Risk and Economic Burden

Readers Question: how does risk create an economic burden?

Generally, people are risk averse.

For example, you may have a 0.1% chance of your house burning down. But, if it did burn down, the effects would be disastrous. Therefore, most people are willing to pay a premium to insure their house against this very unlikely scenario.

Therefore, there is a market for insurance. But insurance creates economic costs. For example insuring goods may cause moral hazard.

If I insure a bike for its full amount, I am likely to take less care about insuring the bike. This means the cost of insuring items goes up. (Insurance companies will try to avoid this by making people pay first £50. It means you can rarely insure against the full costs of something)

Why Do People Insure Some things and Gamble on Others?

People insure a house – showing risk aversion, but, gamble on other items showing in that case they can be a risk taker.

The reason is due to the diminishing marginal utility of money.

If you lose everything, e.g. your house burns down – you cannot live. If you have to spend £20 a month insuring your house, that £20 is not going to significantly reduce your living standards.

Also, if you lose £10 gambling on winning the lottery no harm.

Basically, people gamble a sum that they can afford to lose.

Other Areas of Risk in Economics

  • Currency Fluctuations – appreciating currency can reduce profitability of exports
  • Investment – encourages people to diversify
  • Lending – higher risk requires higher interest rates. In the current credit crunch no one wants to take the risk of lending to people. This is causing the recession we are now seeing. Confidence is very important for influencing investment e.t.c.