Slide 1Econ 410: Micro TheoryRisk Reduction and Behavioral EconomicsWednesday, October 3rd, 2007Slide 2Risk Reduction We have learned that consumers are generally risk averse Because of risk aversion, people may take steps to reduce risk. Three of the ways consumers attempt to reduce risk are:1. Diversification2. Insurance3. Obtaining more informationSlide 3Diversification Diversification consists of reducing risk by allocating resources to a variety of activities whose outcomes are not closely related Example – The stock market Investing in a single stock can be risky Many investors choose to spread risk out by investing in a variety of stocks or investments Mutual Funds The ability to diversify is affected by the correlation between risky alternatives.Slide 4Insurance We have seen from our discussion of risk premiums that risk averse people are willing to pay to avoid risk If the cost of an insurance policy equals the expected loss, risk averse people will buy enough insurance to recover fully from a potential financial loss.Insurance? Fire (Pr=0.5)No Fire (Pr=.95)Expected WealthStd Dev.No $80,000 $100,000 $99,000 4359Yes $99,000 $99,000 $99,000 0Insurance? Fire (Pr=0.5)No Fire (Pr=.95)Expected WealthStd Dev.No $80,000 $100,000 $99,000 4359Yes $99,000 $99,000 $99,000 0Slide 5Insurance Insurance companies know that although single events are random and largely unpredictable, the average outcome of many similar events can be predicted “Law of Large Numbers”When insurance companies sell many policies, they face relatively little riskSlide 6Insurance & Actuarial Fairness Firms set premiums so money received will be enough to pay expected losses When an insurance premium is set to equal the expected payout of the company, the policy is said to be actuarially fair. Typically, premiums are higher than this Why? Government Intervention Refusal to sell insuranceSlide 7Valuing Information Risk often exists because we don’t know all the information surrounding a decision Because of this, information is valuable and people are willing to pay for it The value of complete information The difference between the expected value of a choice with complete information and the expected value when information is incomplete Relationship to the risk premiumSlide 8Valuing Information Is making information publicly available always better? Why or why not? Example – Medical “Report Cards” Report cards of physician performance were made mandatory by several states during the 1990’s What impact might this have on physician incentives? Current researchSlide 14For next time… Prepare questions for the review session on Friday Don’t Forget Your midterm exam is this Monday, October 8th. After your exam… We’ll begin our discussion of problems surrounding asymmetric information in economics By next Wednesday, be sure you have read sections 5.5 and 17.1 in your
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