- Study Guide (Course-wide Content)
A. Economics of Risk and Uncertainty
- Economic life is full of uncertainty. Consumers face uncertain incomes and employment patterns as well as the threat of catastrophic losses; businesses have uncertain costs, and their revenues contain uncertainties about price and production.
- In well-functioning markets, arbitrage, speculation, and insurance help smooth out the unavoidable risks. Speculators are people who buy and sell assets or commodities with an eye to making profits on price differentials across markets. They move goods across regions from low-price to high-price markets, across time from periods of abundance to periods of scarcity, and even across uncertain states of nature to periods when chance makes goods scarce.
- The profit-seeking action of speculators and arbitragers tends to create certain equilibrium patterns of price over space, time, and risks. These market equilibria are zero-profit outcomes where the marginal costs and marginal utilities in different regions, times, or uncertain states of nature are in balance. To the extent that speculators moderate price and consumption instability, they are part of the invisible-hand mechanism that performs the socially useful function of reallocating goods from feast times (when prices are low) to famine times (when prices are high).
- Speculative markets allow individuals to hedge against unwelcome risks. The economic principle of risk aversion, which derives from diminishing marginal utility, implies that individuals will not accept risky situations with zero expected value. Risk aversion implies that people will buy insurance to reduce the potentially disastrous declines in utility from fire, death, or other calamities.
- Insurance and risk spreading tend to stabilize consumption in different states of nature. Insurance takes large individual risks and spreads them so broadly that they become acceptable to a large number of individuals. Insurance is beneficial because, by helping to equalize consumption across different uncertain states, it raises the expected level of utility.
- The conditions necessary for the operation of efficient insurance markets are stringent: there must be large numbers of independent events and little chance of moral hazard or adverse selection. When market failures such as adverse selection arise, prices may be distorted or markets may simply not exist.
- If private insurance markets fail, the government may step in to provide social insurance. Social insurance is provided by governments when private insurance markets cannot function effectively and society believes that individuals should have a social safety net for major risks such as unemployment, illness, and low incomes. Even in the most laissez-faire of advanced market economies today, governments insure against unemployment and health risks in old age.
- Health care is the largest social insurance program. The health-care market is characterized by multiple market failures that lead governments to intervene. Healthcare systems have major externalities. Additionally, the asymmetric information between doctors and patients leads to uncertainties about the appropriate treatment and level of care, and the asymmetry between patients and insurance companies leads to adverse selection in the purchase of insurance. Finally, because health care is so important to human welfare and to labor productivity, most governments strive to provide a minimum standard of health care to the population.
- When the government subsidizes health care and attempts to provide universal coverage, there will be excess demand for medical services. One of the challenges is to develop efficient and equitable mechanisms of nonprice rationing.
- Schumpeter emphasized the importance of the innovator, who introduces "new combinations" in the form of new products and new methods of organization and is rewarded by temporary entrepreneurial profits.
- Today, the economics of information emphasizes the difficulties involved in the efficient production and distribution of new and improved knowledge. Information is different from ordinary goods because it is expensive to produce but cheap to reproduce. The inability of firms to capture the full monetary value of their inventions is called inappropriability. To increase appropriability, governments create intellectual property rights governing patents, copyrights, trade secrets, and electronic media. The growth of electronic information systems like the Internet has increased the dilemma of how to efficiently price information services.