Frank Knight's Skeptical View of Economic Education

Much of what is fundamental in modern economic pedagogy and content is directly derived from Frank Knight, an ardent advocate of and contributor to economic education. Yet, as the author explains, he held strong reservations about the impact of education on strong and widely held views.     

Welfare economics,risk and uncertainty

Social decisions in risky contexts raise a number of difficult questions, such as: (1) Should social decisions be more or less risk averse than the average person? (2) Should we try to avoid large catastrophes more than frequent but limited harms with similar expected impact? (3) Should social decisions be ambiguity averse or stick to the expected utility canon? This paper reviews the welfare economics of risk and uncertainty and examines possible answers to these questions, based on the pros and cons of utilitarianism, ex ante egalitarianism and ex post egalitarianism.     

Time-varying uncertainty and variance risk premium

This paper extends the AK production model in Pindyck and Wang (2013) into a more general setting in which the volatility of capital stock is stochastic and driven by shocks. After solving the equilibrium, the fundamental shocks are embedded into the stock price and the leverage effect is contributed from three distinct channels. As an application, we employ our extended AK production model to match well the negative variance risk premium.     

Increasing risk and equilibrium under uncertainty

The impact of increasing risk on social welfare and resource allocation is analysed in a general equilibrium model with endowment uncertainty. It is shown that the equilibrium allocation of resources is affected only by an increase in those risks which are important for society as a whole. In contrast, increases in purely individual risk do not influence achievable social welfare and have no effect on the utility of traders in a competitive market.     

Information,endogenous uncertainty and risk aversion

The importance of incomplete information and risk aversion for the allocation of economic resources is shown to depend critically on whether uncertainty is exogenously imposed or endogenously related to the ability of the price system to aggregate and disseminate the information possessed by the agents in a decentralized market economy. The specific example analysed in this paper is a two-period exchange model with competitive markets and a homogeneous product.Comments and suggestions by anonymous referees, Jacques Drèze, Jan Rose Sørensen, and financial support from the Danish Social Science Research Council are gratefully acknowledged.     

Individual risk and Lebesgue extension without aggregate uncertainty

Many economic models include random shocks imposed on a large number (continuum) of economic agents with individual risk. In this context, an exact law of large numbers and its converse is presented in [Y.N. Sun, The exact law of large numbers via Fubini extension and characterization of insurable risks, J. Econ. Theory 126 (2006) 31-69] to characterize the cancellation of individual risk via aggregation. However, it is well known that the Lebesgue unit interval is not suitable for modeling a continuum of agents in the particular setting. The purpose of this paper is to show that an extension of the Lebesgue unit interval does work well as an agent space with various desirable properties associated with individual risk.     

Past experience of uncertainty affects risk aversion

In an experiment with more than 500 participants we study how past experience of uncertainty (imperfect knowledge of the state space) affects risk preferences. Participants in our experiment choose between a sure outcome and a lottery in 32 periods. All treatments are exactly identical in periods 17–32 but differ in periods 1–16. In the early periods of the risk treatment there is perfect information about the lottery; in the ambiguity Treatment participants perfectly know the outcome space but not the associated probabilities; in the unawareness treatment participants have imperfect knowledge about both outcomes and probabilities. We observe strong treatment effects on behavior in periods 17–32. In particular, participants who have been exposed to an environment with very imperfect knowledge of the state space subsequently choose lotteries with high (low) variance less (more) often compared to other participants. Estimating individual risk attitudes from choices in periods 17–32 we find that the distribution of risk attitude parameters across our treatments can be ranked in terms of first order stochastic dominance. Our results show how exposure to environments with different degrees of uncertainty can affect individuals’ subsequent risk-taking behavior.     

Political uncertainty,risk of Frexit and European sovereign spreads

Using data from a prediction market (crowd-based forecasts), we build a daily measure capturing the risk of Frexit related to the 2017 French presidential elections. We study how unexpected changes in this new measure of political uncertainty in France affect European sovereign spreads vis-à-vis Germany. We show that our uncertainty proxy drives not only the French sovereign spread but also the spreads of those EU countries deemed the most vulnerable to the risk of desegregation of the Euro Zone. These results suggest that specific political uncertainty affects short-term investor’s expectations and may outweigh other economic determinants of sovereign spreads shortly prior to high stake elections     

Attitudes to risk and attitudes to uncertainty: experimental evidence

In a series of experiments the interactions among individual attitudes towards risk and uncertainty, the sign of the outcome domain, and the way uncertainty is represented are tested. This is done in a unified framework, eliciting individual values by means of a second price auction. Results confirm the presence of the well-known fourfold pattern of risk attitude (risk aversion for gains and risk seeking for losses at high probability, and risk seeking for gains and risk aversion for losses at low probability) and show that this pattern can also be extended to uncertainty. In the valuation of losses the modal pattern is decreasing risk and uncertainty aversion as the probability of loss increases, while increasing risk and uncertainty aversion is observed for gains. Moreover, it is found that the size of reaction to uncertainty does not depend on the outcome domain, and that it persists in the face of an incentive-compatible mechanism to elicit preferences.     

