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Chapter 17 - Chapter 17 Choice and Markets in the Presence...

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Chapter 17 Choice and Markets in the Presence of Risk Life is full of risk — yet in everything we have done thus far, we have assumed that individuals operate in an economic environment that involves no risk. 1 Sometimes the risks we face are per- sonal — the increased risk of lung disease a coal miner faces or the risk of dying in a car crash when we get on the road. As I am writing this, I face the risk of investing a lot of my time in a book that I think is great only to find out that no one will read it – not to mention having to admit to my wife that no one actually cares about my brilliant thoughts. Other times, the risk is strictly financial — when we purchase a house whose value may rise or fall, when we make investment decisions in our retirement portfolio or when we buy a new computer without knowing for sure whether it will break down in three months. If I don’t care about the humiliation of writing a book that no one reads, I still face a financial risk of having spent time I could have used to make money in other ways on a project that does not pay off financially as I had hoped. Where there is risk, however, there is also a potential market for products that reduce risk. In many instances, such products take the form of insurance – like health, disability or life insurance – but they can also come in the form of extended warranty agreements on the computer I buy or through financial planning strategies that balance different forms of risky assets. My publishers have provided me with some insurance for writing this book by giving me an advance on future royalties, an advance that they will recoup if the book sells but not otherwise. We will find in this chapter that some tweaking of the tools we have already developed will allow us to extend our analysis of choice (and markets) to circumstances where risk is central to the concerns of the individual who is choosing. In much of the chapter, we will use the example of life insurance to illustrate a model that can be used to address all sorts of situations that involve risk. Again, it will be a combination of tastes and constraints that will determine choice, with different individuals having different attitudes (or tastes) toward risk, and with prices in markets determining the options that individuals have for dealing with the risks they face. And again we will find that, in the absence of distorting forces such as those listed at the end of Chapter 15, 1 Most of this chapter builds on a basic understanding of consumer theory as captured in Chapter 6, with some brief references to material from Chapter 11. Only toward the end – in Sections 17A.3 and 17B.3 – do we build on general equilibrium theory from Chapter 16. These sections can (and should) be skipped if you have not yet gone through Chapter 16.
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594 Chapter 17. Choice and Markets in the Presence of Risk competitive markets result in efficient outcomes. In Chapter 22, however, we will discover that
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