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Economics for CED. Noémi Giszpenc Spring 2004 Lecture 5: Micro: Markets and Information Investment and Insurance March 30, 2004. What is investment?. Investment means to apply resources in ways that you hope will produce more resources later. “Wealth creation”

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Economics for ced l.jpg

Economics for CED

Noémi GiszpencSpring 2004Lecture 5: Micro: Markets and InformationInvestment and Insurance

March 30, 2004


What is investment l.jpg
What is investment?

  • Investment means to apply resources in ways that you hope will produce more resources later.

  • “Wealth creation”

  • Also necessary to shore up used-up resources--replacement & maintenance

    • Does not add to “net” investment

Economics for CED: Lecture 5, Noémi Giszpenc


How do firms decide to invest l.jpg
How do firms decide to invest?

  • Based on calculation: “By the book”--will expected returns exceed expected costs by an acceptable margin?

    • A great deal of uncertainty exists about the future: a lot of guesswork involved

  • Based on confidence: leap in the dark

    • Expectations about what other investors are doing

Economics for CED: Lecture 5, Noémi Giszpenc


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A detour into accounting

  • Basic accounting equation:Assets = Liabilities + Equity

  • Can be seen as a description of capital’s Uses and Sources

  • Different (combos of) uses bring different returns

  • Different sources have different costs

Economics for CED: Lecture 5, Noémi Giszpenc


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Structure of a balance sheet

Economics for CED: Lecture 5, Noémi Giszpenc


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Uses & sources: returns & costs

Annual costs/returns per $100

Cost of capital funds

Investment 1

Investment 2

Investment 3

Investment 4

Investment projects

0

$ Quantity of funds

Economics for CED: Lecture 5, Noémi Giszpenc


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4 sources of capital

  • Equity: creating & selling new shares

    • Pays dividends dependent on performance

    • “Dilutes” stock of existing shareholders

  • Retained earnings: “internal funds”

    • Cheapest & most common source

  • Bonds: promises to pay interest & principal

    • Buyers of bonds can trade these in markets

  • Bank debt: easier to obtain than bond-buyers

    • Must pay market rate of interest, meet conditions

Economics for CED: Lecture 5, Noémi Giszpenc


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Calculating return (5 ways)

  • Total return: good for one-off, immediate & definite return projects

    • Compare percent difference between returns and costs with market interest rate

  • Payback: useful for comparing similar investments with similar lifetimes

    • How long will it take for project to cover costs and start earning?

    • What will assets be worth and what will they earn after the payback period?

      • Ex: Farm, office building, bus

Economics for CED: Lecture 5, Noémi Giszpenc


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Calculating return: 5 ways (cont.)

  • Accounting rate of return

    • Good for productive investments with regular returns, analogous to interest rates

  • Discounted present value of cash flow

    • For investments with different patterns of earning over time

    • The amount of money that would need to be invested now, at compound interest at current or expected interest rates, to generate the future asset or income.

Economics for CED: Lecture 5, Noémi Giszpenc


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Calculating return: 5 ways (cont.)

  • Internal rate of return

    • The rate of compound interest that would yield the expected return to an investment

    • Discounts returns in the future because tied-up capital could be used & earning elsewhere

    • Can be used to compare alternative investments; compare expected returns w/market returns; estimate present value of future returns

Economics for CED: Lecture 5, Noémi Giszpenc


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Example: Bonds vs. Pine trees

Economics for CED: Lecture 5, Noémi Giszpenc


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Effects of different tax regimes

  • Net profit split between dividends to shareholders and retained earnings

    • Retained earnings lead to investment, growth in share value --> capital gains for shareholders

    • Different taxation of dividends & K gains: can encourage or discourage retention

      • Chosen policy depends on beliefs about how firms, investors choose to invest funds

Economics for CED: Lecture 5, Noémi Giszpenc


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Why does investment fluctuate?

  • Lumpy capital

    • Much productive building & equipment can be paid for over time but must be acquired all at once

  • Innovation

    • New product to be produced or new process

  • Expectations

    • Better to invest when strong demand expected

    • Firms tend to invest when others are investing

  • Acceleration and deceleration

    • Intensifies booms and slumps

Economics for CED: Lecture 5, Noémi Giszpenc


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Portfolios of investments

  • “hedge”: reduce overall risk by spreading investment over many independent projects

  • The word risk from sailors’ word for steep rock: merchants could lose all their investment in one cataclysm

    • So they invented insurance

Economics for CED: Lecture 5, Noémi Giszpenc


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What is insurance?

  • To make sure. To remove uncertainty and protect against risk.

  • People prefer certainty: they have an aversion to risk.

