# The Economics of Uncertainty

## 8/5/2021

The Economics of Uncertainty is one of the Great Courses from the company of the same name. The course is from 2015, though I just listened to it since courses to be listened to or watched are just as piled up as books to be read. Several of the Great Courses have prompted musings over the years. This course mentions several useful concepts that I don’t recall from earlier exposures to Economics. I won’t try to summarize the course—I will just very briefly mention a few concepts that might be worth exploring in more detail. The course deals with uncertainty in many everyday areas, not just during “interesting times”.

Black Swan Events are too improbable for us to include in our plans, but they can and do still happen, so me must cope with them when they occur.

Turning Uncertainty into Risk involves assigning probabilities to make risk modeling and evaluation possible. A Utility Function is the part of an economic model relating people’s actions and experiences to happiness. Declining Marginal Utility describes how utility (happiness) from an increasing good tapers off as you get more of the good.

Probabilities are a critical part of dealing with uncertainty. There are two main types of probabilities: frequentist and subjective. Frequentist probability is simply the relative frequency for an event to occur, and can have issues with accuracy, relevance, and credibility. Subjective probability is probability as a degree of belief.

The System 1 / System 2 model of the brain helps explain why we often misjudge likelihood and risk. Fast System 1 responses are less able to get correct probabilities than slower, more energy-intensive, System 2 evaluations. System 1 responses are often based on biases and shortcuts, and are especially bad with rare events. Because the brain tends to try to expend as little energy as possible, the more careful System 2 evaluation can be skipped if we aren’t paying close attention.

Adverse Selection is a problem that can arise from asymmetric (hidden) information, when some participants in an interaction have information that others don’t (such as knowing if a used car is a lemon). The knowledge gap can lead to less desirable products dominating a market. Bringing in experts is one way to try to solve this. Guarantees are another way.

Moral Hazard Problems can arise from hidden actions (usually actions that violate a declared intention, like violating rental-car insurance limits or using a loan for something other than what you said it was for). Monitoring and creating better incentives are ways to try to prevent these problems.

Principal-Agent Problems are a subset of Moral Hazard Problems that involve a principal (a person with a goal) hiring an agent (a person to enable a principal to reach a goal). Agents can take advantage of information hidden from principals. Monitoring and incentives are again ways to try to prevent these problems.

Finding the best way to structure compensation (pay for work) is an area with a lot of uncertainty. Options include piecework, milestone payments, commissions, salaries, promotions, bonuses, stock options, and restricted shares.

Economics models altruism (caring for others’ well-being) in terms of risk sharing. Altruism comes into Utility Functions when the model includes how the happiness of other people can contribute to your happiness.

More than one lecture touches on the difficulties of getting valid numbers for many economic issues. A point that caught my attention was that people trying to control inflation aim for a small positive rate rather than aiming for zero so that the actual rate will still be positive even after you allow for the uncertainty of the data.

A Regulatory Cycle was discussed, circling from a crisis, to a government response, to private-sector innovation, to a new crisis. My immediate responding thought was that saying “innovation” was not the right wording—that the private-sector response to new regulations that can lead to a new crisis is exploitation of loopholes, not innovation.

Other topics the course covers include:

Using Models

Diversification

Risk Sharing

Risk Avoidance

Absorption of Risk

Decision Science Tools

Gambling Economics

Game Theory

Insurance

Uncertainty in the Numbers