare economics  The branch of economics dealing with normative issues.  Its purpose is not to describe how the economy works  but to assess how well it works. 16.10 Equity and efficiency  Horizontal equity – the identical treatment of identical people  Vertical equity – the different treatment of different people in order to reduce the consequences of their innate differences 16.11 Pareto efficiency  An allocation is Pareto-efficient for a given set of consumer tastes, resources and technology, if it is impossible to move to another allocation which would make some people better off and nobody worse off. 16.12 Perfect competition and Pareto efficiency  If every market in the economy is a perfectly competitive free market, the resulting equilibrium throughout the economy will be Pareto-efficient.  As expressed in Adam Smith’s notion of the Invisible Hand. 16.13 Competitive equilibrium and Pareto-efficiency  At any output such as Q1*, the last film must yield consumers P1* extra utility.  The supply curve for the competitive film industry (SS) is the marginal cost of films.  Away from P1*, Q1*, there is a divergence between the marginal cost and the marginal benefit derived by consumers  so a move to that position makes society better off. D SSD Q1* P1* Quantity of films 16.14 Distortions  A distortion exists whenever society’s marginal cost of producing a good does not equal society’s marginal benefit from consuming that good. – Some such distortions may be inevitable – and it may be more efficient to spread such distortion over a wide range of markets, rather than concentrating it in one market – this results from the theory of the second-best 16.15 Market failure … occurs when equilibrium in free unregulated markets will fail to achieve an efficient allocation.  Imperfect competition  Social priorities (e.g. equity)  Externalities  Other missing markets – future goods, risk, information. 16.16 Externalities  An externality arises whenever an individual’s production or consumption decision directly affects the production or consumption of others…  other than through market prices e.g. a chemical firm discharges waste into a lake & ruins the fishing for anglers 16.17 A production externality Quantity DD Suppose DD represents the demand curve for a product (which we may interpret as marginal social benefit). MPC MPC is the marginal private cost incurred by the firm in producing the good (assumed constant for simplicity). P Q The market clears where MPC=DD at price P and quantity Q. 16.18 A production externality Quantity DD (MSB) MPC Q MSC If the firm causes pollution, it imposes costs on society, presented by marginal social costs (MSC). Q* So the social optimum is where DD(MSB)=MSC at Q*. The overall welfare loss to society from the market failure is given by the excess of MSC over MPC between Q* and Q. 16.19 A consumption externality DD MPC, MSC Quantity P ri c e Q A consumption externality may cause marginal social benefit to diverge from marginal private benefit. If MSB>MPB, then the free market equilibrium provides the quantity Q. MSB Q' As compared with the social optimum at Q', where MSB = MSC. The red area shows the welfare loss. E.g. neighbours may benefit from a well-kept garden. 16.20 Greenhouse gases 0 20 40 60 80 100 120 Index (1990 = 100) Ja pa n US A Ge rm an y UK Ita ly Emission of greenhouse gases 1990 1995 2012