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Unformatted text preview: C H A P T E R 17 Choice and Markets in the Presence of Risk In this chapter, we expand the consumer model to include the presence of risk. In the process, we are able to think about certain types of markets that insure against risk, markets that play important roles in modern life. And we can use the gen- eral equilibrium approach developed in Chapter 16 to investigate the market forces that arise when individuals attempt to insure against risk. In many classes, the pri- mary emphasis will be on the material in the first section of the chapter, a section that deals with basic models of risk aversion when gambles are primarily about money. In the second section, we then see how this model is actually a special case of a model in which there are other things about the different “states of the world” that matter, and in the third section we introduce risk into the general equilibrium model. Chapter Highlights The main points of the chapter are: 1. When money is all that matters, we can model attitudes over risk in a straight- forward way using a consumption/utility relationship whose shape deter- mines the degree of risk aversion . Within this context, we can develop con- cepts like certainty equivalence and risk premium , both of which are related to the degree of risk aversion. 2. Actuarily fair insurance contracts have the feature that the expected value of consumption remains unchanged when the individual buys insurance — implying that the insurance company makes zero profits on average. In the simplest model of risk aversion, any risk averse individual will fully insure against risk when faced with a full menu of actuarily fair insurance contracts. 3. When tastes are state-dependent , the model becomes richer in that it al- lows for risk averse individuals to rationally choose to over- or under-insure. Choice and Markets in the Presence of Risk 216 The state-independent model is a special case of the more general state- dependent model. 4. In a general equilibrium setting, actuarily fair insurance contracts often can- not arise. The presence of aggregate risk in an economy, for instance, implies that there are not enough individuals willing to sell “recession insurance” on terms that would be actuarily fair. As a result, risk averse individuals in such an economy will not fully insure because of the equilibrium pricing of such insurance. Using the LiveGraphs For an overview of what is contained on the LiveGraphs site for each of the chapters (from Chapter 2 through 29) and how you might utilize this resource, see pages 2-3 of Chapter 1 of this Study Guide . To access the LiveGraphs for Chapter 17, click the Chapter 17 tab on the left side of the LiveGraphs web site....
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- Fall '08
- Utility, insurance policy