The Optimal Allocation of Risk James Mirrlees Chinese University of Hong Kong At Academia Sinica, Taipei 8 October 2010.

Slides:



Advertisements
Similar presentations
Optimal Contracts under Adverse Selection
Advertisements

Tor Iversen Health service provision Economic incentives and organization of the hospital sector I.
Economic Systems Ohio Wesleyan University Goran Skosples 5. How a Market System Works.
Choice under Uncertainty. Introduction Many choices made by consumers take place under conditions of uncertainty Therefore involves an element of risk.
Health and Human Sciences Economics and Health: a taster Masters in Public Health Key reference: McPake B., Kumaranayake, L. & Normand, C (2002) Health.
Lecture 5: Arrow-Debreu Economy
Chapter 12 Uncertainty Consider two lotteries L 1 : 500,000 (1) L 1 ’: 2,500,000 (0.1), 500,000 (0.89), 0 (0.01) Which one would you choose? Another two.
Chapter 37 Asymmetric Information In reality, it is often the case that one of the transacting party has less information than the other. Consider a market.
1 Chapter 14 Practice Quiz Environmental Economics.
Fall 2008 Version Professor Dan C. Jones FINA 4355 Class Problem.
Pablo Serra Universidad de Chile Forward Contracts, Auctions and Efficiency in Electricity Markets.
Global Imbalances and Policy Frictions James Mirrlees Chinese University of Hong Kong European Colloquia Iseo, 14 September 2011.
1 Entrepreneurship and Incentives James Mirrlees Chinese University of Hong Kong At National Tsing Hua University, Taiwan 11 December 2007.
MACROECONOMICS MACROECONOMICS and the FINANCIAL SYSTEM © 2011 Worth Publishers, all rights reservedPowerPoint® slides by Ron Cronovich N. Gregory Mankiw.
Lecture 5: Externalities (chapter 9) Relation to lectures 1-4 Negative externalities Positive externalities: public goods and empathy Efficiency wage relation.
2. Free Trade and Protection. Summary 1.Theory of Comparative Advantage: Why trade is good. 2.Where comparative advantage comes from: Heckscher-Ohlin.
© 2009 Pearson Education Canada 20/1 Chapter 20 Asymmetric Information and Market Behaviour.
Rational Expectations and the Aggregation of Diverse Information in Laboratory Security Markets Charles R. Plott, Shyam Sunder.
P.V. VISWANATH FOR A FIRST COURSE IN INVESTMENTS.
Health Insurance October 19, 2006 Insurance is defined as a means of protecting against risk. Risk is a state in which multiple outcomes are possible and.
The Importance of Macroeconomics
317_L13, Feb 5, 2008, J. Schaafsma 1 Review of the Last Lecture finished our discussion of the demand for healthcare today begin our discussion of market.
Chapter 14 Government spending and revenue
317_L12, Feb 1, 2008, J. Schaafsma 1 Review of the Last Lecture discussed the effect of proportional health insurance on the healthcare market => showed.
Chapter 9 THE ECONOMICS OF INFORMATION Copyright ©2002 by South-Western, a division of Thomson Learning. All rights reserved. MICROECONOMIC THEORY BASIC.
Chapter Twelve Uncertainty. Uncertainty is Pervasive u What is uncertain in economic systems? –tomorrow’s prices –future wealth –future availability of.
ECON 850 Health Economics Gilleskie Lecture 1: Introduction What is economics? What is health economics?
Strategic Synergy Investments, LLC – “SSI” An Explanation of Core Strategies COMMODITY TRADING INVOLVES SUBSTANTIAL RISK OF LOSS AND IS NOT SUITABLE FOR.
Ch.8 Arrow-Debreu Pricing 8.1 Introduction 8.2 Setting: An Arrow-Debreu Economy 8.3 Competitive Equilibrium and Pareto Optimality Illustrated 8.4 Pareto.
Fair Premiums, Insurability of Risk and Contractual Provisions
Basic Tools of Finance Finance is the field that studies how people make decisions regarding the allocation of resources over time and the handling of.
Lecture 3: Arrow-Debreu Economy
Capital Asset Pricing Model Part 1: The Theory. Introduction Asset Pricing – how assets are priced? Equilibrium concept Portfolio Theory – ANY individual.
Microeconomics and Corporate Analysis State Intervention, Public choice and Economic Regulation Lecture Slides Rui Baptista.
TOPICS 1. FINANCIAL DECISIONS, INVESTMENT DECISIONS AND DIVIDEND DECISIONS 2. FINANCIAL MANAGEMENT PROCESS 3.PROFIT MAXIMIZATION AND WEALTH MAXIMIZATION.
Economic Systems SSEF4 The student will compare and contrast different economic systems and explain how they answer the three basic economic questions.
Equity, Efficiency and Need
Interest Rates. An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example,
ENTREPRENEURS IN A MARKET ECONOMY
Investment Analysis and Portfolio Management
Principal - Agent Games. Sometimes asymmetric information develops after a contract has been signed In this case, signaling and screening do not help,
Incentives and the Welfare State James Mirrlees University of Melbourne and Chinese University of Hong Kong Trevor Swan Lecture ANU 13 March 2008.
Capital Structure.
Chapter 37 Asymmetric Information. Information in Competitive Markets In purely competitive markets all agents are fully informed about traded commodities.
Introduction to the Financial System. In this section, you will learn:  about securities, such as stocks and bonds  the economic functions of financial.
9/12/20151 Growth in the 1990s: Common lessons across sectors Presentation to ICRIER September 28, 2004.
1 Externalities. 2 Externalities  Externalities are a market failure (so Government intervention may be advisable).  Externalities imply that there.
Asymmetric Information
Capital Asset Pricing Model CAPM I: The Theory. Introduction Asset Pricing – how assets are priced? Equilibrium concept Portfolio Theory – ANY individual.
© 2010 W. W. Norton & Company, Inc. 37 Asymmetric Information.
Asymmetric Information
Chapter Outline 9.1Principals of Business Valuation Valuation Formula Components of the Opportunity Cost of Capital Compensation for Risk 9.2Risk Management.
Evaluation of Fiscal Policy. The effectiveness of fiscal policy, as a measure to influence aggregate demand and output, is open to much debate. The argument.
Profit Margins In General Insurance Pricing (A Critical Assessment of Approaches) Nelson Henwood, Caroline Breipohl and Richard Beauchamp New Zealand Society.
CHAPTER 14 Government spending and revenue ©McGraw-Hill Education, 2014.
Chapter 15: Externalities, Public Goods and Social Choice
© 2010 W. W. Norton & Company, Inc. 12 Uncertainty.
A2 External Influences Government policies affecting business.
Economies of Scale Introduction and appropriation issues.
L6: Risk Sharing and Asset Pricing1 Lecture 6: Risk Sharing and Asset Pricing The following topics will be covered: Pareto Efficient Risk Allocation –Defining.
Chapter Thirty-Six Asymmetric Information. Information in Competitive Markets u In purely competitive markets all agents are fully informed about traded.
Cost of Money Money can be obtained from debts or equity both of which has a cost Cost of debt = interest Cost of equity = dividends What is cost for.
Efficiency and Equity in a Competitive Market
Eco 3311 Lecture 12 One Period Closed Economy Model - Equilibrium
Asymmetric Information
12 Uncertainty.
William F. Sharpe STANCO 25 Professor of Finance
Risk Aversion and Capital Allocation to Risky Assets
Role of the state.
Presentation transcript:

