The Concept of Risk and Uncertainty

Risk and uncertainty are foundational concepts in decision-making, particularly in fields such
as economics, finance, and behavioral sciences. Though often used interchangeably in casual
conversation, they represent distinctly different situations, especially in terms of
predictability and measurability.
Risk
Risk refers to situations where the outcomes of a decision are uncertain, but the probabilities
of each possible outcome are known or can be reliably estimated.
Examples:
 Tossing a coin: The outcome is uncertain, but the probability of heads or tails is
known (50-50).
 Financial investments: The probability of returns or losses can often be estimated
using historical market data.
Key Characteristics of Risk:
 Quantifiability: Probabilities can be assigned to different outcomes.
 Predictability: All possible outcomes are known.
 Variability: The more the outcomes differ, the greater the risk. For instance, investing
in high-volatility stocks carries more risk than investing in stable government bonds.
Uncertainty
Uncertainty occurs when outcomes are unknown and their probabilities cannot be
estimated, often due to a lack of information or extreme variability.
Examples:
 Oil exploration in an unproven field: There is no reliable way to estimate the
probability of success or expected yield.
 New technologies or market disruptions: Future outcomes may be entirely novel or
unpredictable.
Key Characteristics of Uncertainty:
 Non-quantifiability: Probabilities of outcomes are unknown or unknowable.
 Unpredictability: Some outcomes may not even be foreseen.
 Subjective Judgment: Decisions must rely on intuition, experience, or scenario
planning rather than probability-based models.
St. Petersburg Paradox
 The St. Petersburg paradox shows that even when a game is mathematically fair or
has a high expected monetary value (EMV), most people still refuse to play it.
 This seems strange — and that’s the paradox
Example of a Fair Game
Suppose you're offered a bet:
 If you win, you get ₹1000 more.
 If you lose, you lose ₹1000.
 Your current wealth = ₹3000
Let’s calculate both scenarios:
 If you win:
₹3000 + ₹1000 = ₹4000
 If you lose:
₹3000 - ₹1000 = ₹2000
Now, let’s calculate the Expected Monetary Value (EMV):
EMV = 0.5 \times (4000) + 0.5 \times (2000) = 2000 + 1000 = ₹3000 ]

➡️ So, EMV = ₹3000, which is equal to your current wealth.

That means — mathematically, it’s a fair game.
But Why Do People Refuse
Even though the money works out, people don’t feel that way because:
 The pain of losing ₹1000 is felt more deeply than
 The pleasure of gaining ₹1000
This is where Bernoulli’s Hypothesis comes in — it explains that we care about utility
(satisfaction), not just money.
Bernoulli's Hypothesis, part of his groundbreaking work on expected utility theory, suggests
that individuals make decisions based on maximizing their expected utility, not just the
expected monetary value. This is central to understanding how people handle risk and
uncertainty in economic decision-making.
1. Expected Utility vs. Monetary Value: Bernoulli argued that people value outcomes
based on their expected utility, not simply their monetary worth. This was a
significant departure from earlier views that assumed individuals always seek to
maximize wealth.
2. Diminishing Marginal Utility of Money: Bernoulli's theory introduces the idea that
the more wealth a person has, the less additional utility they get from gaining an extra
unit of wealth. This is why individuals behave differently when they stand to gain a
small amount of money compared to a large amount, with diminishing marginal
returns.
In Figure 17.2, it can be seen that although the monetary loss is smaller, the loss in total
utility is larger than the gain in total utility, despite a higher potential increase in money if the
individual wins the bet. This happens because the marginal utility of money decreases rapidly
as the individual's money increases.
Figure 17.1 shows Bernoulli’s hypothesis: the unwillingness to participate in a 'fair game' is
higher when the marginal utility of money declines rapidly.
It's important to note that in this discussion, it is assumed that the individual does not derive
pleasure from gambling for its own sake. This means the individual behaves rationally,
making decisions based on expected gains and losses in utility from winning or losing money
in gambling.