Insolvency regimes and firms' default risk under economic uncertainty and shocks

One of the arguments often advanced for implementing a stronger insolvency and bankruptcy framework is that it enhances credit discipline among firms. Using a large cross-country firm-level dataset, we empirically test whether a stronger insolvency regime reduces firms' likelihood of defaulting on their debt. In particular, we examine whether it reduces default risk during increased economic uncertainty and various external shocks. Our results confirm that a stronger insolvency regime moderates the adverse effects of economic shocks on firms' default risk. The effects are more pronounced for firms in the top half of the size distribution. We also explore channels through which improved creditor rights influence firms' default risk, including dependence on external finance, corporate leverage, and managerial ethics. Our main results are robust to an alternative measure of default risk, inclusion of currency and sovereign debt crisis episodes, and alternative estimations.     

Why uncertainty matters: discounting under intertemporal risk aversion and ambiguity

Uncertainty has an almost negligible impact on project value in the standard economic model. I show that a comprehensive evaluation of uncertainty and uncertainty attitude changes this picture fundamentally. The illustration of this result relies on the discount rate, which is the crucial determinant in balancing immediate costs against future benefits, and the single most important determinant of optimal mitigation policies in the integrated assessment of climate change. First, the paper removes an implicit assumption of (intertemporal or intrinsic) risk neutrality from the standard economic model. Second, the paper introduces aversion to non-risk uncertainty (ambiguity). I show a close formal similarity between the model of intertemporal risk aversion, which is a reformulation of the widespread Epstein–Zin–Weil model, and a recent model of smooth ambiguity aversion. I merge the models, achieving a threefold disentanglement between risk aversion, ambiguity aversion, and the propensity to smooth consumption over time.     

Technological risk perception and nuclear power costs : The quantification of uncertainty

The cost of nuclear power has escalated significantly in recent years, confounding the optimistic projections of planners and contributing to a serious slowdown in the industry. In this paper we investigate the factors underlying nuclear cost escalation and specify a nonlinear regression technique that identifies costs caused by public and professional uncertainty about future technological performance as opposed to costs based on objective design and construction-related factors.Using multivariate analysis of variance we establish a positive relationship between costs related to uncertainty and such plant specific factors as size, age, and vintage (year of initial operation). Specifically, uncertainty and its associated costs are shown to be greater for larger plants with more advanced technology and to decrease as plants accumulate operating experience. This result suggests that the tendency in the industry toward rapid deployment of large plants with innovative technologies has had a deleterious impact on power generation costs.     

Bertrand vs. Cournot equilibrium with risk averse firms and cost uncertainty

Summary. In an oligopoly game with cost uncertainty and risk averse firms, we show that Bertrand and Cournot equilibrium have different convergence properties when the market is replicated. The Cournot equilibrium price converges to the competitive price. Under very typical and somewhat general conditions, the highest Bertrand equilibrium price converges to one higher than the competitive equilibrium. We also give examples to show how to compute the limit of the highest Bertrand equilibrium prices and illustrate the ideas of the proof. We explore conditions under which the supply curve is upward sloping, a useful condition for our results. Received: April 20, 2000; revised version: May 10, 2001     

On the effects of rare disasters and uncertainty shocks for risk premia in non-linear DSGE models

This paper studies how rare disasters and uncertainty shocks affect risk premia in DSGE models approximated to second and third order. Based on an extension of the results in Schmitt-Grohé and Uribe (2004) to third order, we derive propositions for how rare disasters, stochastic volatility, and GARCH affect any type of risk premia in a wide class of DSGE models. To quantify the effects, we set up a standard New Keynesian DSGE model where total factor productivity includes rare disasters, stochastic volatility, and GARCH. We find that rare disasters increase the level of the 10-year nominal term premium, whereas a key effect of uncertainty shocks, i.e. stochastic volatility and GARCH, is an increase in the variability of this premium.     

Economic uncertainty,monetary uncertainty and the Korean demand for money

Economic uncertainty and monetary uncertainty are said to affect public’s holding of money in either direction. In this paper, we consider the Korean demand for money, and after including two GARCH-based measures of output uncertainty and monetary uncertainty, we show that both measures exert significant effects on the demand for money in Korea in the short run. However, only the adverse effects of output uncertainty lasts into the long run. Indeed, including the two uncertainty measures yield a stable demand for money in Korea.     

Endogenous factor market distortion, risk aversion, and international trade under input uncertainty

In the context of non-diversifiable and sector-specific risks in labour markets, we show that the resulting factor market distortion – attributable to an endogenous intersectoral wage differential – can provide a possible rationale that explains why larger wage dispersion prevails in developing nations. We also demonstrate how endogenous wage distortions spill over to capital markets, with capital-poor economies offering lower rates of returns. In addition, we show that inequality in the distribution of wealth further deviates factor allocation away from first-best and impairs intersectoral mobility of the poor.
Ce mémoire montre que la distorsion dans le marché des facteurs qui résulte de risques non diversifiables et spécifiques à certains secteurs (et qui se traduit par un différentiel de salaire endogène entre secteurs) peut expliquer pourquoi on observe une dispersion plus grande des salaires dans les pays en voie de développement.On montre aussi comment des distorsions endogènes de salaires débordent vers les marchés de capitaux,ce qui fait que les pays pauvres en capital ont des rendements plus faibles.De plus, on montre que l'inégalité dans la distribution de la richesse contribue à faire dévier l'allocation des ressources de son optimum de premier ordre et nuit à la mobilité inter-sectorielle des pauvres.     

On the stability of the constant relative risk aversion (CRRA) utility under high degrees of uncertainty

Growth models under uncertainty and constant relative risk aversion (CRRA) utility are fragile in explaining consumers’ choice, as equilibrium consumption is dependent on distributional assumptions. We show that, under semi-nonparametric distributions, general equilibrium models are stable, as the existence of expected utility is guaranteed.