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Unit-28: Economics of Risk and Uncertainty

To decide the size of risk, we increase our example and describe this in Fig. 28.3. Point A and C to be net Notes
by a line of the TU curve, which is linked with the income utility level of the 15,000 with 22 utility and
5,000, with 10 utility. In figure we can see that the expected utility with certainty on the point B is 8,500 at
TU curve. This amount is equal to amount of certainty in the game by the man. Averse but the preference
to the utility 16 will 10,000 certain income as is explained by the drawing a horizontal line to the point B
to D on the line AC. Similarly risk premium BD part in the figure is 1,500. The difference of income is on
the equal expected utility 16 on the 10,000 certain and 8,500 uncertain.

Measures to Reduce Risk
Apart from risk-lovable people, people do not want to take risk always when they face the risk. There
are various solutions which reduce the risk among people. The details are—

1. Insurance

People take insurance policy against various risks like death, injury, theft etc. and transfer their risk.
The insurance companies take the premium and on the basis of that premium they cover the risk and
compensate. The lesser risk taking people buy policies by paying premium to cover their risks.
Think about a man who takes decision to buy policy for loss of house if fire. If the cost of house is
20,00,000 and the probability to catch fire in a year is 400 (1/400). He has two options — First, if he
does not take policy and there is no fire then the cost of house remains 20,00,000 and in case of fire, it
is zero. Second, if he buys policy and pays 5,000 to insurance company as premium, then the cost of
his house after 8 years, if there is not fire, 20,00,000 – 5,000 = 19,95,000. If the house destructs from fire
then the insurance company will pay him 20,00,000 as cost of his house.

2. Diversification
Risk can be lowered by diversification. When a firm instead of concerntrating only on one type business
and starts running another type of business, then the risk gets lowered. The insurance companies are
profit maximization firms. So by just doing a type of insurance, they sell policy for home, health, car,
life etc. By diversification in various insurances, they expand their risks. Thus, an investment can lower
his risk by diversification in market. By adding various stocks to his portfolio, he can safe from expected
loss stocks.

3. Future Market

The people try to reduce their risks by future market. Generally, the future market is present in
agricultural products and stock etc. Suppose that farmer grows rice and he does not know that the price
of rise would increase or decrease later. He is indefinite about his future and income. So he needs the
policy for lower market price. To cover the risk of his future, he signs an agreement with a rice stockist
to come with a unique quantity of rice on a special date. If the price of an expected bag of rice is 300
and the expected high is 400 then the fair odds delivery price would be 350. To give the rice on this
price, the farmers reduces his risk without taking any risk in future.

Self Assessment

State whether the following statements are True/False:
8. Generally it is expected that the big risk covers big profit.
9. The player pays by tossing the coin in gambling.
10. A risk-loving man does not participate in game if he finds there is no possibility in his favour.

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