8-Uncertainty (II)

8-Uncertainty (II) - Agenda Course Overview Managing Risk...

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1 Agenda • Course Overview • Managing Risk • Insurance • Hedging and Diversification • Acquiring information • Case study: Turnstiles in Los Angeles MTA • What To Take Away Microeconomics The Structure of the Course Consumers and Producers Market Interaction Today’s lecture Uncertainty Perfect competition Monopoly and Pricing strategies Competitive Strategy Auctions Information in Markets and Agency Game Theory Introduction to Markets Consumer Theory and Demand Technology and Production
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2 Agenda • Course Overview • Managing Risk • Insurance • Hedging and Diversification • Acquiring information • Case study: Turnstiles in Los Angeles MTA • What To Take Away Managing Risk Consumers are generally risk averse and would like to reduce the risks they face. Three ways consumers attempt to reduce risk are: 1. Insurance and Risk sharing 2. Hedging and Diversification 3. Acquiring more information
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3 Agenda • Course Overview • Managing Risk • Insurance • Hedging and Diversification • Acquiring information • Case study: Turnstiles in Los Angeles MTA • What To Take Away Insurance Risk averse consumers are willing to pay to avoid taking a risk If the cost of insurance equals the expected loss, risk averse people will buy enough insurance to recover fully from a potential financial loss. For the risk averse consumer, guarantee of same income regardless of outcome has higher utility than facing the probability of risk. Expected utility with insurance is higher than without. How much would a risk averse consumer be willing to pay to avoid facing risk? As we discussed in the previous lecture, the maximum a risk averse consumer would be willing to pay to be fully insured against a risk is precisely his risk premium.
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4 Agenda • Course Overview • Managing Risk • Insurance • Hedging and Diversification • Acquiring information • Case study: Turnstiles in Los Angeles MTA • What To Take Away Diversification Consumers (and firms) can reduce the risk they face by allocating resources to different activities/assets/projects whose outcomes are not closely related. “Don’t put all your eggs in one basket”. What do we mean by “outcomes are not closely related”? We are comparing activities/assets/projects on the basis of how outcomes tend to move relative to each other: if they tend to move in the same direction they are positively correlated, if they tend to move in opposite directions then outcomes are negatively correlated. Risk can be reduced by combining assets that are negatively correlated.
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5 Suppose a firm has a choice of selling air conditioners, heaters, or both The probability of it being hot or cold is 0.5 How does a firm decide what to sell?
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8-Uncertainty (II) - Agenda Course Overview Managing Risk...

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