1 Risk Decision Making Under Uncertainty – Class 13

2 Risk Is the potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable outcome). The notion implies that a choice having an influence on the outcome exists (or existed). Potential losses themselves may also be called "risks". Almost any human endeavor carries some risk, but some are much more risky than others.

3 Risk: Normative Theory Reduction of risk usually has a cost The marginal utility of money spent on risk reduction is declining. The cost of reducing each percent of risk goes up, the benefit ( excepted utility terms) of a 1% reduction is the same.  1% - 0% or 20% - 19%. If the benefit is the same for each percent change in risk but the marginal utility is declining it follows that an Optimal amount of risk reduction.  Cost of reducing the next 1% is greater than the reduction in the expected disutility.  There is an optimal amount of risk Risk reduction can be measured as a decrease in the probability of some bad event happening to a single person in a year. Risk drives us to make decisions regarding the allocation of resouces.

4 Public Control of Risk Public mechanisms for risk control: Direct expenditure of public funds  Public safety Regulation  Places cost of risk reduction on those who engage in risky activity. Provision of information  Provide information on activities that have higher levels of risk. Tort System (Lawsuits)  Negligence  Who is responsible  Compensation

5 Risk Regulations Why do some agencies or governments spend more money in one area but not another? Psychometric Approach: Focus on the characteristics of the risk and their acceptability  Unknown, new, involuntary and delayed Food coloring, food preservation, pesticides, spray cans (high reg) Hunting, motorcycles, fire fighting, mountain climbing  Severity of consequences, dread and catastrophic Aviation, nuclear power (high) Lawn mowers, appliances

6 Risk Regulations: con’t Voluntary vs Involuntary Spend more money on involuntary risks  Cars vs motorcycles vs airplanes  Obesity vs smoking vs drinking Known vs Unknown GMO grains, medicines How much uncertainty is acceptable? Catastrophic vs Individual Decisions that may result in catastrophic lose is perceived to require more regulation that one which has equivalent individual lose.

7 Risk: Proportions vs Differences Changes in risk Concern more about the proportion of risk reduced than the difference in the number of people involved.  Utilitarianism implies the number is more important  Each person is independent  Expected utility theory says number is best Number translates into probability Risk vs Relative Risk Which is most relevant for decision making? Studies show relative risk was more influential in people’s willingness to pay for safety

8 Zero Risk Is this plausible? Does it have the utility that we perceive? How much are you willing to pay in terms of resources to achieve.

9 Risk: Natural vs Artificial Is there a bias towards risk caused by artificial means? If so then why? Are we willing to pay more to reduce risks caused by humans? Omission versus Commission

10 Risk: Insurance and Protective Behavior Insurance is justified in terms of declining marginal utility of wealth.  Or increasing marginal disutility of loses Do not buy insurance for small losses  Utility of money is linear for small losses More willing to buy insurance from a human source than a natural source. Rebate versus lower premiums Willingness to pay for insurance depends on the vividness of the imaged event.

11 Investors and Entrepreneurs Risk Tolerance Investment Manager Risk aspect of risk

12 Individual and Sex differences Is there a difference between the way men and women address risk? Is there a difference between how different ethnics or cultures perceive risk?