From risk to opportunity Lecture 1

1. From risk to opportunityLecture 1 John Hey and Carmen Pasca

2. Welcome • Welcome... • We are Carmen Pasca and John Hey. • We will be teaching this course every Friday for 12 weeks. • We were given the brief to provide an interdisciplinary course on risk, widely interpreted. • It will be interactive and we look forward to your input... • ...though there are lots of you. • We have built a website on which you can find material. • This is the url: http://www-users.york.ac.uk/~jdh1/sciences-po/ • We will seek your advice as to when to make material live... • ... we believe in incentives. • Comments to Carmen Pasca and/or John Hey are welcome.

3. Lecture 1 Introduction: Welcome • We are going to start this course by selling a risky(?) gamble to one of you. • This gamble pays €100 if this fair coin lands Heads (or Tails – the buyer of the gamble chooses). Pays nothing otherwise. This is real money. • First perhaps we should ask you what you understand by the expression “fair coin”? • A physical property of the coin? How tested? • Toss it a large number of times? How many is ‘large’? • The chance/probability of heads/tails is one-half? • Later we show you another way of implementing the gamble.

4. Lecture 1 Introduction: Rules • We will sell the gamble to one of you with an English auction. • Just to make sure that you all understand the auction we shall first do a practice auction. Then we do it for real. • I will count out prices starting at €1 and increasing in steps of €1 until someone buys it (when everyone else has dropped out). • You should put your hand up at any price you would be willing to pay and put it down when the price is too high for you. • The last of you with the hand up will be the buyer and will pay the price at which the penultimate person put his/her hand down. • The buyer will pay me that money and then he/she will toss the coin, having chosen which side he/she will win €100 with.

5. Lecture 1 Introduction: The Auction 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 These prices are in EUROS. I will show prices in sequence from 0 to 100 until there is only one person with his or her hand up. That person will be the buyer, will pay me the price at which the penultimate person dropped out; and will then toss the coin – being paid €100 or €0 depending upon how the coin lands. First we do a practice… …then the real thing. Note in the real thing it is real money. (For the future note where YOU drop out.)

6. Lecture 1 Introduction: Playing it out • OK – we have a winner of the auction… • …paying a price of €? • What side do you want to win on? • OK – toss the coin...

7. Lecture 1 Introduction: What do we infer? • What do we conclude? • First ask: what is the Expected Value of the gamble? • What does this mean? • If you dropped out at a price before this you are risk-averse. • If you dropped out at this price you are risk-neutral. • If you dropped out at a price after this you are risk-loving. Or mad? • We note that risk-attitudes vary across people.

8. Lecture 1 Introduction: Risk and ambiguity • Suppose instead of the coin we used thisBingo Blower. • In this there are 5 blue balls, 3 yellow and 2 pink. • The buyer chooses either blue or yellow and pink. • What is the chance/probability of winning/losing? • Or what if we used this Bingo Blower? • This is what is called by economists a situation of ambiguity – the probabilities exist but they are not known. • At what price would you drop out of this auction? • Is this price the same price at which you dropped out of the auction with the fair coin?

9. Lecture 1 Introduction: Overview of lecture • What we are going to do today. • Give a general introduction to what we might mean by risk. • Provide a general discussion of how people should/might/do react to whatever it is we mean by risk. • Discuss whether the ‘authorities’ should intervene in some way in situations of risk. • Give a general overview of the course. • Conclude with another ‘bet’.

10. Lecture 1 Introduction: what is Risk? • Rather trivially, risk is the absence of certainty about what will happen. • Different disciplines have different ways of characterising ‘risk’. • Economists like to simplify things – into • Risk – where there are known probabilities (whatever they are) of the various possibilities (subjective or objective); • Ambiguity – where the possibilities can be listed but probabilities can not be attached to them. • Economists do not like situations where the possibilities are themselves unknown, but other disciplines are less shy.

11. Lecture 1 Introduction: How should/do people react? • Many disciplines have theories about how people should/do behave under situations of risk. • Economists like to start with axioms, and if people agree with these axioms, then they should behave in accordance with the implied preference functional – for example, Expected Utility theory. • Are certain axioms/theories more rational? (Are risk-lovers mad?) • Other disciplines (particularly psychology and sociology) are more behavioural and try to describe how people do behave.

12. Lecture 1 Introduction: Regulation • Is there a need for government intervention/regulation? • If people have been ‘sold’ bad information? • If people do not know the ‘correct’ probabilities? • If people have the ‘wrong’ attitude to risk? • If people have a ‘wrong’ preference functional? • Do people need to be protected from themselves? • How can allegedly true probabilities be verified ex post?

13. Lecture 1 Introduction: Overview of lectures • An historical perspective • Different approaches to risk • Philosophical approaches to risk • Epistemological approaches to risk • Political approaches to risk • Sociological approaches to risk • Psychological approaches to risk • Economic approaches to risk • Expected Utility theory • Implications of Expected Utility • Market Implications and Overview

14. Looking forward to Lecture 2: Historical approaches • In this lecture we will discusses the historical evolution of the risk concept: from ancient civilizations, passing to the Middle-Age and Modern period and then to the contemporary period. • For the 20th century, first we expose the most famous definitions of risk and uncertainty, those elaborated by Knight and Keynes. • Second, we focus on the relationship between risk and globalisation, risk and science, risk and technologies, and innovations.

