Risk and Uncertainty

The future brings surprises. A rainstorm can change the price of wheat. A fire can destroy your house. The invention of the automobile can make you rich if you own rubber plantations or wipe you out if you manufacture buggy whips.Your wealth tomorrow depends on the state of the world. Examples of alternative states of the world are “rain” versus “sunshine,” “fire” versus “no fire,” and “cars invented” versus “cars not invented”.Markets abound for transferring wealth from one state of the world to another. By placing a bet that it will rain, you increase your wealth in the rainy state of the world while decreasing your wealth in the sunny state. (Of course, you will occupy only one of these states, but at the time you place the bet you don’t know which it will be.) Purchasing fire insurance is a mechanism for increasing your wealth in the “fire” state at the expense of decreasing your wealth (by the amount ofthe insurance premium) in the “no fire”state. Organized markets in stocks and commodities afford numerous opportunities for transferring wealth between states of the world.In this chapter, we will begin by studying the individual’s choice about how much wealth to transfer from one state of the world to another and the determination of the equilibrium price at which she can do so. We will then examine some of the particular markets in which such transactions take place.