Individual behavior towards risk

Risk-Averse
A person is said to be risk-averse if they prefer a certain income over a risky income with the
same expected value. In other words, a risk-averse individual avoids taking risks and chooses
safety even when a gamble offers equal or slightly higher expected returns.
In the case of a risk-averse individual, the marginal utility of income decreases as their
income increases. This is shown by a concave utility curve, such as the curve OU in Fig.
17.2. The concavity reflects diminishing marginal utility—each additional rupee adds less to
overall satisfaction than the previous one.
Such individuals are willing to pay a risk premium to avoid uncertainty. For example, when
given the choice between a guaranteed ₹20,000 or a 50% chance of earning ₹10,000 or
₹30,000 (expected value ₹20,000), the risk-averse person chooses the certain income because
the utility of the certain ₹20,000 is higher than the expected utility of the risky outcome.
Risk-Lover
On the other hand, a person is a risk-preferrer or risk-loving if they prefer a risky outcome
with the same expected income as a certain income. These individuals derive excitement or
pleasure from uncertainty and are motivated by the possibility of higher gains.
In the case of a risk-loving individual, the marginal utility of income increases as their
money income increases. This is shown by a convex utility function, such as curve OU in
Fig. 17.4. The curve becomes steeper, indicating that each additional rupee provides more
utility than the previous one.
Such individuals are more likely to take chances—for instance, preferring a 50% chance of
earning ₹10,000 or ₹30,000 over a sure ₹20,000, even though the expected income is the
same. The expected utility of the risky gamble is higher for them due to their increasing
marginal utility of income.

Risk-Neutral
A person is said to be risk-neutral when they are indifferent between a certain income and a
risky income with the same expected value. They base decisions purely on expected income
and do not consider the risk involved.
In the case of a risk-neutral individual, the marginal utility of income remains constant as
income increases. This is shown by a straight-line utility curve from the origin. The utility
increases proportionally with income.
Such individuals will treat a certain ₹20,000 and a gamble with a 50% chance of earning
₹10,000 or ₹30,000 (also expected ₹20,000) as equally desirable, since both offer the same
expected utility.

