The Economics Metaphor: 19-Risk and Uncertainty

Risk and Uncertainty

This chapter is based on this Excel workbook, which has nine spreadsheets. While much of this follows the standard approach on this topic, the first two worksheets are preliminary material, about diversification, when that is beneficial and when it isn't owing to riskiness of the underlying assets and to systematic risk. The third worksheet covers the St. Petersburg Paradox and shows that an expected utility like assumption that embeds a notion of risk aversion resolves the paradox. There are also some notes on the math and philosophy of probability embedded as a word document. Those notes are also available as a separate pdf file. Students will most likely be familiar with the beginning of the notes, but the stuff near the end on Jensen's inequality and degrees of risk aversion are likely to be new.

There is then a worksheet on the Expected Utility Hypothesis, another that offers a critique a la Kahneman and Tversky, then a two-state version of the state-preference model so we can draw indifference curves, a subsequent worksheet on the demand for insurance, and the two concluding worksheets, one on moral hazard, the other on adverse selection and the lemons problem. Several of the worksheets have textual narrative to amplify what is explored in the graphs.

Portfolios and Diversification.

This initial video gives a counter intuitive example where putting all one's eggs in one basket is less risky than diversification because the underlying asset is safer and there is systematic risk. The example is meant to encourage students to consider when diversification is effective at reducing risk.