The Optimal Allocation of Risk James Mirrlees Chinese University of Hong Kong At Academia Sinica, Taipei 8 October 2010

Risky contracts Insurance Outcome conditional on accident Pensions Outcome could be conditional on capital market performance; or on GDP “Securities” conditional on companies' performance or default Loans conditional on own experience – might default

Optimality Arrow and Debreu are supposed to have shown that an optimum can be implemented by a full set of free markets in securities, with income redistribution. Does not even need to be a full set. Second-best considerations imply the need for taxes on goods and services and securities, but do not affect the main Arrow/Debreu argument. But the claim is wrong.

Moral Hazard Familiar objection. People's actions are not always observable, or deducible from outcomes, and contracts cannot be made conditional on them. Intuitively, one guesses contracts should be conditional on outcomes, as imperfect proxies for actions. But that is not enough.

Optimal contracts with moral hazard. Let insurers sell contracts to people with moral hazard. The contracts should pay conditional on all observables that are influenced by, or influence the hidden action. The contracts exclude clients from other contracts conditioned on these observables. Insurers maximize expected profit, and compete. An optimum can be achieved with these contracts.

Feasibility? CDOs. These are traded contracts, i.e. there is no exclusion. Wrong incentives for the client, in this case a mortgage lender, for example. Health insurance. Coinsurance proposed. But thought that people can still insure the coinsurance payment. Then coinsurance has no effect, and incentives are wrong. Conclusion? State monopoly?

Multiple relevant observables Car insurance. Miles driven is observable, for some contracts – e.g. buying petrol. Clearly associated with accident risk. It is too costly for insurers to include miles driven in contracts. That can be corrected, imperfectly, with higher petrol taxation. In many cases, complexity rules out intervention of this kind. Case for regulation.

Another flaw in Arrow/Debreu: ignorance. Arrow/Debreu uses individual preference, e.g. expected utility. – in terms of whatever probabilities individuals happen to believe. Surely welfare must be judged by outcomes, if not entirely, then mainly. Two people, identical preferences, opposite beliefs – sun for sure, rain for sure. They will trade so that one starves if rain, the other if sun. Plainly not an optimum.

Back to fundamentals Karl Borch considered allocation where everyone has the same beliefs. Aggregate output varies across states of nature, and has to be allocated to individuals. He showed that each individual's allocation is an increasing function of total output. It can be achieved with Arrow/Debreu securities. There would be no short trading. If probabilities differ, utilities are the same, equal sharing of output is optimal: i.e. no consumer choice.

The general problem Two major difficulties. To define optimality, one must have true probabilities. One feels these are not always known (though since they should correctly describe uncertainty, they should allow for that ignorance). Anyway, fully informed people will disagree. Secondly, it is technically challenging.

11 Varied risk preferences. Simpler version: x scalar, no resource constraint. If second-best taxation creates optimal incentives for labour supply, income- contingent variability of r may be quite small, relative to belief-variance.

12 Varying risk preferences In reality people have different false beliefs, and also different risk preferences, and they find themselves with different prospects – hence hedging and insurance seems desirable. One can ask when it is desirable to restrict choice, e.g. by suppressing such gambling as (some kinds of) CDSs. Answer (roughly): when the variance of risk- preferences is less than the variance of probabilities. Really, it should depend on the individual gambler's prospects, hard to observe.

13 Policy? The conclusion is that in certain circumstances, probably many, though difficult to identify, government should ensure that certain kinds of trades should not take place. The technical theorem so far gives little help in identifying asset classes that shoul be severely regulated. The constraint might take the form of saying that only certain kinds of contracts should be traded. Prohibiting short trading is an example. And it may be a case for prescribing the form of pension contracts.