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Unformatted text preview: c h a p t e r 431 18 >> N M ARCH 1998 THE F LINT R IVER OVER- flowed its banks and flooded the town of Albany, Georgia. It was a catastrophe. The town’s residents were especially distraught because many of them had no flood insurance—they had dropped their coverage after a similar flood in 1994 led insurance companies to raise their premiums. The case of Albany’s floods reminds us that uncertainty is an important feature of real-world economies. Up to this point, we have assumed that people make decisions with knowledge of exactly how those deci- sions will affect their welfare. In reality, people often make economic decisions—such as whether to build a house near a river—without full knowl- edge of their future conse- quences. As the residents of Albany learned, making deci- sions when the future is uncer- tain carries with it the risk of loss. Yet it is often possible for individuals to use markets to reduce the risk they face. The Flint River flood made head- lines because it’s unusual for so many victims of a disaster to be without insurance. In fact, through insurance and other Uncertainty, Risk, and Private Information A F T E R T H E F L O O D I What you will learn in this chapter: ➤ That risk is an important feature of the economy, and that most people are risk-averse —they would like to avoid risk ➤ Why diminishing marginal utility makes people risk-averse and determines the premium they are willing to pay to reduce risk ➤ How risk can be traded, with risk-averse people paying others to assume part of their risk ➤ How exposure to risk can be reduced through diversification and pooling ➤ The special problems posed by private information —situations in which some people know things that other people do not devices, the modern economy offers many ways for individuals to reduce their exposure to risk. Does this mean that a market economy can solve all the problems created by uncertainty? Alas, no. Markets do very well at coping with situations in which nobody knows what will happen. But they run into trouble when some people know things that others do not—a situation known as private information . We’ll see that private information can cause ineffi- ciency by preventing mutually beneficial transactions. By failing to maintain their flood insurance, these Albany, Georgia, homeowners incurred huge losses in 1998. A P / W i d e W o r l d P h o t o s The Economics of Risk Aversion In general, people don’t like risk and are willing to pay a price to avoid it. Just ask the U.S. insurance industry, which collects more than $1 trillion in premiums every year. But what exactly is risk? And why don’t people like it? To answer these questions, we need to look briefly at the concept of expected value and the meaning of uncertainty....
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This note was uploaded on 10/31/2009 for the course BU BU224 taught by Professor Pakula during the Fall '09 term at Kaplan University.
- Fall '09