Risk & Uncertainty - Microeconomics 3rd Year Essay

Risk & Uncertainty - Microeconomics 3rd Year - Essay ExampleThe expected return function has some very convenient properties of analysing choice under uncertainty. Since to subvent or not to insure is a choice we can apply it to an policy problem. Indifference curves is used to measure utility or level of satisfaction as will be seen later.An individuals certainty equivalent (CE) of a lottery is the amount of money that the individual is willing to pay to avoid the risk of the lottery i.e. to extend the expected value (EV) instead of the lottery. For a risk averse individual CE 0 for altogether lottery.In the real world insurance is not actuarially fair. In the previous example it was assumed that the insurance did not charge anything to cover operating expenses or to allow for profit. In the cases that follow a dispatch factor is added to cover operating expenses and thus makes insurance actuarially unfair. This implies that EV of the insurance benefit.The options available to the individual is a lower job with slope = p1/p2. At the initial point E is larger and therefore the line is lower. An sluggishness curve through the original point yields the diagram to a higher place (right).In diagram above (right) E (fixed loading) is larger this implies x = 0 with fixed loading and the optimal choice is no insurance in this case as the indifference curve lies above the actuarial line which is suggestive that it does will the level of utility required by the individual.It is optimal for the consumer to choose F where w (1 + m)px = w L + x px mpx which implies x = 1 (representative of full insurance). A fair line F implies that an indifference curve is tangent to the line at F. see diagram (left)