  • In particular people would not like to see income (or rather consumption) dip below a certain minimum.

    • Willing to pay to “smooth” consumption

Economics for CED: Lecture 5, Noémi Giszpenc


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Risk, uncertainty, and insurance

  • Economists use lotteries to think about uncertain situations:

    • Example 1: say you pay $10 to get:

      • 10% chance of winning $100

      • 90% chance of losing (winning 0)

    • Example 2: (real life uncertainty --- no charge)

      • 5% chance of losing $1,000 in a burglary

      • 95% chance of no burglary, so loss = 0

    • Example 3: Plaintiff is injured in an accident and files a lawsuit. She has a

      • 70% chance of winning damages of $10,000.

Economics for CED: Lecture 5, Noémi Giszpenc


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Expected Value

  • Example 1: EV = .10(100) + .90(0) = $10

    • Note: this lottery is “fair,” because the cost of the lottery ticket equals the EV of what the buyer will get.

  • Example 2: EV = .05(-1,000) + .95(0) = -$50.

  • Example 3: EV = .70(10,000) = $7,000

Economics for CED: Lecture 5, Noémi Giszpenc


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Attitudes toward risk

  • Risk neutral: a risk neutral person is indifferent about “fair” bets. She doesn’t care how much uncertainty she bears. So s/he gets equal utility from having $10 or having a 10% chance of receiving $100 and a 90% chance of receiving 0 (the winnings in example 1).

  • Risk averse: a risk averse person prefers certainty over “fair” bets. So s/he prefers to have $10 over having the lottery in example 1.

  • Risk loving: a risk loving person prefers “fair” bets over certainty. So s/he prefers having the lottery in example 1 to having $10.

Economics for CED: Lecture 5, Noémi Giszpenc


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Utility and Uncertainty: EU

  • Utility in each state is weighted by its probability of occurring; EU is weighted sum.

  • Example 2

    • Suppose the person’s initial wealth is W.

    • She faces two possible outcomes:

      • If the burglary occurs, her wealth falls from W to W-1000, and her utility is U(W-1000), which is lower than...

      • If no burglary occurs, and her utility is U(W).

    • Situation (1) occurs with probability .05 and (2) occurs with probability .95.

      • So her expected utility (the expected value of her U) is:EU = .05 U(W-1000) + .95 U(W)

Economics for CED: Lecture 5, Noémi Giszpenc


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Expected Wealth

  • Still Example 2:

    • The person’s expected wealth (or the expected value of her wealth) is:EW = .05(W-1000) + .95 (W) = W – 50

  • Risk neutral people act as though they are maximizing their expected wealth.

    • They are indifferent to more/less uncertainty and only care about the expected value of their wealth.

Economics for CED: Lecture 5, Noémi Giszpenc


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Relationship of wealth to utility

The slope is the additional utility that individuals receive from an extra dollar of (expected) wealth.

Economics for CED: Lecture 5, Noémi Giszpenc


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Relationship of wealth to utility

  • Utility from wealth leads to risk preferences

  • For risk neutral people, the slope is constant.

    • This means that they get the same increase in happiness/utility from an additional dollar, regardless of whether they are poor or rich.

  • For risk averse people, the slope declines as W rises.

    • Therefore they get a larger increase in happiness/utility from an additional dollar when they are poor than when they are rich.

    • Because of this, they don’t like uncertainty.

Economics for CED: Lecture 5, Noémi Giszpenc


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Relationship of wealth to utility: risk averse people

  • Suppose that instead of W, they have either W+100 or W-100, each with .5 probability.

  • The value of the extra $100 in additional utility is less than the cost in lost utility of losing $100.

  • So they gain less from having an additional $100 than they lose from having $100 fewer dollars.

  • Their utility level when they have W with certainty is U(W), and their expected utility level if they have W+100 or W-100, each with equal probability, is .5U(W+100) + .5U(W-100).

  • So U(W) > .5U(W+100) + .5U(W-100).

  • So if they face uncertainty, they will want insurance.

Economics for CED: Lecture 5, Noémi Giszpenc


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Relationship of wealth to utility

  • Risk loving people are the opposite of risk averse people.

    • They get a larger increase in happiness/utility from an additional dollar if they are rich than if they are poor.

    • As a result, they prefer having W+1 or W-1, each with the same probability, to always having W.

    • So U(W) < .5U(W+100) + .5U(W-100).

  • Most people are risk averse.

Economics for CED: Lecture 5, Noémi Giszpenc


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A role for insurance

  • Insurance helps reduce or eliminate uncertainty.

  • Example 2 with burglary insurance:

    • Suppose there are 20 people who face the same risk of losing $1000 with 5% probability.

