Steven Landsburg, University of Rochester Chapter 18 Risk and Uncertainty Copyright ©2005 by Thomson South-Western, a part of the Thomson Corporation. All rights reserved.

Landsburg, Price Theory and Applications, 6th edition2 Introduction State of the world Individual choice about transferal of wealth –Determining equilibrium prices –Examples of markets where transfers exist

Landsburg, Price Theory and Applications, 6th edition3 Attitudes Toward Risk Basket of outcomes –Indifference curves represent individual’s preferences Ex ante –Determined before state of world known Ex post –Determined after state of world known

Landsburg, Price Theory and Applications, 6th edition4 Characterizing Baskets Expected values –Average value over all states of world with each state weighted by its probability –Law of large numbers Repeat gamble many times Average outcome is expected value Riskiness –Risk-free

Landsburg, Price Theory and Applications, 6th edition5 Opportunities Budget line and prices Fair odds –Odds that reflect true probabilities of various states of world –Expected value of betting same as expected value of not betting Individual offered fair odds –Budget line coincides with expected value line

Landsburg, Price Theory and Applications, 6th edition6 Preferences Consumer’s optimum –Frequent gambler Diversify Risk-neutral –Indifference curves identical to iso-expected value lines –Indifferent about amount bets whether fair or unfair odds Risk-averse Risk-preferring –Gambling at favorable odds Risk attitude

Landsburg, Price Theory and Applications, 6th edition7 EXHIBIT 18.4Risk Neutrality

Landsburg, Price Theory and Applications, 6th edition8 EXHIBIT 18.5Risk Aversion

Landsburg, Price Theory and Applications, 6th edition9 EXHIBIT 18.8Gambling at Favorable Odds

Landsburg, Price Theory and Applications, 6th edition10 Risk and Society Societies’ desire for risk neutrality in some instances Individual entrepreneurial endeavors promote risk aversion –Underinvest in risky projects –Corporations good buffer

Landsburg, Price Theory and Applications, 6th edition11 Market for Insurance Facilitate transfer of risk from one party to another Diversification Imperfect information –Moral hazard –Adverse selection Uninsurable risks

Landsburg, Price Theory and Applications, 6th edition12 EXHIBIT 18.9Adverse Selection

Landsburg, Price Theory and Applications, 6th edition13 Futures Markets Futures contract –Deliver specified good at specified future date at specified price Futures market –Market for futures contracts Spot market –Market for goods for immediate delivery Spot price –Price in spot market

Landsburg, Price Theory and Applications, 6th edition14 Speculation Speculator –Attempts to earn profits in futures market –Predicts future changes in supply or demand Speculation and welfare –Guess future correctly Earn profit Increase social welfare

Landsburg, Price Theory and Applications, 6th edition15 Market for Risky Assets Returns –Assets valued not for uses in consumption but for potential increase to owners’ wealth Expected returns –Expected present value of those returns Standard deviation –Measure of risk –Spread in possible outcomes Investors

Landsburg, Price Theory and Applications, 6th edition16 Portfolios Combination of risky assets –Standard deviation of portfolio at most equal to average standard deviation of individual stocks –Expected return to portfolio exactly equal to average expected returns of individual stocks Efficient set and portfolios

Landsburg, Price Theory and Applications, 6th edition17 EXHIBIT 18.13The Efficient Set

Landsburg, Price Theory and Applications, 6th edition18 Investor’s Choice Capital asset pricing model –Model assumes investor cares only about expected return and risk –Risk measured by standard deviation Risk-free asset –Market line and portfolios Rational investor –Hold portfolio combines risk-free asset with market portfolio in some proportions

Landsburg, Price Theory and Applications, 6th edition19 EXHIBIT 18.14The Investor’s Choice

Landsburg, Price Theory and Applications, 6th edition20 Constructing a Market Portfolio Portfolios consists of all risky assets in economy –Held in proportion to their existing quantities Mutual funds

Landsburg, Price Theory and Applications, 6th edition21 Rational Expectations Setting prices in face of uncertain demand Market for uncertain demand –Rational expectations Expectations held by market participants Fulfill expectations on average Making wrong predictions –Econometricians

Landsburg, Price Theory and Applications, 6th edition22 EXHIBIT Rational Expectations

Landsburg, Price Theory and Applications, 6th edition23 EXHIBIT Lumberjacks’ Income and the Price of Lettuce