15. Looking forward to Lecture 3: Different approaches to risk • This lecture sets the scene for subsequent lectures by discussing the various different approaches to risk in the social and human sciences: philosophical, epistemological, political, sociological, ethical, psychological and economic; it also explores the relationships and connections between these different approaches. • In particular, this lecture focuses on how the issue of risk gave rise to important new problems for several disciplines.

16. Looking forward to Lecture 4: Philosophical approaches to risk • This lecture examines the work of the key philosophers during the modern and contemporary periods who wrote about risk: Pascal, Descartes, Rousseau, Rawls, Karl Popper and Richard Rorty. • Philosophical ideas include dealing with: cause and effect; uncertain knowledge; defining human values; measuring values; experts; the role of science in society; the role of judgment in human affairs.

17. Looking forward to Lecture 5: Epistemological approaches to risk • This lecture examines the transformation of risk into an abstract concept; this started in the eighteenth century, at the initiative of Buffon, Laplace and Condorcet; and continued into the twentieth century with Keynes, Savage and Allais. • The use of this term is based on a subtle combination of knowledge and uncertainty. • The epistemological understanding and definition of risk will be investigated from a multidisciplinary approach.

18. Looking forward to Lecture 6: Political approaches to risk • This lecture looks at the way political analysts portray risk as having a fundamental role in contemporary political society. • When viewing the policy and political process in political risk terms, we discover that there is a need to explore the various nuances and observations made about risk more generally. • The political concept of risk is related to the approach for understanding and appreciating politics and public policy making: risk and regulative politics.

19. Looking forward to Lecture 7: Sociological approaches to risk • This lecture covers the work of sociologists in the field of risk going from Max Weber’s Theory of Rationality to the Risk Society of Ulrich Beck, and explores the relationship between concepts of rationality used by sociologists and those used by economists. • The idea of “reflexive modernization,” on the other hand, is not just central to Beck’s theory of “Risk Society,” but is also a keystone to the thinking of a number of other European thinkers—Anthony Giddens, Scott Lash, M.Douglas, Niklas Luhmann.

20. Looking forward to Lecture 8: Psychological approaches to risk • Some of the psychological theories of decision under risk appear to have been introduced as a consequence of empirical dissatisfaction with Expected Utility theory (which we start by discussing briefly and then give more detail in Lecture 9). • Coombs developed an alternative he called portfolio theory(a terminological choice confusing to economists). • Kahneman and Tversky developed a critique of expected utility theory as a descriptive model of decision making under risk, and produced their own, which they call prospect theory. • This has since undergone several revisions. • We note that these psychological approaches are usually based on the process through which people take decisions.

21. Looking forward to Lecture 9: Economic approaches to risk • Economists, perhaps starting with von Morgenstern and Morgenstern and their followers, like to impose concepts of rationality on the analysis of behaviour under risk; and hence start with axioms of rational behaviour. • We note that this approach differs from psychological approaches – which are more concerned with the processes by which people take decisions. • The most famous economic theory is Expected Utility Theory. • [We examine experimental evidence casting doubt on Expected Utility theory. • We then go on to discuss new economic theories (based on less restrictive axioms) that have been proposed in the light of the experimental evidence – most notably Prospect Theory or Rank Dependent Expected Utility theory.] • We then show how Expected Utility theory can also cover situations of ambiguity – where probabilities are not known. • And in so doing, we show that if economic agents follow the reasonable axioms of SEUT, they act as if they attach probabilities to uncertain events.

22. Looking forward to Lecture 10: Expected Utility Theory • This is the most popular theory used in economics, though it does have its critics. • It says that individuals choose between risky gambles on the basis of the utility expected from them. • We state the underlying axioms of the theory. • Most crucial is Independence: if an individual prefers a to b then that individual prefers [getting a with probability p and some c with probability 1-p] to [getting b with probability p and the same c with probability 1-p]. • Then we look at the implications in static problems under risk. • We generalise briefly to dynamic problems and then to those under ambiguity (where probabilities do not exist). • We discuss the axioms underlying (S)EUT. • We discuss the implications. • We briefly mention the circumstances under which (S)EUT reduces to Mean/Variance theory (much used in Finance).

23. Looking forward to Lecture 11: Implications and Applications of EU • This lecture examines the way that EU has and can be used. • We show you how you can find your own (EU) utility function and hence understand how risk-averse you are. • We will look at two measures of risk aversion and loving: absolute and relative. • We look at two particular popular utility functions (CARA and CRRA) • Examples of the use of Expected Utility theory in economics: • The theory of the competitive firm facing price uncertainty. • The life-cycle savings problem under income risk.

24. Looking forward to Lecture 12: Market Implications and Overview • The first part of this lecture looks at implications of EU in a market context. • We discuss how insurance works. • We note that if people are insured then the probabilities of the risks may change (moral hazard). • We discuss the problems when the insurer is not sure about the probabilities (adverse selection). Regulation? • We also show how the exchange of risks is mutually beneficial even if everyone is risk-averse – exchange is an opportunity. • The final part of this lecture briefly summarises From Risk to Opportunity as a whole.

25. Lecture 1: A concluding bet • Let us conclude with a simple bet on the French stock index – CAC40. • You can either bet on it going up by 14.55 on Friday the 14th of September relative to its level at this moment, or it going down. • Write your name and your bet (Up or Down) on a bit of paper and give the bit of paper and €1 to us. • If n students bet, we will next week divide the €n we have collected collectively to the set of m students who bet on the right event (so each gets €n/m). • In the unlikely event that the index does not change, we shall refund all bets.

26. Lecture 1 • Goodbye!