    • They each put $50 into a cigar box, so $1000 is collected in total.

    • Over the next year, one of them has a burglary and the $1000 is paid to her.

    • So the insurance provides coverage of $1000 for losses in return for a premium of $50/year.

Economics for CED: Lecture 5, Noémi Giszpenc


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“Fair insurance”

  • “Fair insurance” if the insurance premium ($50) just equals the expected value of each insured person’s loss, which is ($1000)(.05) = $50.

    • So the insurance company makes zero profit.

  • With the insurance, the person no longer faces uncertainty. She has wealth of

    • W – 50 if no burglary occurs or

    • W- 50 –1000 + 1000 = W - 50 if a burglary occurs.

    • So her utility is U(W-50), regardless of whether a burglary occurs or not.

  • Suppose the fair insurance premium is called f.

Economics for CED: Lecture 5, Noémi Giszpenc


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Risk preferences and premiums

  • risk neutral: indifferent between certainty or uncertain situation with same expected wealth, as in the burglary example.

    • Indifferent to fair insurance against the risk: expected wealth EW is W-50, regardless

  • risk averse: prefer certainty over uncertain situation with same expected wealth.

    • Better off buying fair insurance.

    • Means that they would be willing to pay more than the fair insurance premium of $50 to get the insurance.

Economics for CED: Lecture 5, Noémi Giszpenc


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Risk preferences and premiums

  • risk loving: prefer uncertainty over facing an uncertain situation with same expected wealth.

    • If offered fair insurance, better off not buying it.

    • Means they would be willing to pay less than the fair insurance premium of $50 to get the insurance.

Economics for CED: Lecture 5, Noémi Giszpenc


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Risk aversion and willingness to pay

  • Assume U= √W

  • Risk from example 2: 5% chance of a burglary and loss of $1000.

  • If no insurance, then EU = .05 U(W-1000) + .95 U(W)

    • Initial wealth, W, is $2,000.

    • EU = .05*(√ 1000) + .95*(√ 2000) = 44.066 utils

  • Say person buys fair insurance for a premium of f = $50

    • then her wealth is always $1950 and her utility is:

    • U = √(1950) = 44.159 utils (higher)

Economics for CED: Lecture 5, Noémi Giszpenc


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Maximum premium

  • Utility if no insurance is U = 44.06.

  • The maximum insurance premium that she would be willing to pay would leave her with same utility as no insurance: 44.06 utils.

  • Suppose the max insurance premium is denoted m.

  • If she buys insurance for m, then she always will have wealth of 2000 – m and her utility will be U = √(2000 – m) with certainty.

  • So U = √(2000 – m) = 44.06 and m = $58.15.

    • This is more than the fair insurance premium of $50.

Economics for CED: Lecture 5, Noémi Giszpenc


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Conclusions on premiums

  • a risk averse person is better off if she can buy full insurance for a fair premium than if she goes uninsured.

  • a risk averse person is willing to pay more than the fair premium to obtain insurance, so m > f.

  • Note: People can be more/less risk averse. The closer their utility functions are to straight lines, the less risk averse they are and the closer m is to f.

Economics for CED: Lecture 5, Noémi Giszpenc


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Who buys insurance? Who sells?

  • Risk averse people: willing to buy insurance for more than the fair insurance premium.

    • So selling insurance is profitable. (Selling fair insurance means making zero profit.)

  • So risk neutrals sell insurance to risk averses.

    • Risk neutral people absorb risk

      • but are made better off: they receive premiums that are higher than the fair level.

    • Risk averse people pay more than the fair insurance premium

      • but are better off because they get rid of risk.

Economics for CED: Lecture 5, Noémi Giszpenc


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Problems w/ story’s assumptions

  • Many insurance buyers w/ identical risks.

    • In our example, all have a 5% chance/year of losing $1000 in a burglary.

    • The “law of large numbers” allows the insurance company to predict risks very accurately.

  • Insured persons’ risks of loss independent:

    • one person’s probability of a loss unaffected by whether another person has a burglary.

    • Examples of non-independent risks:

      • Burglars who steal from several apartments in a building. Hurricane or earthquake insurance.

      • These risks are positively correlated.

Economics for CED: Lecture 5, Noémi Giszpenc


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Problems w/assumptions (cont.)

  • No moral hazard.

    • Refers to increases in the probability of an event occurring if it is insured against.

    • Example of moral hazard: people with burglary insurance may become careless about locking their doors.

  • Or, if there is moral hazard, then insurance companies have perfect information.

    • Example: an insured person doesn’t lock his door. So his probability of loss rises from 5% to 20%.

