The economics of uncertainty is a field of economics (primarily microeconomics) that investigates how uncertainty and risk affect the allocation of scarce resources, especially in financial markets and in the provision of insurance. Central to this study is the difference between uncertainty (not knowing which of several possible outcomes might occur) and risk (assigning probabilities to different possible outcomes).
People have different preferences about risk. Some prefer to avoid risk (risk aversion), others are indifferent (risk neutrality), while others enjoy risk (risk loving). Risk aversion in particular is a driving force behind the provision of insurance. Those who dislike risk are willing to pay to avoid it.
Risk and uncertainty are important to financial markets, as well. The exchange of financial instruments, such as stocks and bonds, are based on uncertainty of the future, tempered with attempts to quantify the risk of different possibilities.
Uncertainty and RiskA cornerstone of the economic analysis of uncertainty is the difference between uncertainty and risk. While closely related concepts that are occasionally (and erroneously) used interchangeably, uncertainty and risk have important differences.
While anything is possible (which is the essence of uncertainty) everything is not equally probably (which is the essence of risk). Many who participate in the financial markets and in the insurance industry spend a great deal of time and effort trying to transform uncertainty into risk. This can be accomplished with simple historical extrapolation. If, for example, every winter 5 people out of 100 contract the flu, then the projected risk of this outcome is 5%. In actuality, more sophisticated analysis is frequently used. That is, the risk of flu contraction might be evaluated based on lifestyle, weather conditions, medical treatment, and other factors.
- Uncertainty: Uncertainty is the observation that the future is not known. You don't know what might happen tomorrow. You might step in a puddle of mud on the way to class. Or you might anger an intelligent extraterrestrial life form that retaliates by destroying all life on the planet. You just never know.
- Risk: Risk is assigning quantitative probabilities to alternative future outcomes. While it is possible that you could either step in a mud puddle or your could cause total destruction of the planet, both are not equally likely outcomes. Risk is the process of assigning probabilities to these alternatives (for example, 99.999999999% chance of mud puddle stepping versus 0.000000001% chance of total planet destruction).
Risk PreferencesDifferent people have different views, perspectives, and preferences about risk. Some people enjoy a risky situation and others do not. This gives rise to three alternative risk preferences -- risk aversion, risk neutrality, and risk loving. As the names suggest, some people prefer to avoid risk (risk aversion), others enjoy engaging in risk (risk loving), and still others are indifferent (risk neutrality).
These three alternatives can be more precisely defined based on the marginal utility of income. Marginal utility is the change in utility resulting from a given change in the consumption of a good. Marginal utility of income is then the change in utility resulting from a given change in income. The standard presumption is that marginal utility declines as more of a good is consumed, that is, decreasing marginal utility. As a general rule the marginal utility of income also declines with an increase in income. However, it can also increase or remain constant.
Suppose, for example, that you have $100 of income and are confronted with a $50 wager on the flip of a coin. If the coin comes up heads, then you win $50 and thus have a total of $150. If the coin comes up tails, then you lose $50 and thus have a total of only $50. Risk preferences determine your willingness to decline the wager and keep the $100 of income that you have (certain income) or agree to the wager not knowing whether you will win or lose (risky income).
It is important to note that the income expected from the wager (so called expected income) is actually equal to certain income ($100). That is, because the coin has an equal chance of coming up heads or tails, if you undertake this wager 100 times, you can expect to win 50 times and lose 50 times. The loses exactly equal the wins and the income you can expect to end up with is $100.
These three alternatives give rise to risk aversion, risk loving, and risk neutrality.
Most people tend to be risk averse, preferring certain income to an equal amount of risky income. Not only do they prefer certainty over risk, they are willing to pay. This is the essence of insurance. People pay a relatively small insurance premium to avoid the prospect of incurring a much bigger loss. They are thus guaranteed a certain income, net of the insurance premium, and eliminate the risk, albeit a small risk, of a loss of income.
