The Economics of Uncertainty

Professor Fullenkamp begins with black swan events; occurrences that are considered as improbable as black swans; a notable recent example is the 2008 financial crisis.; examining the nature of uncertainty and the best strategy for dealing with it.

Turning an uncertain situation into a risky situation; risk is probability and knowledge is power; this may sound counterintuitive, but is a surprisingly effective approach, pioneered by economist Frank Knight; where it applies in economic settings.

In dealing with uncertainty, it makes sense to have an arsenal of different strategies; five techniques for risk management that can be used in every sphere of life; producing information, diversifying, sharing risk, avoiding risk and absorbing risk.

Examining two different types of probability; frequency-based probabilities rely on many examples of a phenomenon; subjective probabilities call on personal experience and judgment; thinking critically about these two approaches and using them.

Handling uncertainty by studying two ways that people reach decisions; system 1 excels at making snap judgments; system 2 is analytical and more time-consuming; the strengths and weaknesses of each; the problem of estimating probabilities.

Converting uncertainty to risk; probing how probabilities can gauge rewards and risks; testing risk-assessing tools used in finance, including expected value, variance, standard deviation, coefficient of variation, Sharpe ratio, covariance and beta.

Knowing when a risky project is worth doing; how corporate managers decide whether they should undertake a new enterprise; simple graphic aids, such as scenario analysis and decision trees, are tools for weighing risk in both business and daily life.

Gambling gives valuable insight into any type of risk-taking activity; investing and entrepreneurship; the role of games of skill and chance in the economy; applying their lessons to activities such as banking and retirement planning.

Using game theory to shed light on strategic interactions; competitive transactions involving people or organizations; negotiating the sale of a house; pricing products for maximum sales; an intriguing competition between two potato chip brands.

Adverse selection occurs when the lack of information by one party leads to a distorted result; how this situation surfaces in many different contexts; used car sales, investment deals and Internet purchases; recognizing the adverse selection trap.

Another outcome of asymmetric information is the moral hazard problem; this peril rises spectacularly in the 2008 financial crisis; the widespread sale of bad loans to unwitting investors; it also lurks in many small-scale transactions; fighting it.

A case of moral hazard; the principal-agent problem; an agent is appointed to handle a matter beyond the expertise of the person doing the hiring; the agent may take unfair advantage of this situation; from home repair to government contracting.

The uncertain realm of compensation contracts, which ideally motivate employees to do a good job; often they have unintended consequences; the pluses and minuses of efficiency wages, milestone payments, promotions, stock options and other incentives.

Altruism is more complicated than simple selflessness; discovering the power of viewing altruism as economists do; as a mathematical expression called the utility function; studying altruism's connection to the moral hazard problem.

The ways one can insure against misfortune, from extended warranties to travel insurance to identity-theft protection; health, car, home and life insurance; how insurance products work; getting tips on what one should cover and at what value.

Statistics are tools for dealing with uncertainty, but they should be used with caution; putting unemployment rate and consumer price index into context; probing how such statistics are measured; what the sampling error and confidence interval say.

Nothing is as certain and yet so unpredictable as the business cycle; economic expansion is invariably followed by a recession and vice versa; studying different theories of the business cycle; knowing how to prepare for the next boom or bust.

Even in times of low inflation, no one knows when prices will take off again; the causes of inflation and efforts to control it; the surprising wisdom of promoting a small degree of inflation; the disaster of deflation, a generalized drop in prices.

Some market somewhere is making headlines because it is either hitting record highs or crashing down to earth; how to approach the uncertainty of financial markets with savvy and common sense; strategies that can help one reach their financial goals.

Government policies are a major source of uncertainty; the outcomes from several government interventions in the U.S. economy; looking at the regulatory cycle model, which shows how a complex system responds to new regulations.

Free trade produces uncertainty in economic players; how comparative advantage governs who benefits in the competition for international trade; tips for how individuals can cultivate their own comparative advantage in the labor market.

Looking at possible catastrophes that are decades away, such as overpopulation, scarcity of raw materials and environmental degradation; seeing that society has so far escaped the worst predictions of experts; why that is; what the future may hold.

Examining tools that professionals use to hedge against financial risk; studying the suitability of these instruments for individuals; probing real options, which are opportunities that can be seized or declined as conditions warrant.

Learning how to take the economic "stress test", inspired by bank evaluations made in the wake of the 2008 financial crisis; this helps to anticipate the most significant reversals and approach uncertainty with confidence and calm.