    • The insurer observes this and raises the premium from $50 to $200.

Economics for CED: Lecture 5, Noémi Giszpenc


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Real world insurance

  • In actuality, the assumptions for fair insurance aren’t met.

    • So insurance companies use deductibles and co-insurance to reduce moral hazard.

      • Deductibles: if a loss occurs, the insured person pays the first $100.

      • Co-insurance: if a loss occurs, the insured person pays 10%.

    • Sometimes insurance isn’t available, particularly when risks are positively correlated.

      • Example is earthquake insurance, which is only available as a government program. Why?

Economics for CED: Lecture 5, Noémi Giszpenc


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Adverse selection

  • Imperfect information sometimes leads to good risks dropping their insurance coverage.

    • Example: there are healthy people with 1% chance of getting a disease and unhealthy people with 5% chance of getting the same disease.

    • People know their types, but insurance companies can’t observe individuals’ types.

    • So it charges all insureds the same premium of .03L, where L is the cost of treating the disease.

    • So the healthy subsidize the unhealthy and this causes some healthy people to drop the coverage.

Economics for CED: Lecture 5, Noémi Giszpenc


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Adverse selection (cont.)

  • The proportion of unhealthy people in the group of people buying insurance rises.

  • So the insurance company must raise the price of insurance in order to avoid losing money.

    • But the unhealthy people may not be willing to pay the high premium.

    • If so then the insurance disappears completely.

Economics for CED: Lecture 5, Noémi Giszpenc


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Breakdowns in the system

  • If buyer of insurance knows more than seller of insurance, there could be adverse selection or moral hazard

  • If buyer of labor knows less than sellers, could be group-based discrimination

    • Works the same way in deciding loans

  • Among results: redlining (not selling insurance or awarding loans in particular areas or for particular populations)

Economics for CED: Lecture 5, Noémi Giszpenc


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“Lemons” example: used car market

  • Two types of used cars: good cars and lemons

  • Sellers know if their used cars are lemons or not.

  • Value of a lemon is L, and value of a good used car is G: G > L.

  • Buyers can’t find out if individual used cars are lemons or not.

    • They only know the overall probability of used cars being lemons = p.

  • Buyers’ willingness-to-pay for used cars is the expected value of a used car:EV = pL + (1-p)G

Economics for CED: Lecture 5, Noémi Giszpenc


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“Lemons” example continued

  • Sellers’ incentives:

    • keep good cars because G > EV

    • sell lemons because L < EV.

  • Adverse selection makes good used cars disappear.

  • Buyers eventually learn this

    • so p rises and EV falls.

  • This makes sellers’ incentives to keep good cars even stronger.

  • The market for used cars turns into a market for lemons only.

Economics for CED: Lecture 5, Noémi Giszpenc


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Bankruptcy example

  • Suppose a person borrows an amount B and promises to repay B(1+r) next year.

  • Next year, with probability p she will lose her job. In this case, her income falls from Y to Y’.

  • Her expected utility without bankruptcy isEU = (1-p)U(Y-B(1+r)) + pU(Y’-B(1+r))

  • Introduce bankruptcy: If she files for bankruptcy her debt will be discharged.

    • No obligation to repay from future earnings.

  • Now her expected utility with bankruptcy isEU = (1-p)U(Y-B(1+r)) + pU(Y’)

Economics for CED: Lecture 5, Noémi Giszpenc


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Bankruptcy example continued

  • Bankruptcy makes borrower better off by partially insuring against job loss.

  • Bankruptcy may cause problems:

    • lenders raise the interest rate on loans, since borrowers who lose their jobs don’t repay. This makes those who repay their debts worse off.

      • Bankruptcy is estimated to cost the average debtor who repays $400/yr in extra interest payments.

    • borrowers may work less hard and become more likely to lose their jobs, since the bad outcome isn’t so bad (moral hazard).

  • What problems caused w/no bankruptcy laws?

Economics for CED: Lecture 5, Noémi Giszpenc


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Workarounds the breakdowns

  • Signaling (costly)

    • Pay to reveal your type or

    • Undertake activity that is less costly for your type of person

      • Examples: university degrees, “resume” paper

  • Social capital

    • Investments in reciprocal relationships

    • Form of insurance, loan guarantees

Economics for CED: Lecture 5, Noémi Giszpenc


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More workarounds

  • Conditionality

    • Often imposed by banks

    • (doesn’t change underlying motivations)

  • Loan sharks

    • Loan to populations thought to be bad risks and charge high premiums

    • Often use inside knowledge; sometimes threat of violence

Economics for CED: Lecture 5, Noémi Giszpenc


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