- Risk Aversion: This exists when a person has decreasing marginal utility of income. In this case you prefer the certain income to the risky income. With decreasing marginal utility of income you obtain less utility from the income won than the income lost. Even though the expected income is equal to the certain income, the utility obtained from the certain income exceeds the utility obtained from the expected income. The utility from winning is exceeded by the utility from losing. You are better off not wagering.
- Risk Loving: This exists when a person has increasing marginal utility of income. With increasing marginal utility of income you obtain more utility from the income won than the income lost. Even though the expected income is equal to the certain income, the utility obtained from the expected income exceeds the utility obtained from the certain income. The utility from losing is exceeded by the utility from winning. You are better off wagering.
- Risk Neutrality: This exists when a person has constant marginal utility of income. With constant marginal utility of income you obtain the same utility from the income won as the income lost. Not only is the expected income is equal to the certain income, the utility obtained from the expected income is equal to the utility obtained from the certain income. The utility from losing is matches by the utility from winning. You are equally well off wagering or not wagering.
InsuranceUncertainty of the future and the quantification of this uncertainty as risk is fundamental to the provision of insurance. Insurance is a service that transfers the risk of large losses from an individual to a larger group. The larger group is typically represented by an insurance provider. This transfer of risk is undertaken in exchange for a premium payment. That is, the individual agrees to incur a small guaranteed loss (the premium) but avoids incurring a less likely but much larger loss.
For example, a person pays an automobile insurance premium each month (guaranteed), but shifts the (slight) risk of a major expense associated with an accident to the insurance provider.
The insurance provider spreads this slight risk of a large expense for one person over a large group, the vast majority who pay the premium but do not incur the expense. Suppose, for example, that insurance is provided to 100 people and one member of this group is involved in an accident that incurs a cost of $20,000. The insurance provider spreads this $20,000 expense over the 100 people by charging each a premium of $200.
The key is that the insurance provider knows that 1 of the 100 customers will incur the $20,000 expense, it just doesn't know which specific person it will be.
Financial MarketsRisk and uncertainty are also key to financial markets. Financial markets exchange financial instruments or legal claims, such as stocks, bonds, and futures contracts. The most common financial market is the stock market that exchanges corporate stock, which are legal claims representing ownership of corporations.
Those who buy and sell legal claims do so with recognition that the future is uncertain. However, they also attempt to transform this uncertainty into quantifiable risk. For example, you might be willing to buy a few shares of OmniConglomerate, Inc. based on expectations that the company will be more profitable in the near future.
While the future profitability of OmniConglomerate, Inc. is uncertainty, you might be able to assign probabilities to alternative outcomes. Perhaps you know that over the past 20 years, the company has had positive profit three-fourths of the time and a loss only one-fourth of the time. The odds are three to one of a positive profit in the coming year.
You might then adjust this probability with other information. Perhaps because you heard that the company is on the verge of obtaining a lucrative government contract. Or perhaps you read that the economy will be prospering and with it the demand for company production will increase.
The accuracy of the information plays a big part in who "wins" and "loses" in the financial markets. If your information is better and the price does increase, then you win. If the seller has better information and the price decreases, then you lose.
The Economics of InformationThe economics of information studies the importance of information to the allocation of scarce resources. The standard assumption at the basis of most economic theories is one of perfect information, that buyers and sellers, producers and consumers, have perfect (or at least complete) information.
The economics of information, however, indicates that perfect information is just not possible. While information is beneficial to have, it is also costly to acquire. Like the production of any good, the efficient acquisition of information is a matter of balancing benefits against costs. The primary indication is that perfect, complete, or total information is not economically efficient. That is, most people rationally choose to be ignorant (about some things).
In addition to risk and uncertainty, the economic study of information and the efficient search for information provides useful analysis for a number of important issues, including asymmetric information, adverse selection, moral hazard, and information search.
ECONOMICS OF UNCERTAINTY, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2018. [Accessed: August 17, 2018].