Risk Aversion and Insurance

Our previous discussion explains why most people choose to buy insurance when faced with
risky and uncertain situations. Since most individuals are risk-averse, they prefer to avoid
risk, even if it means giving up a portion of their expected income. Insurance provides that
security by offering a guaranteed outcome in place of a risky one..
Example: House Income and Fire Risk
Suppose a person owns a house that gives him an income of ₹30,000 per month. However,
there's a 50% chance that the house might catch fire. If that happens, the income drops to
₹10,000 per month due to damage.
So, we calculate the expected income in this uncertain situation as:
E(X)=(0.5×₹30,000)+(0.5×₹10,000)= ₹15,000+₹5,000=₹20,000
This expected income of ₹20,000 is a weighted average of the two possible incomes, based
on their probabilities.
But remember—expected income is not the actual income. The person will either get
₹30,000 or ₹10,000, not ₹20,000. However, in decision-making, people often compare the
utility (satisfaction) from these possibilities.
Utility and Risk Premium
Now, let’s consider the person’s utility function—a curve showing how satisfied they are
with different levels of income.
 At ₹30,000, utility = 75
 At ₹10,000, utility = 45
So, the expected utility is:
E(U)=(0.5×75)+(0.5×45)=37.5+22.5=60
In the utility diagram (Fig. 17.7), a straight line AB connects the points for utility levels of
₹30,000 and ₹10,000. Point D on line AB shows the expected utility of 60. However, when
we look at the actual utility curve OU, we find that a certain income of ₹16,000 also gives
utility of 60.
Understanding the Risk Premium
This means:
 The person is indifferent between taking a risky expected income of ₹20,000 or a
certain income of ₹16,000.
 They are willing to give up ₹4,000 (20,000 - 16,000) to avoid the risk.
This ₹4,000 is called the Risk Premium — the maximum amount a risk-averse person is
willing to pay to eliminate the uncertainty.
Why Do People Buy Insurance?
This analysis clearly explains why people:
 Buy fire insurance for their homes
 Get health insurance for medical emergencies
 Even purchase life insurance for future financial security
They are willing to pay a premium (like the ₹4,000 risk premium in our example) to avoid the
possibility of a large financial loss. In return, they get peace of mind and certainty, which
brings higher utility even if their expected income is technically lower.
Asymmetric Information Economics
Asymmetric information" is a term that refers to when one party in a transaction is in
possession of more information than the other. In certain transactions, sellers can take
advantage of buyers because asymmetric information exists whereby the seller has more
knowledge of the good being sold than the buyer. The reverse can also be true.
Asymmetric information in economics is an information aspect that arises when one party to
an economic transaction possesses greater or better information compared to the other party.
In this way, it leads to inefficiencies in the market, hence suboptimal outcomes for the
participants' behavior in different markets.
Market failure results from asymmetric information in the sense of inefficient allocation of
resources, and these would mean higher prices, reduced market participation, or in worst
cases, a complete breakdown. It is these dynamics that economists explore in their quest to
design improved market mechanisms, regulations, and policies that can reduce information
asymmetries and enhance market outcomes. Since many economic interactions are based on
asymmetric information, this influences the way choices are mentally made and efficiency
markets. It is of paramount importance and very weighty to solve these informational
imbalances for the markets to be fair enough to work properly.
Advantages and Disadvantages of Asymmetric Information
Advantages:
Asymmetric information isn't necessarily a bad thing. In fact, growing asymmetrical
information is the desired outcome of a healthy market economy. As workers strive to
become increasingly specialized in their chosen fields, they become more productive, and can
consequently provide greater value to workers in other fields.
For example, a stockbroker's knowledge is more valuable to a non- investment professional,
such as a farmer, who may be interested in confidently trading stocks to prepare for
retirement. On the flip side, the stockbroker does not need to know how to grow crops or tend
to livestock to feed themselves, but rather can purchase the items from a grocery store that
are provided by the farmer.
In each of their respective trades, both the farmer and the stockbroker hold superior
knowledge over the other, but both benefit from the trade and the division of labor.
One alternative to ever-expanding asymmetric information is for workers to study all fields,
rather than specialize in fields where they can provide the most value.
However, this is an impractical solution, with high opportunity costs and potentially lower
aggregate outputs, which would lower standards of living.
Disadvantages:
In some circumstances, asymmetric information may have near fraudulent consequences,
such as adverse selection, which describes a phenomenon where an insurance company
encounters the probability of extreme loss due to a risk that was not divulged at the time of a
policy's sale.
In certain asymmetric information models, one party can retaliate for contract breaches, while
the other party cannot.
For example, if the insured hides the fact that they're a heavy smoker and frequently engage
in dangerous recreational activities, this asymmetrical flow of information constitutes adverse
selection and could raise insurance premiums for all customers, forcing the healthy to
withdraw. The solution is for life insurance providers to perform thorough actuarial work and
conduct detailed health screenings, and then charge different premiums to customers based on
their honestly disclosed risk profiles.
Difference between Adverse Selection and Moral Hazard
The terms adverse selection and moral hazard are both used in risk management, economics
and insurance. Both terms describe situations between parties where one person gains a
competitive advantage over the other, leading to the exploitation of the other. Knowing the
differences between adverse selection and moral hazard ensures that all parties reach an
efficient outcome and helps avoid parties being exploited.
Adverse Selection:
Adverse selection takes place occurs when one entity or person, (more often the seller) has
differing or more accurate information about a deal than the other person, (more often the
buyer) before reaching an agreement.
Such a situation favours the party that has more info while the other person is forced to enter
into an unfavourable deal. And in most cases, it is difficult for the party who does not have
sufficient info to access the risk or value out of the deal. And since the more knowledgeable
entity or person has all the information, they can easily evaluate the situation and access how
they will benefit from it.
Adverse selection is one of the main causes of low-quality goods and services and inefficient
outcomes.
• Example of adverse selection
If you have ever bought a used car, you know how much information you need to ensure you
do not get short-changed. The car seller has more knowledge about the car than a buyer. For
instance, if a car has ever been involved in an accident or some parts are faulty, the seller may
not always disclose this to the buyer. In most instances, the buyer cannot distinguish between
high quality and low-quality car. This results in the buyer purchasing the low-quality car at
the price of a high- quality car. The seller benefits since they have more info about the vehicle
while the buyer gets short changed.
Another example of adverse selection is the purchase of health insurance. While a person is
well aware of the health issues that they face, the insurance company is not. As such, the
insurer is at more risk of an unfavourable outcome.
Moral Hazard:
This is a situation where one entity or person entering into a deal provides misleading
information that affects the entire agreement once the agreement has been made. It can also
occur when one person (more often the buyer) changes their behaviour once the parties enter
into an agreement since they believe they will not face consequences for their actions. Moral
hazards put the sellers in unfavourable situations since they are forced to deal with the
unfavourable outcomes.
• Example of Moral Hazard
The insurance industry is often marred with moral hazards. For instance, homeowners who
have not purchased flood insurance and live in flood-prone areas are very careful during the
storm seasons. Most will move furniture, install drainage pumps and invest in a good
drainage system.
However, once they purchase flood insurance, they are less careful with measures to mitigate
the risks. This results in a greater risk for claims to the insurance company.
Similarities between Adverse selection and Moral hazard
• Both refer to situations where one entity or person has an advantage over the other
Differences between Adverse selection and Moral hazard

What is an example of a moral hazard?

Homeowners who have not purchased flood insurance and live in flood-prone areas are very
careful during the storm seasons. Most will move furniture, install
drainage pumps and invest in a good drainage system. However, once they purchase flood
insurance, they are less careful with measures to mitigate the risks. This results in a greater
risk for claims to the insurance company.
Can adverse selection exist without moral hazard?
Yes, adverse selection can occur without moral hazard.
What is the meaning of adverse selection?
Adverse selection takes place when one person or entity, (more often the seller) has differing
or more accurate information about a deal than the other person, (more often the buyer)
before reaching an agreement.